By: Allen Kogan

Since their dramatic rise in popularity, cryptocurrencies have taken center stage in a jurisdictional power-struggle between U.S. regulators.[1]  Faced with claims of cryptocurrency-related fraud, the Securities & Exchange Commission (“SEC”) and the Commodities Futures Trading Commission (“CFTC”) have risen to the forefront of the fight to regulate virtual currency investments and derivatives.[2]  The CFTC established its jurisdiction over Bitcoin-related fraud in federal court earlier this year when the Eastern District of New York deemed Bitcoin a commodity subject to federal commodities laws.[3]  Notably, however, that case involved a pro se defendant, and other jurisdictions have already challenged the court’s ultimate application of commodities laws without specific allegations of market-manipulation.[4]

This year, the SEC strengthened its resolve to regulate “Initial Coin Offerings” (“ICOs”), or crowd-funding projects for tokens on emerging blockchain networks, as securities.[5]  During this time, ICOs have already raised about $18.7 billion.[6]  In March, SEC Chairman Jay Clayton warned that his agency will strongly pursue ICO-related violations of US securities laws, which he believes are wide-spread.[7]  Until now, most federal criminal cases involving virtual currency transactions focused on the use of cryptocurrencies for money laundering, and only civil cases directly considered classifying cryptocurrencies as securities.[8]

On September 11, 2018, in the first federal action against an ICO issuer brought under US securities laws, a federal court held that ICOs may meet the legal definition of “investment contracts” and may therefore fall within the SEC’s jurisdiction.[9]  The case involves Maksim Zaslavskiy, a Brooklyn business-man charged with conspiracy and two counts of securities fraud for his involvement in two ICOs which allegedly defrauded investors.[10]  Federal prosecutors allege that, despite advertising their tokens as backed by real-world real estate and jewelry holdings, the ICOs had no asset-backing of any kind.[11]  If convicted, Mr. Zaslavskiy faces up to five years’ imprisonment, a fine, or both.[12]

Mr. Zaslavskiy moved to dismiss the government’s complaint, arguing that the ICOs at issue are “exchanges of currency” rather than securities, and that federal securities laws are too vague to put him on notice of their application to his allegedly fraudulent conduct.[13]  The court denied Mr. Zaslavskiy’s motion and found that the case should move forward to trial.[14]  In doing so, the court held that, because Congress’ purpose for creating securities laws was to regulate investments in any form they appear, Mr. Zaslavskiy’s labeling of the ICOs at issue is irrelevant.[15]  The court then applied the Supreme Court’s Howey test for classifying securities and found that, because the ICOs at issue may satisfy each of Howey’s four factors, they may be investment contracts subject to federal securities laws.[16]  The court noted, however, that while allegations in the indictment would support this finding, whether these ICOs are in fact securities is ultimately a question for the finder of fact.[17]

Both Eastern District of New York decisions dealing with cryptocurrency classifications are bound to significantly impact developers, investors, and users.  Primarily, developers and ICO issuers must, for the first time, consider whether to register under SEC guidelines before releasing their tokens to the public.  Given that the Zaslavskiy decision is only a pre-trial ruling on an issue of first-impression and leaves the ultimate decision to the fact-finder, developers must weigh the risks of failing to register their ICOs and complying with securities laws against the significant complexities and costs of doing so.[18]  Similarly, financial institutions and investment advisors must now consider impacts of federal commodities laws on their offerings, and whether to comply with CFTC regulations in the face of Monex Credit Co., which specifically required allegations of market-manipulation.[19]  The impact on individual users, however, is the most clear: federal regulators are finally clamping down on cryptocurrency-related fraud on multiple fronts and, as a result, will likely reduce many of the risks currently associated with investing in the largely unregulated cryptocurrency market.[20]

 

[1] Kate Rooney, Your Guide to Cryptocurrency Regulations Around the World and Where They Are Headed, CNBC (Mar. 27, 2018, 6:00 AM), https://www.cnbc.com/2018/03/27/a-complete-guide-to-cyprocurrency-regulations-around-the-world.html.

