As the U.S. Securities and Exchange Commission (SEC) stated previously, it is continuing to scrutinize and commence enforcement actions against companies, advisors and investors involved in the offering of cryptocurrencies and related activities.

According to a recent report published by Lex Machina, securities litigation in general and those that are related to blockchain, cryptocurrency or bitcoin specifically, showed a marked increase during the first two quarters of 2018 as compared to 2017.  The total number of securities cases that referenced "blockchain," "cryptocurrency" or "bitcoin" in the pleadings tripled in the first half of 2018 alone compared to 2017.

Although these numbers also reflect litigation commenced by shareholders, a significant portion are proceedings brought by the SEC and Commodity Futures Trading Commission (CFTC).  The uptick in securities litigation and enforcement actions involving cryptocurrencies and related activities by the SEC and CFTC reflects the joint statement by the chairman of the SEC and the chairman of the CFTC made earlier this year that both agencies are focusing on bringing transparency and integrity to the cryptocurrency markets and deterring and prosecuting fraud and abuse.

Recent Victories In Court for the SEC and CFTC

On June 15, 2018, the SEC obtained an additional emergency court order to freeze the assets of the PlexCoin ICO founders, Dominic Lacroix and Sabrina Paradis-Royer, after alleging false marketing and fraudulent activity.  The SEC's complaint against the PlexCoin ICO founders was the first filed by the SEC's Cyber Unit, which was created in September 2017 to "focus the Enforcement Division's cyber-related expertise on misconduct involving distributed ledger technology and ICOs, the spread of false information through electronic and social media, hacking and threats to trading platforms."

On August 23, 2018, the U.S. District Court for the Eastern District of New York decided in favor of the CFTC when it found that Patrick K. McDonnell and CabbageTech, Corp. d/b/a Coin Drop Markets (CDM) engaged in a deceptive and fraudulent virtual currency scheme by soliciting customers to send funds in exchange for purported real-time virtual currency expert trading advice, and for managed trading services under McDonnell's direction.

Earlier this month, in U.S. v. Zaslavskiy, a Brooklyn federal judge left unanswered the question whether federal securities laws could apply to digital tokens as securities, but concluded that Zaslavskiy's two initial coin offerings (one of which he styled an "initial membership offering") bore sufficient resemblance to securities to allow the case to proceed past initial pleadings.  The defendant argued that digital tokens were not securities and, therefore, the federal securities laws did not apply.  U.S. District Court Judge Raymond Dearie will allow the case to proceed to trial, holding that only a jury can decide whether these digital tokens constituted securities under the federal securities laws.  In doing so, Dearie rejected the defendant's parallel argument that the SEC's prior enforcement actions and statements were unconstitutionally vague and failed to put the defendant on notice that the securities laws could apply to his enterprises.  This case is one of the first criminal cases that puts directly into question whether digital tokens can be securities as "investment contracts" under the Howey-test to which the federal securities laws apply.   

Recent SEC Enforcement Actions

On September 11, 2018, the SEC announced its first-ever enforcement action against a hedge fund manager for an investment company registration violation. The SEC entered an order finding that Crypto Asset Management LP (CAM) offered a fund that operated as an unregistered investment company while being falsely marketed as the "first regulated crypto asset fund in the United States" and claiming that it had filed a registration statement.  CAM and Timothy Enneking, CAM's sole principal, agreed to the SEC's cease-and-desist order and censure, without admitting or denying the findings against them, and agreed to pay a penalty of $200,000.

On the same day, the SEC announced its first charge against unregistered broker-dealers for selling digital tokens after the SEC issued The DAO Report in 2017.  The SEC charged TokenLot LLC (TokenLot), a self-described "ICO Superstore", and its owners, Lenny Kugel and Eli L. Lewitt, with failing to register as broker-dealers.  TokenLot received orders from over 6,100 retail investors and traded more than 200 different digital tokens.  The SEC took into consideration that TokenLot, Kugel and Lewitt promptly cooperated and took remedial actions, provided valuable information to the SEC's staff, stopped the conduct and refunded money to investors.  Without admitting or denying the SEC's charges, TokenLot, Kugel and Lewitt consented to the order and agreed to pay $471,000 in disgorgement plus $7,929 in interest, and to engage an independent third party to destroy TokenLot's remaining inventory of digital assets.

Other Recent Developments

The Financial Industry Regulatory Authority (FINRA) filed its first disciplinary action involving a cryptocurrency when it charged Timothy Tilton Ayre, a broker in Agawam, Massachusetts, with securities fraud and the unlawful distribution of unregistered cryptocurrency, HempCoin. FINRA alleges that Ayre issued and sold HempCoin to the public in an attempt to fund his "worthless" public company, Rocky Mountain Ayre, Inc. (RMTN) by marketing HempCoin as "the first minable coin backed by marketable securities" and by disseminating fraudulent and misleading positive statements about RMTN.  From FINRA's complaint, it appears that Ayre bought the rights to HempCoin and sold the coins as being backed by RMTN common stock.  Investors mined more than 81 million HempCoin securities through late 2017 and bought and sold the security on two cryptocurrency exchanges.  Ayre is being charged with unlawful distribution of HempCoin as well as making false and misleading statements in RMTN's financial statements.

The SEC is continuing its probe into public companies that appear to incorporate and seek to capitalize on the blockchain technology.  The effect of referencing "blockchain" in a company's title has caused stock value to increase significantly and has allowed for short-term profiteering and added publicity.  For example, Riot Blockchain Inc. (Riot), a former biotech company that shifted its focus to the cryptocurrency market and changed its name to include the word "blockchain," saw its stock jump from eight dollars to over forty dollars per share following its name change.  According to Riot's latest 10-Q quarterly report filed on August 14, 2018, the SEC is examining the disclosure in certain of the company's registration statements under Section 8(e) of the Securities Act of 1933 (Securities Act).  If the SEC finds any "untrue statement of material fact" or "omitted material fact", the SEC may issue a stop order that would suspend the effectiveness of those registration statements and halt trading in the company's shares.

Key Takeaways

  • The SEC, CFTC and Department of Justice are actively working together to prevent and prosecute fraud and abuse in the cryptocurrency space.
  • The SEC interprets the term "security" broadly and applies the federal securities laws in cryptocurrency cases not only against issuers of ICOs but also those involved in trading in the secondary market, such as broker-dealers and hedge fund managers.
  • FINRA is becoming increasingly aware and active in preventing and fighting fraud and abuse in the cryptocurrency space.
  • The SEC may take into account certain factors such as prompt cooperation, return of investors' funds and sharing of information in determining an appropriate settlement.
  • The SEC is continuing to scrutinize public companies' filings with respect to their activity in the cryptocurrency space and may issue a stop order suspending the effectiveness of a registration statement if it finds any "untrue statement of material fact" or "omitted material fact" under the Securities Act.

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