By: Antonio Andrés Franco
Congress enacted the federal securities laws in the 1930s to address information asymmetry issues in the nation’s capital markets.[1] However, since passing the Securities Act and Exchange Act, Congress has discovered new patterns of securities fraud and responded by enacting legislation broadly enhancing the enforcement authority of the Securities and Exchange Commission (SEC).[2] Ultimately, the SEC aims to: 1) protect investors; 2) maintain fair, orderly, and efficient markets; and 3) facilitate capital formation. Under its statutory mandate, the SEC promulgates rules that “[t]he agency believes are needed.”[3] Until recently, the SEC has been unclear whether it believes cryptocurrencies should be subject to the same regulations as securities.
The media has paid significant attention to cryptocurrencies in the past year. Although the jury is still out whether cryptocurrencies, like Bitcoin, are subject to federal regulation, “crypto” investors would be remiss if they did not consider the implications of regulation.[4] South Korea, for one, has taken significant steps in recent weeks to formally regulate cryptocurrencies.[5] Among U.S. regulators, the SEC has also recently indicated that cryptocurrencies and initial coin offerings (ICOs) may be securities, and thus within its regulatory jurisdiction.[6] Although courts have not decided many cases involving cryptocurrencies, it appears that at least some cryptocurrencies meet the common-law’s definition of a security.
To determine if a financial instrument is a security, the Supreme Court has held that an investment must involve: 1) a person’s monetary investment; 2) in a common enterprise; 3) made with the expectation to profit; and 4) solely from the efforts of the promoter.[7]
In SEC v. Shavers, the court held without reservation that the defendant’s bitcoin scheme involved the sale of unregistered securities.[8] In Shavers, the defendant attracted $30 million, purporting to trade bitcoin against the U.S. dollar. In Shin v. Time Squared LLC, investors were defrauded through a bitcoin mining scheme.[9] The investors were promised daily revenue from ASIC chip leases for cryptocurrency mining; ASIC chips are used to create bitcoins. In fact, the defendants did not design or produce ASIC chips. In U.S. v. Faiella, the defendants sold bitcoins to investors through a “money transmission service.”[10] To purchase bitcoins, customers sent cash deposits to the defendant, who then deposited purchased bitcoins in customer accounts.[11]
- A Person Invests Their Money
In Shavers, Shin, and Faiella, all of the cryptocurrency investors paid cash. In Shavers, multiple parties invested millions of dollars in the defendant’s bitcoin trading scheme.[12] In Shin, the investors bought ASIC chip leasing rights in exchange for a one-time payment.[13] In Faiella, Silk Road customers bought bitcoins with cash deposits.[14]
- In a Common Enterprise
In Shavers, the investors bought interests in the defendant’s fraudulent fund, the Bitcoin Savings and Trust (BTCST), which the defendant managed from a “main operating wallet.”[15] In Shin, the defendant’s company, Time Squared LLC, pooled investor capital by soliciting investments through the company website.[16] Similarly, the defendant’s website in Faiella was the exclusive vehicle for managing customer’s bitcoins.[17]
III. Led to Expect Profits
In Shavers, the investors were promised weekly returns of 7% for their investment in BTCST.[18] In Shin, the investors were promised daily revenue from their investment in bitcoin mining leases.[19] In Faiella, the expected profit is less apparent although not altogether absent, because many Silk Road users purchased bitcoins to facilitate separate profit-seeking transactions.[20]
- Solely From the Efforts of Another
In Shavers, the investors expected returns from the efforts of BTCST traders.[21] In Shin, similarly, the promoters told investors that Time Squared LLC manufactured and leased ASIC chips to bitcoin miners.[22] And, in Faiella the customers believed that the defendant would exclusively manage their bitcoin credit accounts, at no additional cost to their initial purchase.[23]
- Leveling the Playing Field
If companies continue raising capital through ICOs, Shavers and Shin demonstrate that legally, cryptocurrency investments are highly similar to investments in securities. Unlike Faiella, bitcoins today are not managed through the defunct Silk Road, but instead, are usually traded on increasingly sophisticated exchanges. Until cryptocurrencies are formally regulated, however, their uncertain legal status will continue suppressing investors’ appetite for blockchain technology. Taking advantage of the reality that cryptocurrencies are not subject to the same disclosure requirements as registered securities, opportunistic promoters will also likely take advantage of enthusiasm for cryptocurrencies by selling fraudulent “alt-coin” imitator currencies.[24]
Cases of cryptocurrency-fraud demonstrate that, typically, investors purchase cryptocurrencies seeking returns. In effect, cryptocurrencies are deserving of regulation because information asymmetry issues are persistent in cryptocurrency offerings.[25] By making cryptocurrencies subject to a similar disclosure regime as registered securities, the government could protect the investing public by mandating greater transparency in public cryptocurrency offerings.[26]
[1] Stephen J. Choi & A.C. Pritchard, Introduction to the Securities Markets and Securities Regulations, in SECURITIES REGULATIONS: CASES AND ANALYSIS 1, 1 (Robert C. Clark ed., 2015) (noting that congress primarily enacted the federal securities laws in the 1930s to protect investors from abuses by company insiders and market professionals; many believed that a lack of transparency caused the stock market crash and the Great Depression that followed).
