J Scott Colesanti (Left) and Savannah Aronson (Right)

The art of oversighting cryptocurrency offerings remains a primer on federalism, as the Securities and Exchange Commission and the states have evidenced varying (if not conflicting) regulatory approaches. This article summarizes the dominant approaches of the moment while noting that polemic solutions rewarding either government registration or discipline form the most discernible guidance for the immediate future.

Technology Grounded in Orange Groves

Since 2013, the SEC has reined in crypto deals inviting investors under the Howey test of 1946. Under that hallowed standard, an issuance of digital assets (e.g., coins) can bring the issuing entity within the securities laws where the transaction satisfies a multi-part test. That test, long dignified in precedent, seeks investments in a common enterprise with the expectation of profits from the efforts of others. Defendants in such "Section 5" disciplinary cases can range from entities raising capital through the offering of digital currency to Ponzi schemers, to Bitcoin miners promising future fortune and "exchanges" serving as novel market centers. Accordingly, administrative actions/civil lawsuits such as ZenMiner (2015), Munchee (2017), and PlexCorps (2017) have garnered public attention and halted issuer offerings seen as unregistered sales of securities.

Likewise, this year has revealed disciplinary cases faulting issuers for not registering ersatz digital securities. In March, the SEC issued a complaint in Texas against three individuals, for fraud in connection with the offer, purchase or sale of securities after soliciting investors for "Meta1," an unincorporated entity, by offering coins. It was alleged that over two years the defendants raised at least $4 million from over 150 investors. The defendants allegedly made false claims that the coins were digital coins backed by $1 billion in art and $2 billion in gold.

Additionally, the SEC claimed that defendants told investors that the coins would never lose value, and that each coin would conservatively have a return of up to 224,923%. Following the collection of investor funds, the defendants allegedly failed to distribute the coins and began to use the money raised for personal expenses. The SEC was able to obtain an asset freeze and is moving forward by seeking permanent injunctions, disgorgement of ill-gotten gains, and civil penalties.

Likewise, in May, the SEC settled with BitClave PTE Ltd. for conducting an unregistered "Initial Coin Offering." BitClave began marketing its CAT tokens, which were to be used on its platform, on social media, at industry events, and on its own website. BitClave announced in its White Paper that the funds raised from the ICO would be used to develop, administer, and market the platform. In addition, the company claimed that the value of the CAT tokens would increase and that the tokens would be available to trade on digital asset trading platforms. Over the course of its offering from June to November 2017, BitClave raised $25.5 million from 9,500 investors without ever registering their offering. Ultimately, BitClave was ordered to pay disgorgement in addition to other penalties. As part of the order, BitClave also agreed to transfer the remaining tokens to a "fair fund" that would return money to injured investors.

To be sure, without a statute or formal rule, issuers and investors reside in a state of suspenseful caution as to what actions will be subjected to the SEC's enforcement. Not only has there been opposition from the crypto industry over this unpredictable regulation, but between Chairman Jay Clayton and Commissioner Hester Pierce, there is a public divide. Clayton believes that digital assets satisfying Howey should be regulated the same as any other securities. Conversely, Pierce casts the Howey test casts as confusing both issuers and investors on whether a token is a security itself (as opposed to the contract, scheme, or transaction used to purchase the token). Pierce has gone so far as to propose a safe harbor that would give digital asset developers a three-year grace period where they would be exempted from the registration requirements.

While the SEC exhibited a spirit of cooperation with offerors via the TurnKey "No Action" letter of 2018, that limited guidance essentially exempted "utility tokens" only when completely lacking capital formation purposes. Most recently, the Commission has revealed a softer touch for those entities willing to reimburse "investors" and/or register the deal or the entity with the relevant state or with the Commission. Earlier this month, an issuer called Ceres registered with the SEC its planned distribution of coins to be used as part of a cannabis network. The registration option—somewhat rare and normally costly—has existed for some time at the state level.

State Approaches

For example, with much publicity, the celebrity Winklevoss brothers received the stamp of approval from the New York State Department of Financial Services (DFS) in September 2018 for their Gemini dollar. The stablecoin (i.e., a digital coin tied to a less volatile asset) is backed by one U.S. dollar. The Gemini dollar is nominally subject to rigorous regulations, including controls to prevent the coins from being used in connection with certain crimes and disclosures posting terms and conditions. Significantly, the stablecoin is touted as part of the Winklevoss' Gemini exchange, which is promoted as the world's "most regulated cryptocurrency exchange" (in the absence of evidence to the contrary).

However, many states continue to embrace the minimalist approach of offering regulatory guidance. The sole common denominator can be said to be money transmitter requirements, which at last tally by the industry are codified for crypto issuers in 49 of 50 States. Moreover, a measure proposed by legislative commission ("The Uniform Regulation of Cryptocurrency-Businesses Act") has stalled in its travels.

Some states have pursued the regulation of crypto with concerted actions. In 2019, Wyoming passed several laws that allowed it to be at the forefront of state regulation that promoted crypto. One of the laws passed was the Financial Technology Sandbox, which waived a number of regulatory financing, corporation, and trade and commerce statutes and rules that would normally apply. Under the measure, anyone who creates an innovative financial product or service may offer it without the burden of the waived laws for up to 3 years – dubbed the "sandbox period." A contemporaneous Wyoming statute classified digital assets within the Uniform Commercial Code as either digital consumer assets, digital securities, or virtual currency and identified which sections of the UCC apply to each asset.

Meanwhile, New Jersey has proposed according a form of full faith and credit to registrations in other States. Specifically, the Digital Asset and Blockchain Act (No. 8291), introduced in February 2020, would resemble New York's requirement of a license to engage in the digital asset business; however, the measure does allow for those licensed in another state to engage in digital asset business if a prior license emanated from a State protocol as protective of consumers as that of New Jersey. Among other things, the bill requires the disclosure of terms and conditions in consumer contracts for digital assets which must be complete, contain no material misrepresentations, and be written in understandable language.

Of course, New York's "BitLicense" remains the standard for conservative regulation by implementing, among other things, net capital, recordkeeping, and custody requirements. Initially resisted, the 2015 regulations have prodded over two dozen enterprises to embrace oversight by the Empire State.

Likely Future

To be sure, the SEC's activism has succeeded in bringing deals and issuers onto the radar screen, and weeding out some bad actors. On the other hand, some registered entities have simply taken on additional registrations (e.g., Robin Hood, a registered broker-dealer that also owns the New York cryptocurrency registration).

The most recent Congressional proposal was introduced in March 2020. The Crypto-Currency Act would identify three different types of digital assets: crypto-commodities, crypto-currencies, and crypto-securities. In turn, the types would each be assigned to a different government entity (i.e., the CFTC, the Treasury Department's Financial Crimes Enforcement Network, and the SEC).

Nonetheless, the overarching definition, rule or statute hoped for by both promoter and investor alike still appears to be in the distance, as is the assignment of the most relevant agency. Significantly, on July 10, a New York court denied a motion to dismiss criminal charges against a crypto exchange accused of connections to fraud numbering $800 million. Consequentially, those decrying the emergence of dire legal responses must nonetheless concede the persistence of questionable yet lucrative schemes triggering activism at both the State and federal levels. While a "one size fits all" standard is sought, it would appear both the carrot of registration and the stick of limitless penalties seem clearly in vogue.

Scott Colesanti, a former regulator, is a professor at the Hofstra University School of Law, where he has taught Securities Regulation since 2002. Savannah Aronson is a candidate for dual Hofstra JD/MBA degrees in 2021 who has centered her research on cryptocurrency .