SUMMER 2018 SPEcial topic
Cryptocurrency, Blockchain, & the SEC's Actions
To understand why governments are interested in regulating cryptocurrencies, background about their potential function is necessary.
To understand why governments are interested in regulating cryptocurrencies, background about their potential function is necessary.
Following the appointment of Chairman Joseph Simons to the Federal Trade Commission (FTC), large tech companies including Google, Facebook, and Amazon should expect tougher enforcement against anti-competitive behavior. In recent years, the FTC has become increasingly concerned that these large tech companies may be violating antitrust law and limiting competition in the market by acquiring small startups or otherwise vertically integrating.
Simons’ appointment comes at a time when mega-mergers among technology companies are commonplace.
With the revolutionary technology known as blockchain quickly spreading across the globe, regulators are struggling to find an ideal balance between regulation and innovation. The critical question is whether cryptocurrencies and initial coin offerings (“ICOs”) are unique enough to warrant the creation of a new categories or if they should be considered securities and therefore subject to existing securities laws and requirements. Because new cryptocurrencies do not require government backing, many leaders in the cryptocurrency arena fear additional regulatory delay, or excessive regulations, will lead many cryptocurrency founders to take their innovation and multibillion dollar businesses overseas to countries with more established and favorable regulations (Kate Rooney, CNBC).
The emergence of cryptocurrency and blockchain poses questions for financial regulators around the world. Regulators are struggling to understand both where cryptocurrency fits within their regulatory framework and how to set up parameters for transparency and investor integrity. (Bob Pisani, CNBC). Recently, American regulators increased scrutiny for broker-dealers working with cryptocurrency. (Benjamin Bain, Bloomberg). Financial powers in other countries are also responding individually to the crypto-movement, and France exemplifies a recent response.
In SEC v. Cade, No. 2:18-cv-01323-JEO (N.D. Ala. Aug. 17, 2018), the SEC filed an initial complaint against Catlin Cade (“defendant”) alleging a violation of Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and SEC Rule 10b-5 by trading shares of Golden Enterprises, Inc. (“Golden”) on the basis of material nonpublic information.
According to the allegations, a director of Golden learned of nonpublic information pertaining to a contemplated merger between Golden and a second company. The director separately owned and controlled a different privately held company (“Director’s Company”)
Last month the Securities and Exchange Commission (SEC) obtained a permanent officer-and-director and penny stock bar against Tomahawk Exploration LLC founder, David T. Laurance, for perpetrating a fraudulent initial coin offering. (SEC Press Release). On its face, the decision shows the SEC merely enforcing its previous statements that anything resembling a security will be labeled as such and regulated under the Securities Act. The ruling, however, extends the umbrella of SEC oversight to explicitly include “Bounty Programs”—a mainstay practice for many initial offerings.
Crypto exchanges—which operate much like traditional stock exchanges—are online platforms where crypto currencies are traded. Traditional exchanges deal almost exclusively with exchanging fiat, or legal tender currency, for highly regulated securities, such as stocks and bonds. Similarly, crypto exchanges primarily deal with trading one cryptocurrency for another. It is unclear which agency has, or should have, authority to regulate this arena because these exchanges primarily trade one currency for another. Regulating crypto exchanges is difficult because of the subtly different and often overlapping definitions surrounding initial coin offerings (ICOs) and cryptocurrencies (Michael del Casillo, Forbes). The unprecedented growth and increasing number of new crypto exchanges and cryptocurrencies is another factor making unified regulation increasingly difficult.
The Public Company Accounting Oversight Board (PCAOB) is a nonprofit entity that was created with the passage of the Sarbanes-Oxley Act of 2002 and established by Congress to oversee the audits of public companies with the goal of protecting investors and the public's interest by promoting accurate and independent audit reports (About the PCAOB). In addition to its oversight of public company audits, the PCAOB also oversees the audits of brokers and dealers (About the PCAOB). Much like the Securities and Exchange Commission (SEC), the PCAOB's mission is to protect investors.
As cryptocurrency and blockchainbecome more prominent in today’s financial markets, regulators around the worldare coping with how to maintain transparency and legitimacy in the market. Recently, the Securities and Exchange Commission (SEC) and its new cyber unit began requesting specific information about cryptocurrency brokerage and Initial Coin Offerings(ICO’s) for enforcement purposes. (Josephine Wolff, Slate; Benjamin Bain, Bloomberg). The results of the requests remain unclear, but the probe for information sheds light on the SEC’s suspicion of misconduct.
