Regulators are turning up the heat on companies looking to cash in on the cryptocurrency craze.

Major media outlets recently reported that the U.S. Securities Exchange Commission (SEC) has issued dozens of subpoenas and information requests to companies, investors and advisers engaged in cryptocurrency-related activities. The SEC's probe follows repeated warnings that many token sales, commonly referred to as initial coin offerings or ICOs, may be violating securities laws. This activity signals the agency's intention to thoroughly scrutinize ICOs.

Regulators are now taking a more active role in investigating not just ICOs but also the companies developing funds or other investment vehicles focused on cryptocurrencies or ICOs. In the sections that follow, we highlight recent enforcement developments targeting the cryptocurrency community and reflect on both the opportunities and challenges that lie ahead.

Before the Storm: Repeated Warnings by Regulators

Through late 2017, one of the world's most popular cryptocurrencies, Bitcoin, experienced a meteoric rise in value of nearly 2,000 percent. However, from late December 2017 through February 2018, more than 60 percent of that value was lost, including a one-day drop of 25 percent on Jan. 16, 2018. Then on January 18, the SEC's Division of Investment Management issued an open letter to two industry associations expressing concerns about “a number of significant investor protection issues” arising from cryptocurrency-related funds, including valuation, liquidity, custody, arbitrage, manipulation and related risks. From Jan. 26, 2018 to Feb. 5, 2018, Bitcoin's value plummeted another 36 percent. As of April 2, 2018, Bitcoin was trading on popular trading platforms around $7,000. This is its lowest price since the beginning of the surge from mid-November of last year.

Although regulators have repeatedly emphasized the potential benefits of blockchain or distributed ledger technology (DLT) in the financial services industry, they have simultaneously expressed concern about blockchain's lack of transparency and potential for fraud. For example, on Feb. 6, 2018, U.S. Commodities Future Trading Commission (CFTC) Chairman J. Christopher Giancarlo testified that “DLT is likely to have a broad and lasting impact on global financial markets in payments, banking, securities settlement, title recording, cyber security and trade reporting and analysis,” and that “[w]hen tied to virtual currencies, this technology aims to serve as a new store of value, facilitate secure payments, enable asset transfers and power new applications.” At the same time, Chairman Giancarlo cautioned that “[v]irtual currencies … likely require more attentive regulatory oversight in key areas, especially to the extent that retail investors are attracted to this space.”

During the same hearing, SEC Chairman Jay Clayton testified that he was “very optimistic that developments in financial technology will help facilitate capital formation,” but he also cautioned that “promoters of ICOs and cryptocurrencies” were creating “significant risks” by failing to comply with securities laws. Citing a July 2017 SEC report, Chairman Clayton stated that the “Commission's message to issuers and market professionals in this space was clear: those who would use [DLT] to raise capital or engage in securities transactions must take appropriate steps to ensure compliance with the federal securities laws.” In addition, Chairman Clayton warned that focusing on the “utility” or “voucher-like characteristics” of a proposed ICO does not necessarily allow the tokens or coins to avoid securities regulation. Crypto companies and investors should expect the SEC to apply the U.S. Supreme Court's Howey test to ICO activities. That test provides that a transaction is a security if it involves an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.

Clayton's testimony followed similar remarks delivered at the Securities Regulation Institute on Jan. 22, 2018, in which he warned that SEC staff have been instructed “to be on high alert for approaches to ICOs that may be contrary to the spirit of our securities laws.”

In summary, both SEC Chairman Clayton and CFTC Chairman Giancarlo have emphasized their agencies' mandates to enforce current laws to protect investors.

Lightning Strikes: SEC/CFTC Enforcement and Related Activity

According to reports, the SEC has issued subpoenas and document requests to dozens of cryptocurrency issuers, advisors, exchanges and investors in recent months seeking information about the sale and structure of ICOs. The long list of demands includes not only details about organizational structures and funds raised but also investor information, marketing materials and the geographic locations of those involved in the business.

