FinTech and Regulation: BitBlog Weekly Update October 29, 2019
This BitBlog summary focuses on the continuing actions by the U.S. Securities and Exchange Commission (“SEC”) against the issuers of noncompliant initial coin offerings (“ICOs”) and other crypto related transactions including the largest settlement to date, a letter written by the SEC stating that Bitcoin is not a security, a default judgment against a cryptocurrency company accused of supplying false information to obtain qualification under the Regulation A+ securities registration and the rejection of a Bitcoin ETF (exchange traded fund). This summary also covers a new crypto guidance issued by Hong Kong, the launch of a cryptocurrency self-regulatory organization, continued skepticism by foreign regulators over crypto currency and more.
The SEC Reached a $24 Million Settlement with Multi-Billion Dollar ICO Issuer
Another BitBlog summary means another SEC-ICO settlement. In by far the largest crypto related settlement and resulting fine, the SEC announced it had settled with EOS creator, Block.one in connection with the ICO of its EOS token between June 2017 and June 2018. Block.one’s ICO purportedly raised the equivalent of a billion dollars in digital assets through selling the EOS digital token around the world.
On September 30, 2019 Block.one agreed to pay a $24 million civil penalty to resolve claims that the EOS tokens were sold as securities through Block.one without a registration or an exemption from registration under the Securities Act of 1933 (the “Securities Act”). Although Block.one’s Token Purchase Agreement for EOS purportedly included provisions prohibiting U.S. persons from buying the tokens, they rigorously advertised the token sale in the U.S. at blockchain conferences and via a billboard advertisement in Times Square in May 2017. The settlement with Block.one has led to significant debate with some taking the view that this settlement was too harsh given that $24 million is the largest fine to date for an improper crypto offering. The penalty is not without precedent as the SEC has repeatedly taken actions against issuers that have used ICOs. It is important to note that the SEC specified that Block.one sold these tokens after the agency issued its DAO Report stating that most token sales are likely to be securities. The SEC has taken the position the DAO Report put the industry on notice as to the legality of ICOs and that issuers that fail to comply with the Securities Act will face sanctions.
The SEC has No Interest in Regulating Bitcoin as a Security
In response to a registration statement filed by Cipher Technologies Bitcoin Fund, the SEC responded in writing that it did not believe Bitcoin was a security. Although the SEC has given many indications that it does not consider Bitcoin to be a security, this was the first published statement by the agency that Bitcoin was not a security for purposes of the Investment Company Act of 1940. In a short reply, which does not constitute a legally binding precedent, the SEC provided some important guidance that under the reasoning of SEC v. Howey (“Howey”), the seminal Supreme Court case for determining if something is a security, noting:
"current purchasers of Bitcoin are not relying on the …. efforts
of others to produce a profit. Accordingly, because Cipher intends
to invest substantially all of its assets in Bitcoin as currently structured,
it does not meet the definition of an ‘investment company’ under the Investment Company Act."
The SEC’s statement that “current purchasers” is reminiscent of the statement by the Director of the SEC Division of Corporation Finance last year that Ether as of the date of his speech was not a security. These statements indicate that the SEC is looking at the current status of a token rather than when it was first issued.
Also noteworthy is that the SEC did not limit itself to the strict application of the Howey test.The SEC noted that if Bitcoin were a security, it would, “raise substantial other issues” because Bitcoin would then be an, “unregistered publicly-offered security.”
CFTC Considers Ether to be a Commodity
Heath Tarbert, chairman of the Commodity Futures Trading Commission (“CFTC”), formally stated that the CFTC considers Ether to be a commodity under its regulations. Commissioner Tarbert’s statement at Yahoo Finance’s All Markets Summit in New York City, follows a request made by the CFTC last year to market participants for information to, “better inform the Commission’s understanding,” of Ethereum network. While not providing any certainty, Chairman Tarbert indicated that the CFTC would likely treat digital assets created, though a replication or copying of an existing blockchain into a new network, called a “fork”, in the same manner as it treats the original legacy network unless there is a security law reason to consider it otherwise.
