Regulators are turning up the heat on companies looking to cashin on the cryptocurrency craze.

Major media outlets recently reported that the U.S. SecuritiesExchange Commission (SEC) has issued dozens of subpoenas andinformation requests to companies, investors, and advisers engagedin cryptocurrency-related activities. The SEC's probe followsrepeated warnings that many token sales, commonly referred to asinitial coin offerings, or ICOs, may be violating securities laws.This activity signals the agency's intention to thoroughlyscrutinize ICOs.

Regulators are now taking a more active role in investigatingnot just ICOs but also the companies developing funds or otherinvestment vehicles focused on cryptocurrencies.

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Before the Storm: Repeated Warnings by Regulators

Through late 2017, one of the world's most popularcryptocurrencies, bitcoin, experienced a meteoric rise in valueof nearly 2,000 percent. However, from late December 2017 throughFebruary 2018, more than 60 percent of that value was lost,including a one-day drop of 25 percent on Jan. 16, 2018. Then onJanuary 18, the SEC's Division of Investment Management issued anopen letter to two industry associations expressing concerns about“a number of significant investor protection issues” arising fromcryptocurrency-related funds, including valuation, liquidity,custody, arbitrage, manipulation, and related risks. From Jan. 26,2018, to Feb. 5, 2018, bitcoins' value plummeted another 36percent. As of April 2, 2018, bitcoins were trading on populartrading platforms for around $7,000. This is its lowest price sincethe beginning of the surge from mid-November of last year.

Although regulators have repeatedly emphasized the potentialbenefits of blockchain or distributed ledger technology(DLT) in the financial services industry, they havesimultaneously expressed concern about blockchain's lack oftransparency and potential for fraud. For example, on Feb. 6, 2018,U.S. Commodities Future Trading Commission (CFTC) Chairman J.Christopher Giancarlo testified that “DLT is likely to have a broadand lasting impact on global financial markets in payments,banking, securities settlement, title recording, cybersecurity, andtrade reporting and analysis,” and that “[w]hen tied to virtualcurrencies, this technology aims to serve as a new store of value,facilitate secure payments, enable asset transfers, and power newapplications.” At the same time, Chairman Giancarlo cautioned that“[v]irtual currencies … likely require more attentive regulatoryoversight in key areas, especially to the extent that retailinvestors are attracted to this space.”

During the same hearing, SEC Chairman Jay Clayton testified thathe was “very optimistic that developments in financial technologywill help facilitate capital formation,” but he also cautioned that“promoters of ICOs and cryptocurrencies” were creating “significantrisks” by failing to comply with securities laws. Citing a July2017 SEC report, Chairman Clayton stated that the “Commission'smessage to issuers and market professionals in this space wasclear: Those who would use [DLT] to raise capital or engage insecurities transactions must take appropriate steps to ensurecompliance with the federal securities laws.”

In addition, Chairman Clayton warned that focusing on the“utility” or “voucher-like characteristics” of a proposed ICO doesnot necessarily allow the tokens or coins to avoid securitiesregulation. Crypto companies and investors should expect the SEC toapply the U.S. Supreme Court's Howey test to ICOactivities. That test provides that a transaction is a security ifit involves an investment of money in a common enterprise with areasonable expectation of profits to be derived from theentrepreneurial or managerial efforts of others.

Clayton's testimony followed similar remarks delivered at theSecurities Regulation Institute on Jan. 22, 2018, in which hewarned that SEC staff have been instructed “to be on high alert forapproaches to ICOs that may be contrary to the spirit of oursecurities laws.”

In summary, both SEC Chairman Clayton and CFTC ChairmanGiancarlo have emphasized their agencies' mandates to enforcecurrent laws to protect investors.

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Lightning Strikes: SEC/CFTC Enforcement and RelatedActivity

According to reports, the SEC has issued subpoenas and documentrequests to dozens of cryptocurrency issuers, advisers, exchanges,and investors in recent months seeking information about the saleand structure of ICOs. The long list of demands includes not onlydetails about organizational structures and funds raised, but alsoinvestor information, marketing materials, and the geographiclocations of those involved in the business.