Meanwhile, the SEC is also acting quickly to prevent companies that are not complying with the securities laws from proceeding with ICOs. For instance, in December 2017, the SEC halted a $15 million ICO by a California-based social-networking restaurant review app. The SEC order cited the manner of sale as well as the investment intent of purchasers of the coin in its determination that the ICO was an improper securities offering.

The SEC is also targeting those who are improperly attempting to cash in on the cryptocurrency craze through fraudulent or deceptive schemes. In late January 2018, the SEC obtained a court order halting a Texas-based bank from proceeding with an ICO and accused the company, as well as its executives, of misleading investors about plans to acquire a federally insured bank. The bank used social media, a celebrity endorsement and other tactics to raise $600 million of its $1 billion goal in just two months. The SEC accused the bank and its executives of engaging in an “outright scam” by “misrepresenting the company as a first-of-its-kind decentralized bank offering its own cryptocurrency to be used for a broad range of customer products and services.” The SEC cautioned that while this was “the first time the Commission has sought the appointment of a receiver in connection with an ICO fraud,” the SEC would continue to use “all of [its] tools and remedies to protect investors from those who engage in fraudulent conduct in the emerging digital securities marketplace.”

Earlier this month, on April 2, 2018, the SEC filed a complaint against the co-founders of a financial services start-up for an allegedly fraudulent ICO that raised more than $32 million from thousands of investors. The complaint alleges that the co-founders violated the anti-fraud and registration provisions of federal securities laws. According to an SEC press release, the co-founders “us[ed] a sophisticated marketing campaign to spin a web of lies about their supposed partnerships with legitimate businesses” and promoted their ICO by “creat[ing] fictional executives with impressive biographies,” “post[ing] false or misleading marketing materials” online, and paying “celebrities to tout the ICO on social media.”

Most recently, on April 6, 2018, the SEC obtained a court order freezing more than $27 million in trading proceeds associated with a Delaware-based financial technology company. The SEC accused the company and four of its executives of violating securities laws by selling restricted shares of its stock following its acquisition of a “purported cryptocurrency business” that had “no ascertainable value” but caused the company's stock price to rise dramatically.

In addition to shutting down unregistered or fraudulent offerings, the SEC is also proactively seeking information from the market, including looking at specific participants. On March 1, 2018, for example, a publicly listed online retailer disclosed that it had received an SEC voluntary document request related to preferred equity tokens being offered by one of its newly formed subsidiaries which focuses on cryptocurrency. The company acknowledged the SEC request in its public filing and stated that it would cooperate with the investigation. Although the retailer raised over $200 million in its ICO, the company has yet to issue any tokens and has yet to provide any assurances that such tokens will be issued.

In another example, on March 2, 2018, the founder of a major technology blog acknowledged that the SEC subpoenaed him as a part of its investigation into cryptocurrency offerings. The founder stated that the subpoena concerned “a deal [he] invested in last summer” and that he was “terrified” by the fact that the SEC “is going after not just the companies but the investors.”

Similarly, over the past several months, the CFTC has filed several enforcement actions against individuals and companies for potential fraudulent activity, among them:

• Jan. 16, 2018: an enforcement action under seal against several individuals and a Las Vegas corporation for misappropriating over $6 million from customers. According to the complaint, the company at issue maintained a website and distributed solicitation materials for investing in a virtual currency that included misrepresentations. Customer funds were allegedly transferred into personal bank accounts and used to purchase luxury goods.

• Jan. 18, 2018: an enforcement action against a Colorado-based individual and his UK-registered company for using a website to solicit customers to deposit Bitcoin for a pooled investment in binary options trading with a promise of high returns. The complaint accuses the defendants of making Ponzi-style payments to commodity pool participants from other participants' funds, misappropriating funds and failing to properly register with the CFTC.

