SEC statement on digital asset securities issuance and trading
The US Securities and Exchange Commission (SEC) issued a statement on 16 November 2018 on digital asset securities issues and trades, reminding market participants to comply with US federal securities law when dealing with technological innovations such as blockchain. We have previously commented that actions by the SEC may serve as an example of approaches that may be taken by regulators, including by the Australian Securities and Investments Commission (ASIC).
The SEC statement broadly outlines the SEC’s approach to blockchain enabled sales of digital asset securities, investment vehicles and secondary market trading and details recent enforcement actions by the SEC.
A full copy of the SEC’s statement is available here.
For issuers of digital asset securities, the SEC has stated that there is a path to compliance with US federal securities laws, even where issuers have conducted an illegal, unregistered offering of digital asset securities. The primary questions which need to be addressed are:
Where issuers offer digital asset securities illegally, the SEC may take remedial measures to ensure compliance. The most recent examples of this are the orders made against AirFox and Paragon. AirFox is a peer-to-peer lending financial services program which raised approximately $USD15 million to finance development of its digital ecosystem. Paragon raised approximately $USD12 million in an effort to implement its business of adding blockchain technology to the cannabis industry. Both AirFox and Paragon conducted their Initial Coin Offerings (ICOs) in 2017 after the SEC had issued warnings that ICOs can be securities offerings, and neither registered their ICOs pursuant to securities laws.
Pursuant to the orders, AirFox and Paragon will pay penalties, register their tokens as securities in accordance with the US legislation and file periodic reports with the SEC. The orders also require AirFox and Paragon to compensate investors who purchased tokens in the illegal offerings if an investor elects to make a claim.
Notably, these are the first instances where the SEC has imposed civil penalties solely for ICO registration violations. Prior to this, action had been taken against ICOs on the basis of misleading or deceptive conduct by the issuer.
Action has also been taken by the SEC against digital asset securities investment vehicles.
In September 2018, the SEC issued an order against Crypto Asset Management, a fund which invested, held and traded digital assets which were investment securities. The order found that the manager of Crypto Asset Management had formed the fund for the purposes of investing in digital assets and had failed to register the fund as an investment company. The fund operated as a pooled investment vehicle and was required to comply with the regulatory framework for investment companies, even when the securities invested are digital assets.
Subsequently, the SEC warned that investment vehicles that hold digital asset securities and those who advise others about investing in digital asset securities must be aware of their registration, regulatory and fiduciary obligations.
Finally, the SEC has stated that secondary market trading of digital asset securities is also a regulated action.
Platforms that offer trading in digital asset securities and operate as an “exchange” must register with the SEC as a national securities exchange or be exempt from registration. EtherDelta is an example of the enforcement action that the SEC may take in this area.
In November 2018, the SEC charged the founder of EtherDelta, a decentralised trading platform, with operating an unregistered securities exchange. The exchange operated by way of an order book, website which displayed orders, and smart contract run on the Ethereum blockchain. The smart contract was coded to validate order messages, confirm the terms and conditions of orders, execute paired orders and direct the distributed ledger to reflect a trade.
In its statement, the SEC noted that an entity which provides a marketplace for bringing together buyers and sellers of securities, regardless of the applied technology, must adopt a functional approach to determine whether its activities meet the definition of an exchange. It is the activity that occurs between the buyers and sellers which determines whether the system operates as a marketplace.
In addition to potential exchange registration requirements, entities that facilitate the issuance of digital asset securities in ICOs and secondary trading in digital asset securities may also be acting as a “broker” or “dealer” and be required to register with the SEC.
The SEC recently applied its broker-dealer registration requirements to digital asset securities transactions and made an order against TokenLot.
TokenLot was an ICO broker which allowed investors to purchase digital assets during or after an ICO, including in private sales and pre-sales. As part of its activities, TokenLot marketed and facilitated the sale of digital assets, accepted orders and payments, and disbursed the proceeds to the issuers. As TokenLot was regularly purchasing and reselling digital tokens, it was a broker-dealer which required registration with the SEC.
The SEC decisions are a prime example of the regulatory actions that can be taken where issuers and dealers of digital assets do not comply with applicable legislation and are significant in signalling to US based ICO hosts what conduct will not be tolerated.
ASIC has already stated that action is being taken in Australia to halt ICOs due to the operation of illegal unregistered managed investment schemes, use of misleading or deceptive statements, and failures to hold an Australian Financial Services Licence when required. We have yet to see further statements made on digital asset trading in this jurisdiction. If you are considering trading in digital assets, you should obtain advice about whether or not there are obligations under the Corporations Act 2001 or the general law in Australia which may apply.
For more information, please contact our Digital Assets team.