[2] See Trevor Dodge, SEC and CFTC Chairmen Testify Before Senate on Cryptoasset Regulation, Proskauer (Mar. 22, 2018), https://www.blockchainandthelaw.com/2018/03/sec-and-cftc-chairmen-testify-before-senate-on-cryptoasset-regulation/ (discussing recent Senate testimony by SEC’s and CFTC’s respective chairmen).

[3] Commodity Futures Trading Comm’n v. McDonnell, 287 F. Supp. 3d 213, 230 (E.D.N.Y. 2018).

[4] Commodity Futures Trading Comm’n v. Monex Credit Co., 311 F. Supp. 3d 1173, 1189 n.12 (C.D. Cal. 2018).

[5] See Stephen O’Neil, SEC, CFTC, IRS and Others: A Guide to US Regulating Bodies, Coin Tel. (May 26, 2018), https://cointelegraph.com/news/sec-cftc-irs-and-others-a-guide-to-us-regulating-bodies (discussing SEC efforts to regulate ICOs); see also generally Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Sec. & Exch. Comm’n (July 25, 2017), https://www.sec.gov/litigation/investreport/34-81207.pdf (outlining the SEC’s legal basis for regulating ICOs as securities under Howey).

[6] Patricia Hurtado et al., US Judge Says Initial Coin Offering Covered by Securities Law, Bloomberg (Sept. 11, 2018, 5:43 PM), https://www.bloomberg.com/news/articles/2018-09-11/u-s-judge-says-initial-coin-offering-covered-by-securities-law (noting year-to-date ICO sales as of September 11, 2018).

[7] Dodge, supra note 2.

[8] Bochan Kim, New York Federal Court’s View on Cryptocurrency as Securities, The Nat’l L. Rev. (Sept. 27, 2018), https://www.natlawreview.com/article/new-york-federal-court-s-view-cryptocurrency-securities (citing United States v. Mansy, 2:15-CR-198, 2017 WL 9672554 (D. Me. May 11, 2017); United States v. Budovsky, 13-CR-368, 2016 WL 386133, at *1 (S.D.N.Y. Jan. 28, 2016)).

[9] See id. (citing United States v. Zaslavskiy, No. 17-CR-647, 2018 WL 4346339 (E.D.N.Y. Sept. 11, 2018)).

[10] Hurtado, supra note 6.

[11] See id. (discussing federal charges against Zaslavskiy).

[12] Brooklyn Businessman Charged with Fraud in Connection with Two Initial Coin Offerings, U.S. Dep’t of Just. (Nov. 1, 2017), https://www.justice.gov/usao-edny/pr/brooklyn-businessman-charged-fraud-connection-two-initial-coin-offerings.

[13] United States v. Zaslavskiy, No. 17-CR-647, 2018 WL 4346339, at *1 (E.D.N.Y. Sept. 11, 2018).

[14] Id. at *5 (internal citations omitted).

[15] Id. at *7 (citing Sec. & Exch. Comm’n v. Edwards, 540 U.S. 389, 393 (2004); United Hous. Found., Inc. v. Forman, 421 U.S. 837, 848 (1975)).

[16] See id. (citing Sec. & Exch. Comm’n v. W.J. Howey Co., 328 U.S. 293, 297 (1946)).

[17] Id. at *4.

[18] Id.; see also generally Robert Rosenblum et al., Regulation A+ Offerings for Tokens: What is the SEC Waiting For?, Harv. L. Sch. F. on Corp. Governance & Fin. Reg. (Sept. 26, 2018), https://corpgov.law.harvard.edu/2018/09/26/regulation-a-offerings-for-tokens-what-is-the-sec-waiting-for/ (discussing ambiguities in registering ICOs under federal securities laws).

[19] Commodity Futures Trading Comm’n v. Monex Credit Co., 311 F. Supp. 3d 1173, 1189 n.12 (C.D. Cal. 2018).

[20] See generally Peter I. Altman et al., Increased SEC Enforcement Action and Litigation in the Cryptocurrency Space, Akin Gump Strauss Hauer & Feld LLP (Sept. 18, 2018), https://www.akingump.com/en/experience/practices/corporate/ag-deal-diary/increased-sec-enforcement-action-and-litigation-in-the.html (reporting on recent SEC enforcement actions against alleged ICO-related fraud).