This article originally appeared on the New York Law Journal.
The cryptocurrency enforcement landscape continues to evolve with several important developments this past week, including the appointment of a “Crypto Czar,” an enforcement action against a “Blockchain Evangelist” and a government official’s praise of virtual currencies as a “modern miracle” that “will proliferate to every economy and every part of the planet.” In the paragraphs that follow, we analyze these legal developments and their implications for the blockchain and cryptocurrency communities.
All Hail the Crypto Czar
On June 4, the U.S. Securities and Exchange Commission (SEC) announced the appointment of veteran SEC attorney Valerie Szczepanik as associate director of the Division of Corporation Finance and senior adviser for digital assets and innovation. In her capacity as the SEC’s “Crypto Czar,” Szczepanik will coordinate the SEC’s application of U.S. securities laws to emerging digital asset technologies and innovations, including Initial Coin Offerings (ICOs) and cryptocurrencies.
Szczepanik is well versed on these issues. During her two-decade tenure at the SEC, Szczepanik has held several prominent roles—including assistant director in the Division of Enforcement’s Cyber Unit, head of the Distributed Ledger Technology Working Group, and co-head of its Dark Web Working Group. She is involved with several pending crypto enforcement actions in New York federal courts—including the REcoin, Centra Tech, Inc., and Plexcorps cases—and was part of the team that investigated The DAO.
Szczepanik’s remarks about cryptocurrency at several conferences suggest a measured approach to enforcement. According to a May 2018 report, Szczepanik recently stated that the SEC is trying to strike a balance between protecting investors and facilitating the emerging technology: “We do not want to chill the markets.… The promise of blockchain technology is not one that we want to ignore.” Szczepanik suggested that many ICOs are designed not to launch a digital currency but rather to raise money and encourage speculative investment while simultaneously ignoring basic transparency and disclosure requirements. A May 2017 report suggests that she struck a similar tone while speaking on a cryptocurrency regulation panel: “If you want this industry to flourish, protection of investors should be at the forefront.”
Szczepanik also appears to be open to the possibility that some digital tokens are not securities. During the May 2017 event, she is reported as stating that the question of “whether a token is a security” hinges on a facts-and-circumstances analysis—which is a little more measured than SEC Chairman Jay Clayton’s “I believe every ICO I’ve seen is a security” statement from earlier this year.
The Fall of a “Blockchain Evangelist”
On May 29, 2018, the SEC announced that a California federal court granted its request for a temporary restraining order – followed by a preliminary injunction—against self-proclaimed “blockchain evangelist” Michael Alan Stollery (aka Michael Stollaire) and two of his companies: Titanium Blockchain Infrastructure Services, Inc. (TBIS) and EHI Internetwork and Systems Management, Inc. (EHI). In addition to freezing the defendants’ assets, which included digital wallets as well as traditional bank accounts, the court order granted expedited discovery and appointed a temporary receiver for TBIS and its subsidiaries and affiliates.
The SEC’s complaint, which was originally filed under seal, accuses the defendants of masterminding a “create and inflate” scheme that raised over $21 million through the sale of digital assets called “BAR” and “TBAR.” The SEC has accused the defendants of “orchestrating a social media campaign based on false corporate relationships and false testimonials to establish a presence and seeming expertise” and “generating demand for their digital asset by offering various incentives and creating urgency so investors would invest in the ICO.” The complaint contains a full-page chart from the defendants’ offering materials that allegedly misrepresented TBIS’s customers, including the names and logos of thirty large companies and—even more brazenly—the Federal Reserve. The SEC has accused the defendants of making material misrepresentations and omissions as well as offering and selling unregistered securities.
Cryptocurrency—a “Modern Miracle”
On June 4, U.S. Commodity Futures Trading Commission (CFTC) Commissioner Rostin Behnam delivered a rousing speech about cryptocurrencies, explaining that while virtual currencies may be vexing many regulators, there is no doubt that the technology is transforming the world. The remarks were part of his keynote address on “Fostering Open, Transparent, Competitive, and Financially Sound Markets” at the Blockchain for Impact Global Summit in New York. Before a crowd gathered at United Nations headquarters, Commissioner Behnam gave an eyes-wide-open assessment of crypto technology and how it is “bewilder[ing]” regulators:
Some countries have outlawed virtual currencies. Others have new, strict laws to control them. Many countries simply don’t know what to do. Their policy is bewilderment. Or avoidance. And, some countries think virtual currencies are only a problem for developed countries like Switzerland, or Germany, or Singapore, or the United States.
But virtual currencies may—will—become part of the economic practices of any country, anywhere. Let me repeat that: these currencies are not going away and they will proliferate to every economy and every part of the planet. Some places, small economies, may become dependent on virtual assets for survival. And, these currencies will be outside traditional monetary intermediaries, like government, banks, investors, ministries or international organizations.
Commissioner Behnam stated that “[w]e are witnessing a technological revolution” that might be better described as “a modern miracle.”
The CFTC official’s praise of virtual currency was not without qualification. While in one breath Commissioner Behnam suggested that virtual assets could become “the single greatest weapon against corruption” because they could help—with the assistance of cell phones—to “put money directly into the hands of those who need it, without bribery, rake-offs, graft, and shakedowns,” his next breath struck a more dystopian tone when he acknowledged that the same technology could be subverted as “a weapon against the work of the United Nations and others trying to alleviate poverty or violence” because “[v]irtual assets become a means of deeper control of wealth and a means of exploitation.”