Meanwhile, the SEC is also acting quickly to prevent companiesthat are not complying with the securities laws from proceedingwith ICOs. For instance, in December 2017, the SEC halted a $15 million ICO by a California-basedsocial-networking restaurant review app. The SEC order cited themanner of sale as well as the investment intent of purchasers ofthe coin in its determination that the ICO was an impropersecurities offering.

The SEC is also targeting those who are improperly attempting tocash in on the cryptocurrency craze through fraudulent or deceptiveschemes. In late January 2018, the SEC obtained acourt order halting a Texas-based bank from proceeding with anICO and accused the company, as well as its executives, ofmisleading investors about plans to acquire a federally insuredbank. The bank used social media, a celebrity endorsement, andother tactics to raise $600 million of its $1 billion goal in justtwo months. The SEC accused the bank and its executives of engagingin an “outright scam” by “misrepresenting the company as afirst-of-its-kind decentralized bank offering its owncryptocurrency to be used for a broad range of customer productsand services.” The SEC cautioned that while this was “the firsttime the Commission has sought the appointment of a receiver inconnection with an ICO fraud,” the SEC would continue to use “allof [its] tools and remedies to protect investors from those whoengage in fraudulent conduct in the emerging digital securitiesmarketplace.”

Earlier this month, on April 2, 2018, the SEC filed acomplaint against the co-founders of a financial servicesstartup for an allegedly fraudulent ICO that raised more than $32million from thousands of investors. The complaint alleges that theco-founders violated the anti-fraud and registration provisions offederal securities laws. According to an SEC press release, theco-founders “us[ed] a sophisticated marketing campaign to spin aweb of lies about their supposed partnerships with legitimatebusinesses” and promoted their ICO by “creat[ing] fictionalexecutives with impressive biographies,” “post[ing] false ormisleading marketing materials” online, and paying “celebrities totout the ICO on social media.”

Most recently, on April 6, 2018, the SEC obtained a courtorder freezing more than $27 million in trading proceedsassociated with a Delaware-based financial technology company. TheSEC accused the company and four of its executives of violatingsecurities laws by selling restricted shares of its stock followingits acquisition of a “purported cryptocurrency business” that had“no ascertainable value” but caused the company's stock price torise dramatically.

In addition to shutting down unregistered or fraudulentofferings, the SEC is also proactively seeking information from themarket, including looking at specific participants. On March 1,2018, for example, a publicly listed online retailer disclosed thatit had received an SEC voluntary document request related topreferred equity tokens being offered by one of its newly formedsubsidiaries which focuses on cryptocurrency. The companyacknowledged the SEC request in its public filing and stated thatit would cooperate with the investigation. Although the retailerraised over $200 million in its ICO, the company has yet to issueany tokens and has yet to provide any assurances that such tokenswill be issued.

In another example, on March 2, 2018, the founder of a majortechnology blog acknowledged that the SEC subpoenaed him as a partof its investigation into cryptocurrency offerings. The founderstated that the subpoena concerned “a deal [he] invested in lastsummer” and that he was “terrified” by the fact that the SEC “isgoing after not just the companies but the investors.”

Similarly, over the past several months, the CFTC has filedseveral enforcement actions against individuals and companies forpotential fraudulent activity, among them:

• Jan. 16, 2018: An enforcement actionunder seal against severalindividuals and a Las Vegas corporation for misappropriatingmore than $6 million from customers. According to the complaint,the company at issue maintained a website and distributedsolicitation materials for investing in a virtual currency thatincluded misrepresentations. Customer funds were allegedlytransferred into personal bank accounts and used to purchase luxurygoods.

• Jan. 18, 2018: An enforcementaction against a Colorado-basedindividual and his U.K.-registered company for using a websiteto solicit customers to deposit bitcoins for a pooled investment inbinary options trading with a promise of high returns. Thecomplaint accuses the defendants of making Ponzi-style payments tocommodity pool participants from other participants' funds,misappropriating funds, and failing to properly register with theCFTC.