[2] 15 U.S.C. § 78t–1(a) (Congress enacted the Insider Trading and Securities Fraud Enforcement Act to increase sanctions for violations of insider trading); 15 U.S.C. §§ 78u(d)(3), 78u-2; S. REP. NO. 101-337, at 1-10 (1990) (passing the Remedies Act with bipartisan support, Congress sought to “increas[e] the financial consequences of securities law violations”); Bartko v. S.E.C, 845 F.3d 1217, 1220–21 (D.C. Cir. 2017).
[3] Sec. & Exchange Comm’n, RULEMAKING, HOW IT WORKS, https://www.sec.gov/fast-answers/answersrulemakinghtm.html.
[4] Eun-Young Jeong & Gregor Stuart Hunter, Bitcoin Plunges as South Korea Crafts Cryptocurrency Crackdown, THE WALL STREET JOURNAL (Jan. 11, 2018), https://www.wsj.com/articles/bitcoin-plunges-as-south-korea-crafts-cryptocurrency-crackdown-1515664956?mod=searchresults&page=1&pos=12 (explaining that Bitcoin’s value fell to a low of $12,845.71 in response to a series of government measures seeking to eliminate anonymous trading of cryptocurrencies).
[5] Yuji Nakamura & Andrea Tan, Coincheck Says It Lost Crypto Coins Valued at About $400 Million, BLOOMBERG (Jan. 16, 2018), https://www.bloomberg.com/news/articles/2018-01-26/cryptocurrencies-drop-after-japanese-exchange-halts-withdrawals.
[6] Jay Clayton, STATEMENT ON CRYPTOCURRENCIES AND INITIAL COIN OFFERINGS, Dec. 11, 2017, https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11.
[7] SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946) (holding that an investment contract is “[a]n investment of money in a common enterprise with profits to come solely from the efforts of others”).
[8] SEC v. Shavers, No. 4:13-CV-416, 2014 WL 4652121, at *11 (E.D. Tex. Sept. 18, 2014).
[9] Shin v. Time Squared Glob., LLC, No. SACV150943AGGJSX, 2016 WL 8856653, at *2 (C.D. Cal. Feb. 8, 2016) (alleging fraud, negligent misrepresentation, breach of contract, and promissory estoppel when investors discovered the defendant’s pyramid scheme).
[10] United States v. Faiella, 39 F. Supp. 3d 544, 546 (S.D.N.Y. 2014).
[11] Id.
[12] No. 4:13-CV-416, 2014 WL 4652121, at *11.
[13] No. SACV150943AGGJSX, 2016 WL 8856653, at *2.
[14] 39 F. Supp. 3d 544, at 546.
[15] No. 4:13-CV-416, 2014 WL 4652121, at *1-2 (explaining that the defendant managed BTCST investor deposits using a single “main operating wallet” and using the wallet to pay returns to BTCST investors).
[16] No. SACV150943AGGJSX, 2016 WL 8856653, at *2.
[17] 39 F. Supp. 3d 544, at 545.
[18] 4:13-CV-416, 2014 WL 4652121, at *1.
[19] No. SACV150943AGGJSX, 2016 WL 8856653, at *1.
[20] Adrian Chen, The Underground Website Where You Can Buy Any Drug Imaginable, GAWKER (June 1, 2011) (the Silk Road caught the attention of law enforcement because the site facilitated many transactions involving the sale of illicit substances).
[21] 4:13-CV-416, 2014 WL 4652121, at *1-2.
[22] No. SACV150943AGGJSX, 2016 WL 8856653, at *1-2.
[23] 39 F. Supp. 3d 544, at 546.
[24] Paul Vigna, Bitcoin’s Plunge Weighs on Coin Offerings, THE WALL STREET JOURNAL (Feb. 7, 2018), https://www.wsj.com/articles/bitcoins-bear-market-leaves-its-mark-on-coin-offerings-1518014509?mod=searchresults&page=1&pos=4 (explaining that companies have successfully raised billions of dollars over the past year by launching alternative cryptocurrency platforms).
[25] Mix, Cryptocurrency Startup LoopX Pulls Exit Scam After Raising 4.5m in ICO, THE NEXT WEB (Feb. 12, 2018), https://thenextweb.com/hardfork/2018/02/12/cryptocurrency-loopx-scam-ico/.
[26] Paul Vigna, Cryptocurrency Worth $170 Million Missing From Italian Exchange, THE WALL STREET JOURNAL (Feb. 10, 2018), https://www.wsj.com/articles/cryptocurrency-worth-170-million-missing-from-italian-exchange-1518241679 (BitGrail, an Italian cryptocurrency exchange, recently reported that 17 million “nano” tokens valued at $170 million disappeared from the exchange because of hacking).