A year has passed since the SEC issued its groundbreaking DAO Report, in which the SEC, for the first time, unambiguously asserted its regulatory authority over initial coin offerings (“ICOs”)—in which investors typically invest in a blockchain-based enterprise in exchange for digital tokens—and ICO-issued digital tokens.

In doing so, the SEC classified ICO tokens as securities subject to existing securities laws. Since the SEC issued the DAO report, it has aggressively stepped up its public warnings against, and regulation of, these novel fundraising vehicles. ICO proponents have responded in varying ways, whether by exploring creative products that they believe do not trigger SEC regulation, seeking SEC approval or challenging the SEC's position in court. Now, in United States v. Zaslavskiy, the U.S. District Court for the Eastern District of New York will decide the first direct challenge to the SEC's classification of ICOs as securities offerings subject to SEC regulation.

The SEC's Foray into Cryptocurrency Regulation

In a typical ICO, virtual coins or tokens are created using distributed ledger or blockchain technology and then sold to purchasers by promoters of a new project or venture. ICO promoters frequently represent to purchasers that proceeds of the ICO will be used to fund certain initiatives—such as development of a digital platform or software—and that the ICO tokens will allow investors to participate in the potential future profits of the enterprise. One of the SEC's primary concerns regarding ICOs is that these representations are frequently false and intended to entice purchasers to invest in a fraudulent scheme.

The critical question in the regulation of ICOs is whether existing securities laws apply to the coins or tokens at issue in the offering—i.e., whether the coins fall within the definition of a security. The Securities Act of 1933 defines a “security” in part as “an investment contract,” the definition of which was set forth by the Supreme Court in the landmark case SEC v. W.J. Howey Co. Under the now widely known “Howey test,” the factors for determining the existence of an investment contract are: (i) an investment of money (ii) in a common enterprise (iii) with a reasonable expectation of profits (iv) to be derived from the entrepreneurial or managerial efforts of others.

The DAO report relied on the Howey test to determine that ICOs are in fact securities offerings subject to SEC oversight and registration requirements. The SEC's report followed its investigation into an autonomous organization known as The DAO (Decentralized Autonomous Organization), which sold “DAO Tokens” to investors in exchange for the payment of Ether cryptocurrency to raise capital for investment projects that would be selected by DAO “curators.”

The SEC determined that, under the Howey test, the DAO tokens were securities and their sale amounted to an unregistered offering. The SEC did not bring charges against The DAO and its creators. Rather, the SEC used the DAO report as an opportunity to make plain the SEC's position regarding the applicability of federal securities laws to ICOs. The SEC also simultaneously issued an investor bulletin warning of the potential dangers in participating in ICOs, including fraud and lack of regulatory approval.

SEC Enforcement and Outreach

Since then, the SEC has commenced numerous enforcement actions against both ICO issuers and their officers. Most recently, the SEC brought an enforcement action against Tomahawk Exploration and its founder David T. Laurance for conducting a fraudulent ICO to fund oil exploration and drilling. The SEC's Aug. 14 order found that Laurance and Tomahawk inflated projections, touted potential profits and misled investors regarding Laurence's background.

In addition to the enforcement actions against issuers and their officers, in early 2018, the SEC issued dozens of subpoenas and information requests relating to ICOs. Notably, these subpoenas were reportedly issued not only to ICO issuers and advisers but also to exchanges and investors. To date, the SEC's focus in issuing these subpoenas is not clear and interested observers seeking further insight into the SEC's priorities are anxiously waiting to see whether any enforcement actions will follow.

Several state regulators have followed the SEC's lead, seeking or issuing cease-and-desist orders to stop ICOs. Moreover, in May 2018, the North American Securities Administrators Association (NASAA) announced “Operation Cryptosweep,” which involved NASAA members from more than 40 jurisdictions in North America and has resulted in close to 70 inquiries and investigations and 35 pending or completed enforcement actions against ICO issuers.

In addition to its ICO-related enforcement actions and investigations, the SEC has also taken preventative measures to help protect investors from fraudulent ICOs and further educate the public about the potential dangers of ICOs. In May 2018, the SEC's Office of Investor Education and Advocacy rolled out a mock website, HoweyCoins.com, intended to mimic a fraudulent ICO website. The website contains a fake white paper, promises of guaranteed returns, a countdown clock and fake testimonials. The website's “Buy Coins Now” button directs visitors to investor education tools and tips from the SEC and other regulators.