On August 7, Elon Musk made an abrupt announcement regarding his plan to take Tesla private. Mr. Musk claimed that this Twitter announcement came after he had “secured” funding from the Saudi Arabian sovereign wealth fund. (Ben Bain and Matt Robinson, Bloomberg). After the announcement, Tesla’s shares rose in value to over $381 per share, from $342 (the closing price on August 6). (Mark Matousek, Business Insider). Nevertheless, the share price dropped dramatically over the next few weeks to as low as $263 on September 7.
Earlier this year, the Securities and Exchange Commission (SEC) amended Rule 15c2–12 (17 C.F.R. § 240.15c2–12). Rule 15c2-12 ensures that underwriters secure an agreement with states, cities, and other governmental entities issuing municipal securities that those entities will disclose information about the issued securities to the Municipal Securities Rulemaking Board (MSRB) on an ongoing basis. This information is intended to inform interested parties on the financial standing or other condition of the state government that may have an effect on the bonds.
The precipitous rise of cryptocurrencies has numerous implications for securities trading, the most fundamental of which is when, and if, any given cryptocurrency exchange is required to become a registered exchange as defined by the SEC.
A cryptocurrency is a digital currency that can be traded and exchanged (Ian King, Investopedia). One defining feature of cryptocurrency is that it is decentralized, meaning it is not issued by a central bank or regulatory agency. Id.This foundational aspect of cryptocurrencies is desirable to investors because unlike traditional fiat currencies that are subject to governmental control and manipulation, cryptocurrencies and their values operate independently from a central authority.
An initial coin offering (ICO) is a capital raising mechanism whereby companies sell bitcoins to investors or buyers in exchange for funds. (Usman Chohan, Initial Coin Offerings (ICOs): Risks, Regulation, and Accountability). An ICO is different from traditional capital raises. Rather than selling shares of stock in a company, an ICO offers digital currencies or cryptocurrencies. In addition, most ICOs do not offer equity or a stake in the company’s projects. The concept of using ICOs to raise capital has grown exponentially in recent years as they pose a cost-efficient way of conducting transactions with little regulation. ICOs, however, also pose a greater risk of fraud due to their place in the unregulated market.
The regulatory landscape for cryptocurrencies is fast paced, ever-changing, and hard to pin down (see Element Group report). To understand why governments are interested in regulating cryptocurrencies, background about their potential function is necessary. Cryptocurrencies enormous potential comes from the use of “public ledgers” which, through a complicated application of cryptology and software, reduce transaction costs associated with value transfer by creating independently verifiable transaction validations. The public ledger system, however, only documents transactions and ownership. The only identity recorded on the ledger is "a set of letters and numbers . . . representing the [user's] public cryptocurrency address."
Unlike other currencies and monetary systems that rely on a centralized authority, such as banks, to track transactions, maintain records, and ensure balances remain accurate and current; cryptocurrencies operate without any type of centralized reporting system. Instead, cryptocurrencies, such as Bitcoin, utilize a decentralized network to verify and confirm transactions, track balances, flawlessly store and maintain records, and even generate new currency. While the exact manner in which this is accomplished is extremely technical and complex, it essentially boils down to giving every node, or peer, on the network access to all the records, including balances.
With the popularity and growth of cryptocurrencies many companies are using initial coin offerings (“ICOs”) to raise capital. ICOs allow investors to exchange typical currency for a coin or token. The ICO market continues to grow—in 2017 an estimated $4 billion was raised through ICOs. (Jay Clayton, U.S. Securities and Exchange Commission). So far, 2018 has seen $2 billion raised through ICOs. (David Sacks and Josh Stein, Harbor). Funding a venture through a cryptocurrency gives companies and individuals the ability to make transfers regardless of geographic location, and it has lower transaction costs than traditional financing methods. Using cryptocurrencies, however, also has drawbacks—mainly anonymity of purchasers and sellers coupled with a lack of government regulation.
