Regulatory Landscape of Cryptocurrency
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. (Jay Clayton, U.S. Securities and Exchange Commission). ICO compliance under U.S. law depends on how tokens and coins are categorized, how the trades are conducted, and if U.S. regulatory agencies are heavily scrutinizing cryptocurrency trading. Trading platforms have, and will continue to face legal risks from different regulatory agencies who oversee money transmission as well as securities and commodities trading, and there is a likelihood of increased enforcement actions. (Jason Somensatto, Bloomberg BNA).
In June 2017, the SEC applied the Howey test to cryptocurrency—the traditional test for determining what constitutes a security—and determined that such digital assets could be securities. (David Sacks and Josh Stein, Harbor). When testifying before the Senate in February 2018, Jay Clayton, Chairman of the U.S. Securities and Exchange Commission, said: “I believe every ICO I’ve seen is a security… ICOs that are securities offerings, we should regulate them like we regulate securities offerings. End of story.” (Stan Higgins, Coindesk). Mr. Clayton also called on the SEC’s Division of Enforcement for “vigorous” policing of this area.
Federal securities, money transmissions, commodities, and derivative trading regulations contribute to the regulatory landscape of cryptocurrency. ICOs can comply with securities laws using Regulation D, specifically Rule 506. This rule contains two registration exemptions for companies when they offer and sell securities, and it allows companies to raise an unlimited amount of capital. Section 506(b) is a safe harbor under section 4(a)(2) of the Securities Act. A company must satisfy certain requirements to qualify for exemption under Section (b): (1) the company may not use general solicitation or advertising methods to market the securities; (2)the company may sell its securities to an unlimited number of "accredited investors"—those with more than $1 million in net worth, or 2 years of annual income exceeding $200,000 per individual or $300,000 per couple—and up to 35 other purchasers. (SEC’s Office of Investor Education and Advocacy, Investor.gov); (3) the company may not give any information to investors that contains a false or misleading statement, and it must give nonaccredited investors disclosure documents, including audited or certified financial statements; and (4) the company must answer prospective purchasers’ questions. Section 506(c) allows companies to more broadly solicit and advertise the ICO if: (1) all investors are accredited; and (2) the company takes reasonable steps to ensure that all investors are accredited. Companies that comply with either section (b) or (c) are exempt from registering their ICO with the SEC, but they still need to file a Form D. This form is a condensed notice that includes the names and addresses of the company’s officers and directors along with some details about the ICO.
A Regulation D-compliant private sale of cryptocurrency also must enforce restrictions on secondary trading. (David Sacks and Josh Stein, Harbor). Secondary sales of the cryptocurrency are compliant if they meet the requirements under the private resale exemption, Section 4(a)(7). This exemption is available for a seller that is not the issuer or a direct or indirect subsidiary of the issuer. Additional requirements include: prohibiting the seller from offering or selling the securities by means of general solicitation or advertising; requiring the reseller must provide the purchaser with certain information, such as updated company financials; neither the seller nor any individual who or will be compensated for participation in the transaction is qualified as a “bad actor” under Regulation D; The securities being resold are not part of an underwriter’s unsold allotment; and time restrictions that allow investors to resell to another accredited investor after a 90-day post issuance lock-up period. Then, one year after issuance, the general public may buy the coin or token. (David Sacks and Josh Stein, Harbor).
ICOs must also comply with the Federal Bank Secrecy Act (“BSA”) and certain state laws if the trading platform is engaged in the business of “money transmission.” (Jason Somensatto, Bloomberg BNA). Under the BSA, money transmitters must gather and keep customer information, and they must share that information with the Financial Crimes Enforcement Network (FinCEN) to aid in preventing money laundering and terrorist financing. In addition, state law covers transfers of “currency, funds, or other value that substitutes for currency from one person to another person or location.” FinCEN and courts treat cryptocurrency trading platforms as “money transmitters” under the BSA. (Drew Maloney, Department of the Treasury).
ICOs also implicate commodities and derivative trading regulations. In March 2018, a judge in the Eastern District of New York decided that virtual currencies are subject to the Commodity Futures Trading Commission’s (“CFTC”) oversight. Commodity Futures Trading Comm'n v. McDonnell, 287 F. Supp. 3d 213, 230 (E.D.N.Y. 2018). The CFTC has the authority to police fraud and manipulation in the spot markets, so the CFTC is able to monitor the markets and platforms used for cryptocurrency trading. (Jason Somensatto, Bloomberg BNA)
The SEC has a three-part mission: “to (1) protect investors, (2) maintain fair, orderly, and efficient markets, and (3) facilitate capital formation.” (SEC’s Office of Investor Education and Advocacy, Investor.gov). Regulation D protects nonaccredited investors by limiting the number of nonaccredited investors who can participate in the initial offering because typically, accredited investors “have the sophistication and financial resources to deal with the risks of a nascent industry with young companies.” (David Sacks and Josh Stein, Harbor). Because cryptocurrency is treated as a security, it cannot be anonymously owned or traded. This classification increases ICO regulation and should help with the issues of tax evasion, money laundering, and anti-terrorism that are present in the cryptocurrency market.[SB1] (David Sacks and Josh Stein, Harbor). Although the regulation of ICOs and cryptocurrency is relatively new, both the SEC and FinCEN have generally increased the number and size of enforcement actions. (Jason Somensatto, Bloomberg BNA).