According to Commissioner Behnam, the CFTC is trying to address the challenges posed by virtual currencies through a mix of regulation and enforcement. On the regulation front, he noted that two exchanges in 2018 have self-certified several new contracts for futures products for virtual currencies and projected that others will follow suit. On the enforcement front, Commissioner Behnam noted that during the past several weeks the CFTC has filed a series of civil enforcement actions against perpetrators of fraud and market abuse involving virtual currency. He noted that these actions—and others to follow—confirm that the CFTC, in coordination with the SEC and “other fellow financial enforcement agencies,” is “aggressively prosecut[ing] those who engage in fraud and manipulation of US markets for virtual currency.”
There are four notable takeaways from these developments:
The SEC’s appointment of a “Crypto Czar” demonstrates that the agency is prioritizing cryptocurrency enforcement. Federal and state regulators are in the midst of a crypto industry sweep and it comes as no surprise that the SEC tapped an experienced insider to lead its cryptocurrency enforcement initiative. The SEC’s appointment of a Crypto Czar demonstrates the agency’s commitment to policing crypto-related activity and its expectation that enforcement activity will increase—in a more coordinated manner—in the months to come. It should be noted that while the DOJ has yet to anoint its own crypto czar, it does have a crypto-crimes point person: Digital Currency Counsel Michele Korver.
The SEC is actively investigating both companies and individuals for ICO misconduct, and is particularly concerned about fraudulent activity. The TBIS enforcement action—which comes hot on the heels of the Centra Tech, Inc. and RECoin matters—is further evidence that the SEC is still actively investigating and policing ICO activity. In all three cases, the SEC accused the defendants of a number of securities law violations, including misleading investors. In the RECoin matter, the SEC accused the defendants of falsely representing that the business venture was “led by an experienced team of brokers, lawyers and developers” when there was only one employee. In the Centra Tech, Inc. matter, the SEC accused the defendants of touting non-existent relationships with credit card companies, fabricating the identity of a CEO and leveraging paid celebrity promotions. In the TBIS enforcement action, the SEC alleged the defendants posted false testimonials on their website and lied about connections to prominent businesses and the Federal Reserve Bank.
In many ways, these cases represent old wine in new bottles; while the technology may be novel, the schemes—such as the use of material misrepresentations and omissions to mislead investors—are familiar. As a result, the SEC is operating on well-trodden ground.
The SEC has offered a clue on how it might be differentiating between security tokens and non-security utility tokens. Buried in paragraph 44 of the TBIS complaint, the SEC writes that “[a]lthough BAR was characterized in the TBIS whitepapers as a ‘utility token,’ it did not have any functionality at the time of the ICO (nor does it currently), and was sold as an investment.” The SEC appears to be distinguishing between tokens that have functionality at the time of their offer and sale and those that do not, suggesting perhaps that if the token has functionality on an existing digital platform at the time that it is offered or sold, it might qualify as a separate asset class. Whether this distinction opens the doors to arguments that utility tokens are not subject to securities regulation remains an open question. While such a distinction would be welcome news to the blockchain and cryptocurrency industries eager for a bright-line rule to navigate a legal grey zone, the facts as alleged in TBIS suggest that this case will not hinge on the question of whether the BAR/TBAR tokens qualify as utility tokens.
As a result, those operating in this arena must continue to rely on guidance in SEC speeches and public statements, which has ranged from SEC Chairman Jay Clayton’s “I believe every ICO I’ve seen is a security” claim in February 2018 to SEC Commissioner Hester Peirce’s “I am wary of any blanket designation for all ICOs” comment in May 2018. In a June 6, 2018 interview, Chairman Clayton maintained that “most” ICOs are securities, noting that if the ICO offers a return on investment, it is a security. At the same time, he stated that cryptocurrencies that function as replacements for sovereign currencies are not securities. These recent statements suggest a retreat from the “one size fits all” approach to digital asset regulation.
While regulators are warming up to blockchain’s potential and expressing a willingness to work with industry participants, they are persisting with enforcement fervor. CFTC Commissioner Behnam’s recent remarks and those of other regulators suggest that they are entering an era of blockchain enlightenment. Commissioner Behnam lauded blockchain as “an advance that reaches out into every aspect of life [that could be used] to address the most basic, the most primal problems on our planet: corruption, income distribution, poverty, food, and health care.” Meanwhile SEC Commissioner Peirce has suggested that such technology may assist with “capital formation, market efficiency, economic growth, and overall societal well-being.” She suggested that the “best path forward is for regulators to approach ICOs and tokens with intense curiosity” and “put in the effort to learn about these new technologies.” Chairman Clayton’s June 6 remarks included an acknowledgement of the “incredible promise” and potential of blockchain technology to “drive efficiencies not only in financial markets but in a lot of markets.” The CFTC and SEC’s recognition of blockchain’s promise may open the door to a more collaborative dialogue between regulators and the industry about regulating digital assets.
Whether this shift in perspective will ultimately affect enforcement strategies remains unknown but the CFTC and SEC continue to warn that they will not stand for fraud on their watch. Commissioner Behnam noted that the CFTC has “enforcement jurisdiction to investigate fraud and manipulation in underlying virtual currency spot markets and, as appropriate, conduct civil enforcement actions where fraud or manipulation is found.” Similarly, SEC Commissioner Peirce reminded her audience that “it is absolutely essential that we address securities law violations, in particular fraud, that occur in any market under our jurisdiction.” Market participants should continue to proceed with caution and remain focused on regulatory requirements.
Deborah R. Meshulam is a partner at DLA Piper and a former assistant chief litigation counsel in the SEC’s enforcement division. Benjamin D. Klein is a senior associate at DLA Piper and a former international prosecutor. Richard Kelley is an associate at DLA Piper.