The rise of blockchain and cryptocurrency has taken the financial world by storm. In 2017, various companies and financial firms raised capital through initial coin offerings(“ICO”). As cryptocurrency becomes more politically popular, world economic powers are faced with an important question: how do we regulate cryptocurrency? Currently, regulatory approaches vary from country to country. Outside of the core desire to remove anonymity and push adherence to tax laws, government actions have been anything but consistent. (see Element Group report). While the current cryptocurrency regulatory landscape is in flux, this article addresses recent trends and responses to the crypto explosion around the globe.
According to CoinMarketCap, as of July 24, 2018 the total market capitalization of all cryptocurrencies was just shy of $303 billion with Bitcoin’s market capitalization at $140 billion (17.1 million coins in circulation), down from a high of $828 billion and $294 billion, respectively, in early January 2018.
A recent report in the Financial Times indicates that there are approximately 1,600 individual investors (generally thought to be high net worth individuals), known as “Bitcoin whales” who hold one-third of the Bitcoins in circulation, and of those, approximately 100 investors own between 10,000 and 100,000 Bitcoin each in their wallets.
A Decentralized Autonomous Organization (DAO) is an organization in which the traditional business management scheme is replaced by blockchain technology. While DAOs function like corporations in some ways, they replace board members with code and leave business decisions up to token-holders who exist as nodes along the blockchain. No single entity owns the DAO, and the organization’s day-to-day operations are executed via smart contracts. This note introduces readers to DAOs, provides insights into how major industry players and regulators are interacting with them, and speculates on how DAOs may influence the future of corporate law.
By late 2017, the value of Bitcoin (BTC) had risen to an unprecedented $19,843 per coin after trading below $1,000 just a year earlier. Though it has fallen well below those highs, Bitcoin’s value — and the value of other cryptocurrencies like Ethereum — has continued to remain much higher than anyone expected.
Where does this value come from? Among the many potential factors is supply and demand. Bitcoin, for example, is limited to a total of 21 million coins. By now, more than eighty percent of those have already been mined (Molly Jane Zuckerman, CoinTelegraph).
In Stoddard v. S&N Logging, Inc., No. 35038-0-III (Wash. Ct. App. Jan. 25, 2018), S&N Logging, Inc. (“S&N”) and Newman Logging, Inc. (collectively “Defendants”) moved for summary judgment against Roy B. Stoddard (“Plaintiff”) for failure to claim a remedy from the dissolution of a corporation within the time allowed by the statute of limitations. The Washington State Court of Appeals affirmed the trial court’s grant of summary judgment.
By Megan Herr & Thomas Dyer
Innovators have a tendency of identifying problems and subsequently creating a solution instead of the inverse. Great ideas do not make historic innovations; creative solutions to problems do. Cryptocurrency arose out of the identified problems contained in “traditional” fiat currencies. Transactions involving fiat currencies are often traceable by parties who should not otherwise have access to that information. Cryptocurrencies effectively address both of these problems, along with a handful of others through innovations including blind algorithms and the related blockchain technology.
Initial coin offerings (ICOs), also sometimes called token sales, have exploded as the fastest growing segment of the world-wide capital markets. ICOs gained prominence in 2016 following a $160 million raise by an entity called “The DAO.” (Connie Loizos, TechCrunch) ICO fundraises grew from an estimated $263 million in 2016 to north of $5 billion in 2017. (Oscar Williams-Grut, Business Insider) The trend has continued in 2018, with an estimated $9.5 billion raised through the first five months of the year. (Coinschedule; see also Katie Rooney, CNBC) Despite this growth, there is still considerable legal uncertainty as to the status of ICOs and whether they are subject to regulation as securities in the United States.
In Cohen v. Kitov Pharmaceutical Holdings, Ltd., No. 17 Civ. 0917 (LGS), 2018 BL 94656 (S.D.N.Y. Mar. 20, 2018), the United States District Court for the Southern District of New York denied in part and granted in part a motion to dismiss a putative class-action suit against Kitov Pharmaceutical Holdings, Ltd. (“Kitov”), CEO Isaac Israel, and CFO Simcha Rock (collectively “Defendants”) brought by lead plaintiffs Rotem Cohen and Jason Bruening (collectively “Plaintiffs”). The complaint alleged violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (the “Act”). The court denied the motion to dismiss with regard to defendants Kitov and Israel but granted the motion to dismiss concerning defendant Rock.
