As previously covered by the FinTech Monitor, in March 2018 the SEC's Enforcement and Trading and Markets Divisions jointly issued a statement warning investors about the use of online trading platforms for the exchange of tokens and cryptocurrencies. Signaling its heightened interest in enforcing the securities laws with respect to online trading platforms, the SEC's March 2018 statement even encouraged those "employing new technologies to develop trading platforms to consult with legal counsel to aid in their analysis of federal securities law issues..."
The SEC's warning has been borne out.
On November 8, 2018, the SEC issued a Cease & Desist Order individually against Zachary Coburn, who launched and operated EtherDelta, an online platform focusing on trades in ERC20 compatible tokens. The SEC contended that because the ERC20 tokens traded on the platform "included securities as defined by Section 3(a)(10) of the Exchange Act," EtherDelta was an "Exchange" pursuant to Section 3(a)(1) of the Exchange Act, and its 31-year-old operator either had to register the platform as a national securities exchange or operate it pursuant to an exemption.
EtherDelta was in many ways a typical online trading platform: It permitted trading in approximately 500 digital tokens, the website publicized available token pairs, listed the top 500 firm bids and offers, and displayed market depth charts and a list of confirmed trades. According to the SEC, EtherDelta permitted any ERC20 compliant token to be traded on the platform.
Those interested in further SEC guidance on when digital currencies may be considered "securities" will be disappointed. The Cease & Desist Order states ambiguously that the ERC20 tokens traded "included securities," and therefore the operator should have registered the exchange as a national securities exchange. The SEC did not identify the particular tokens that it considered to be securities, nor did it analyze the characteristics of the tokens at issue. Rather, cursorily citing Howey and The Dao, the SEC offered the vague reasoning that the "purchasers of such digital tokens invested money with a reasonable expectation of profits, including through the increased value of their investments in secondary trading, based on the managerial efforts of others."
The SEC's summary declaration—without explanation or analysis—that certain unspecified tokens traded on EtherDelta were securities was likely intended as a further warning to trading platforms to conduct serious legal due diligence on individual tokens before allowing them to trade. The SEC specifically noted in the Order that EtherDelta's operator "performed his own due diligence on these tokens," which included requesting the token's name, any associated web URL, and a paragraph describing the token, among other things. The SEC appears to have considered this non-legal due diligence to be inadequate.
However vague the SEC's latest order may be on the question of which tokens are securities, the Order is entirely clear that trading platforms must engage in bona fide legal due diligence to assess the risk that individual tokens may be deemed securities. The Coburn enforcement action makes equally clear that the SEC will pursue the individuals who operate such platforms.
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