After the DAO Report: ICO Registration

While the DAO report made plain the SEC's intention to regulate ICOs, it did not provide clear rules for determining when a particular token would be classified as a security.

At least two companies have responded by seeking SEC approval for their ICOs. In March 2018, the Praetorian Group filed with the SEC to register its ICO as a security offering. While the company's registration application expressly preserved a position that “the PAX token might not constitute a security,” it nevertheless concluded that “given the uncertainties from a regulatory standpoint . . . it is more prudent to deem the PAX token a security and follow through with the registration process.”

In May 2018, Monster Products, Inc. followed in Praetorian's path, stating in its form S-1 its intention to use the proceeds from selling “Monster Money Tokens” to build an e-commerce platform for selling its products online. If the SEC does ultimately approve either of these ICO applications, it would result in the first SEC-registered ICO and could pave the way forward for others to seek similar approval.

Legal Challenge: 'United States v. Zaslavskiy'

As the regulatory landscape around ICOs continues to unfold, interested parties await a federal district court's decision on a motion to dismiss in the criminal case United States v. Zaslavskiy, in which the defendant Zaslavskiy has mounted the first direct legal challenge to the SEC's authority to regulate ICOs and ICO tokens.

The case against Zaslavskiy arose from the offering of tokens—REcoin and Diamond coins—by REcoin Group Foundation LLC and Diamond Reserve Club, respectively. According to the indictment, Zaslavskiy falsely represented to purchasers that REcoin was a virtual currency “backed by real estate investments in developed economies” and promoted it as an “attractive investment opportunity.”

Similarly, Zaslavskiy allegedly falsely represented that Diamond coins were backed by physical diamonds and forecasted a “minimum growth of 10% to 15% per year.” The SEC and DOJ brought parallel civil and criminal charges against Zaslavskiy, alleging material misrepresentations in connection with offering the two tokens.

In his motion to dismiss the indictment, Zaslavskiy advanced three primary arguments. First, Zaslavskiy argued that the tokens in question are “cryptocurrencies,” and therefore fall outside the scope of securities laws, which exempt currency from the broad definition of “security.” In response, prosecutors have argued that the coins cannot be categorized as currencies because they were never actually developed and therefore had no value.

Additionally, the prosecutors noted that the coins were marketed as an investment opportunity, as opposed to a potential substitute for fiat currency, which suggests that Zaslavskiy never intended them to function as currency. Moreover, the SEC, which received permission in the criminal case to file an opposition brief in support of the United States, argued that even if Zaslavskiy intended the coins to be used as currency, their future use as such necessarily depended on Zaslavskiy's efforts to develop the required blockchain-based ecosystem.

Second, Zaslavskiy argued that, even if cryptocurrencies can be subject to securities laws, REcoin and Diamond coins were not investment contracts under the Howey test. In response, the DOJ and the SEC each emphasized the flexibility of the Howey test and the importance of a fact-specific application. Both the DOJ and the SEC conducted a fact-specific application of each element of the Howey test in arguing that the tokens at issue were in fact investment contracts and therefore securities.

Third, Zaslavskiy argued that the securities laws as applied to cryptocurrencies are void for vagueness. Zaslavskiy asserted that “[t]here is no meaningful guidance for would-be developers to know whether their work runs afoul of criminal securities laws.”

In response, prosecutors argued that the definition of a security is “intentionally broad and flexible” and that Zaslavskiy had “more than sufficient notice” that his offerings constituted investment contracts under Howey, as clarified through a “rich body of case law.” Prosecutors also relied on the SEC's guidance in the DAO report and in public statements and releases to argue that Zaslavskiy was on notice of the potential applicability of the securities laws to token offerings. A decision on the motion to dismiss will hopefully bring some clarity to the appropriateness and perhaps scope of SEC authority in the space.

Conclusion

The increase in activity surrounding ICOs in the year since the DAO report has evinced the SEC's clear intention to assert its authority in the blockchain-based technology space, but also the uncertainty that remains with respect to the parameters of the SEC's authority and the SEC's intentions with respect to future regulation. Interested parties will undoubtedly continue to deploy creative methods of navigating the terrain around this issue, and Zaslavskiy will likely be the first of many judicial opinions providing guidance for regulators, promoters and investors alike.

Una A. Dean is a partner and Adam Y. Yefet is an association in the Litigation Department of Fried, Frank, Harris, Shriver & Jacobson LLP.