Smart contracts are self-executing transactions that are written in computer code often utilized to “facilitate, execute, and enforce agreements between two or more parties.” While the term might sound new to some, the phrase was actually coined in 1994. The concept behind a smart contract is rooted in basic contract law; offer, acceptance, and consideration are all necessary, but smart contracts are enforced by different means. A key advantage of using smart contracts is efficiency. Once uploaded to the blockchain, smart contracts do not rely on a third party for recordkeeping or enforcement. Because they are self-executing and stored on a shared platform, smart contracts could potentially eliminate the manual effort currently necessary to execute domestic and international financial transactions.
An initial coin offering (ICO) is the term used to describe the method that a crypto firm or company utilizes to raise capital to fund a particular venture or project through the sale of its tokens. While an ICO is similar to the concept of raising capital by selling shares of stock, it is also different because the crypto firm is selling a digital asset (i.e. a token). The tokens can be utility tokens meaning the investor can use the tokens to access a product or a service or the tokens can be security tokens meaning the investor has some type of an investment stake. Another significant difference is that investors in ICOs do not generally have an ownership interest in the crypto firm, like a purchaser of common stock. Though this difference in investment may change with the advent of equity tokens. Yet, similar to owning stock, investors earn a return as a result of an increase in the value of their tokens, whether as utility or security token holders.
By Bryston Gallegos & Kasia Parecki
Best known for its role in the rise of cryptocurrencies like Bitcoin, blockchain is a revolutionary technology that has the potential to transform how business transactions are conducted. For now, blockchain is primarily applied in digital financial transactions, like cryptocurrencies, but it presents a lot of opportunities for a wide variety of industries—from home entertainment to real estate to contract drafting —and beyond. This short article offers a brief introduction to blockchain, provides insight about its current uses, and summarizes some future applications.
In Laborers’ Local #231 Pension Fund v. Cowan, No. 17-478, 2018 BL 85103 (D. Del. Mar. 13, 2018), the court granted Rory Cowan and his co-executives’ (“Defendants”) motion to dismiss Laborers’ Local #231 Pension Fund’s (“Plaintiffs”) amended complaint. The court held Plaintiffs failed to state a claim in violation of the Securities Exchange Act of 1934 (the “Exchange Act”) because they failed to allege “a misleading or false statement or omission” in the proxy statement.
In Webb v. SolarCity Corp., No. 5:14–CV–01435–BLF, 2018 BL 79348 (9th Cir. Mar. 08, 2018), the Ninth Circuit Court of Appeals affirmed the district court’s dismissal of a securities fraud action brought in a third amended complaint (“TAC”) by James Webb (“Plaintiff”), a member of a class of plaintiffs who purchased shares in SolarCity, against SolarCity Corporation and two of its cofounders, Lyndon Rive and Robert Kelly (collectively “Defendants”). The court held Plaintiff failed to adequately plead the scienter element necessary to state a claim under § 10(b) of the Securities Exchange Act of 1943 (“Act”).
In Pfizer Inc. 2018 BL 030118 (March 1, 2018), Pfizer Inc. ("Pfizer") asked the staff of the Securities and Exchange Commission (“SEC”) to permit the omission of a shareholder proposal submitted by Trinity Health (“Proponents”) requesting Pfizer disclose the risks from rising pressure to contain U.S. prescription drug prices and explain how Pfizer plans to mitigate those risks. The SEC issued the requested no action letter allowing for the exclusion of the proposal under Rule 14a-8(i)(10).
In General Electric Co., 2018 BL 71731 (Mar. 1, 2018), General Electric Company (“GE”) asked the staff of the Securities and Exchange Commission (“SEC”) to permit omission of a proposal submitted by Martin Harangozo (“Shareholder”) requesting that GE’s board of directors provide cumulative voting in the election of directors. In addition, Shareholder submitted images he wished to be displayed in support of his proposal, three unattributed quotes, and the following statement: “The increase in shareholder voice as represented in cumulative voting may serve to better align shareholder performance to CEO performance (see image).” The SEC declined to issue the requested no action letter in its entirety under Rule 14a-8(i)(4) but found grounds to exclude the attached images under Rule 14a-8(i)(3).
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