• Jan. 18, 2018: A civil enforcementaction against a NewYork-based individual and New York-based company for fraud andmisappropriation in connection with the purchase and trading ofbitcoins and litecoins, and providing purported “virtual currencytrading advice.” The complaint accuses the defendants of notfollowing through on their promise to provide advice or make therequested purchases and trades. According to the CFTC, thedefendants “used their fraudulent solicitations to obtain and thensimply misappropriate customer funds.” On March 6, 2018, a New Yorkfederal judge issued a preliminary injunction prohibiting the defendants from engagingin fraud in violation of the Commodity Exchange Act (CEA) andrequiring them to preserve their books and records. Even morenotably, the judge's order concluded that “[v]irtual currencies canbe regulated by CFTC as a commodity” because they “are goodsexchanged in a market for a uniform quality and value, and fallwithin the CEA's definition of 'commodities' as 'all other goodsand articles … in which contracts for future delivery are presentlyor in the future dealt in.'”

These enforcement actions appear to be the beginning of a majorcampaign to regulate this market and are consistent with the trendof increased monitoring and enforcement by the CFTC.

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The Forecast Ahead: More Enforcement Activity

We anticipate that regulators will continue to scrutinizepotentially fraudulent and deceptive practices related to the sale,exchange, marketing, and promotion of cryptocurrencies throughout2018. This is evidenced by the following:

• The SEC has increased its resourcesdedicated to cryptocurrency-related activity, including thecreationof a Cyber Unit that is investigating ICO-relatedmisconduct.
• The SEC recently establisheddedicated “cyber liaisons” in regional offices to bolster itsenforcement coordination efforts.
• The federal government has developeda cross-agency “DLT Working Group” that includes the SEC, CFTC,Department of Treasury, and various U.S. Attorney's Offices tocoordinate on investigations and enforcement activity.

During remarks at the 2018 SEC Speaks conference, former SECCommissioner Dan Gallagher cautioned that “we are seeing the tip ofthe iceberg” and “there is going to be a ton of enforcementactivity.” Gallagher warned that unregulated token offerings arethe “Wolf of Wall Street on steroids.”

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Weathering the Storm

While SEC Co-Director of the Division of Enforcement StephanieAvakian has praised blockchain technology as having “real benefitand promise” and offered assurances that the SEC is “not looking tostifle innovation or lawful and appropriate capital raising” (inher Panel Remarks at the 32nd Annual National Institute onWhite Collar Crime—Feb. 28, 2018), cryptocurrency companies arefacing a barrage of scrutiny from federal regulators. Suchcompanies should therefore chart a strategy for navigating theincreasingly precarious regulatory and enforcement landscape. Thoseseeking to participate in this brave new world, whether they havealready completed a token generation event or are hard at work tocreate one, should be ready to structure their offerings incompliance with existing law.

Hedge funds—which invested approximately $2 billion incryptocurrencies last year—should also be prepared to respond totough questions from regulators. Recent reports suggest that theSEC is preparing to examine at least 100 crypto-focused private fund managers on topicsranging from the accuracy of their risk disclosures to potentialconflicts of interest.

In addition to federal regulatory activity, companies shouldmonitor state law developments. For instance, Wyoming recentlysigned into law House Bill 70,commonly referred to as the Utility Token Bill, which defines“utility tokens” in a manner that can exclude them from Wyomingstate securities laws. Although such legislation does not directlyimpact federal law, it suggests that state regulators may have adifferent approach to cryptocurrency regulation.

Other states, however, have taken the position that tokens aresecurities, and are aggressively regulating ICO activity. Forinstance, in late March 2018, the Enforcement Section ofMassachusetts' securities regulator ordered five companies toimmediately halt the offering and selling of “unregisteredsecurities” through ICOs and offer rescission for anything alreadypurchased. The regulator accused the firms of promoting coins andtokens that were not properly registered as required by state law.Massachusetts Secretary of State William Galvin has warned that“[a]n offering done to avoid registration with regulators should beseen as a red flag” and described the consent orders as part of an“aggressive sweep” to police the cryptocurrency industry.

Given recent developments, those active in the cryptocurrencyspace should operate under the assumption that their products,services, offerings, and activities may be subject to regulatoryreview. Prudence suggests that planning ahead—and anticipatinggovernment scrutiny—will help in weathering the storm.

Benjamin Klein is an associate,Deborah Meshulam is a partner, andJason Chang is of counsel at DLAPiper.

From: New York Law Journal