SEC Rejects Bitcoin Bitwise ETF
The SEC recently rejected the application of Bitwise Asset Management to launch an exchange traded fund (“ETF”) that invests in Bitcoin on the NYSE Arca Exchange. A Bitcoin ETF would allow retail investors an easy way to invest in Bitcoin and if successful would also demonstrate institutional and regulatory confidence in Bitcoin. The SEC does not appear ready to approve such an ETS.The basis for this rejection is concern over price manipulation. A statement from the SEC noted:
"[the SEC] “is disapproving this proposed [ETF] because . . . NYSE Arca has not met its burden under the Exchange Act and the [SEC]’s Rules of Practice to demonstrate that its proposal is consistent with . . . the requirement that the rules of a national securities exchange be 'designed to prevent fraudulent and manipulative acts and practices.'”
While the SEC supports the development of Bitcoin and ETFs, it has concerns the market is sufficiently secured against manipulation to be sold to retail investors.
The rejection of the proposed Bitcoin ETF suggests the agency is concerned about potential market manipulation in the trading of Bitcoin.
Although the SEC raises legitimate concerns about manipulation of Bitcoin, advocates for Bitcoin ETFs argue the best way to reduce manipulation would be to bring in more “real investors,” such as through a Bitcoin ETF. It is also worth noting that the SEC has approved ETFs for other commodities, such as oil, for which pricing is often far from open and transparent.
The SEC Obtained a $6.8 Million Default Judgment against Company Accused of Fraudulently Obtaining Qualification Under Reg A+
The U.S. District Court for the Southern District of New York entered a default judgment against Longfin Corp., on claims made by the SEC that Longfin and its CEO, Venkata S. Meenavalli, conducted a fraudulent public offering. Longfin, which traded on the Nasdaq and reached a market cap in excess of $3 billion, had promoted its own cryptocurrency before shuttering last November. The SEC asserted that Longfin sought qualification for a Regulation A+ offering by lying in SEC filings about where the company was operated. Longfin had claimed in filings that its principal operations were in the U.S. when, in reality, the company’s operations, assets and management were located elsewhere. The SEC also alleged that Longfin falsified the number of shareholders and shares sold in its offering to meet Nasdaq listing requirements and that Longfin and Meenavalli used sham transactions to fake more than $66 million in revenue.
This most recent civil enforcement action is not the first by the SEC against Longfin and Meenavalli. The SEC had previously sued Longfin, Meenavalli, and three other individuals in connection with the illegal distribution and sale of more than $33 million in Longfin stock. In August 2019, the court in the prior case entered default judgment against Longfin and Meenavalli in the amount of $284,139 and $28,416, respectively. There is also a criminal action pending against Meenavalli in the United States District Court for the District of New Jersey.
The Longfin matter is noteworthy for the size of the scam (and resulting default judgments) and also for the fact that Longfin managed to mislead regulators to obtain a qualification under Regulation A+ and subsequently obtain a listing on a U.S. stock exchange.
The SEC Press Release can be found here.
Hong Kong Regulator Issues Guidance for Money Managers
On October 4, the Hong Kong Securities and Futures Commission (“SFC”) issued formal guidance for fund managers investing in “virtual assets.” The guidance provides a fairly compressive guide for managers wishing to trade in these assets in Hong Kong. Among the most important of these rules, and echoing the global concern about custody of digital assets, is a requirement that the digital assets be functionally separate from other assets with an apparent preference for a third party custodian.
ECB President Says Cryptocurrencies No Substitute for Money
Central bankers and government regulators continue to express skepticism over cryptocurrencies this week. The latest banker to question the utility of cryptocurrencies was Mario Draghi, the influential president of the European Central Bank (“ECB”). Draghi specifically addressed so-called stablecoins, which are digital tokens with values tied to other, stable assets such as U.S. dollars. In a letter to Eva Kaili, a European lawmaker, Draghi noted that stablecoins have popular appeal because of their lower levels of volatility and backing by established tech companies, such as Facebook, which has announced its own stablecoin, Libra. Draghi warned, however, that stablecoins are not a suitable replacement for money in the areas of monetary policy, market infrastructures and financial system stability. He stated that “stablecoins and crypto-assets have had limited implications in these areas.” Despite his skepticism, Draghi tried to strike a conciliatory note by saying that the ECB’s current, dour opinion is digital assets may change in the future due to the rapid pace of technology and changing business models.
Will central bankers ever warm to cryptocurrencies? It seems unlikely unless and until the bankers can figure out a way to gain a measure of control over their use in monetary policy and markets.
A copy of the settlement order can be found here.