• Jan. 18, 2018: a civil enforcement action against a New York-based individual and New York-based company for fraud and misappropriation in connection with the purchase and trading of Bitcoin and Litecoin and providing purported “virtual currency trading advice.” The complaint accuses the defendants of not following through on their promise to provide advice or make the requested purchases and trades. According to the CFTC, the defendants “used their fraudulent solicitations to obtain and then simply misappropriate customer funds.” On March 6, 2018, a New York federal judge issued a preliminary injunction prohibiting the defendants from engaging in fraud in violation of the Commodity Exchange Act (CEA) and requiring them to preserve their books and records. Even more notably, the judge's order concluded that “[v]irtual currencies can be regulated by CFTC as a commodity” because they “are goods exchanged in a market for a uniform quality and value” and fall within the CEA's definition of 'commodities' as 'all other goods and articles … in which contracts for future delivery are presently or in the future dealt in.'”

These enforcement actions appear to be the beginning of a major campaign to regulate this market and are consistent with the trend of increased monitoring and enforcement by the CFTC.

The Forecast Ahead: More Enforcement Activity

We anticipate that regulators will continue to scrutinize potentially fraudulent and deceptive practices related to the sale, exchange, marketing and promotion of cryptocurrencies throughout 2018. This is evidenced by the following:

• The SEC has increased its resources dedicated to cryptocurrency-related activity, including the creation of a Cyber Unit that is investigating ICO-related misconduct.

• The SEC recently established dedicated “cyber liaisons” in regional offices to bolster its enforcement coordination efforts.

• The federal government has developed a cross-agency “DLT Working Group” that includes the SEC, CFTC, Treasury and various U.S. Attorney's Offices to coordinate on investigations and enforcement activity.

During remarks at the 2018 SEC Speaks conference, former SEC Commissioner Dan Gallagher cautioned that “we are seeing the tip of the iceberg” and that “there is going to be a ton of enforcement activity.” Gallagher warned that unregulated token offerings are the “Wolf of Wall Street on steroids.”

Weathering the Storm

While SEC Co-Director of the Division of Enforcement Stephanie Avakian has praised blockchain technology as having “real benefit and promise” and offered assurances that the SEC is “not looking to stifle innovation or lawful and appropriate capital raising,” cryptocurrency companies are facing a barrage of scrutiny from federal regulators. SEC Co-Director of the Division of Enforcement Stephanie Avakian, Panel Remarks at the 32nd Annual National Institute on White Collar Crime (Feb. 28, 2018). Such companies should therefore chart a strategy for navigating the increasingly precarious regulatory and enforcement landscape. Those seeking to participate in this brave new world, whether they have already completed a token generation event or are hard at work to create one, should be ready to structure their offerings in compliance with existing law.

Hedge funds—which invested approximately $2 billion in cryptocurrencies last year—should also be prepared to respond to tough questions from regulators. Recent reports suggest that the SEC is preparing to examine at least 100 crypto-focused private fund managers on topics ranging from the accuracy of their risk disclosures to potential conflicts of interest.

Finally, in addition to federal regulatory activity, companies should monitor state law developments. For instance, Wyoming recently signed into law House Bill 70, commonly referred to as the Utility Token Bill, which defines “utility tokens” in a manner that can exclude them from Wyoming state securities laws. Although such legislation does not directly impact federal law, it suggests that state regulators may have a different approach to crypto-currency regulation.

Others states, however, have taken the position that tokens are securities and are aggressively regulating ICO activity. For instance, in late March 2018, the Enforcement Section of Massachusetts' securities regulator ordered five companies to immediately halt the offering and selling of “unregistered securities” through ICOs and offer rescission for anything already purchased. The regulator accused the firms of promoting coins and tokens that were not properly registered as required by state law. Massachusetts Secretary of State William Galvin has warned that “[a]n offering done to avoid registration with regulators should be seen as a red flag” and described the consent orders as part of an “aggressive sweep” to police cryptocurrency industry.

Given recent developments, those active in the cryptocurrency space should operate under the assumption that their products, services, offerings and activities may be subject to regulatory review. Prudence suggests that planning ahead—and anticipating government scrutiny—will help in weathering the storm.

Benjamin Klein is an associate, Deborah Meshulam is a partner and Jason Chang is of counsel at DLA Piper.