The Securities and Exchange Commission recently released an investigative report warning securities market participants that the sale of digital assets by “virtual” organizations are covered by the federal securities laws. Such solicitations and sales, typically effectuated by entities using distributed ledger or blockchain technology, are known as “initial coin offerings” or “token sales.”
The SEC made clear, however, that whether a particular investment transaction involves the offer or sale of a security, notwithstanding the terminology used to describe it, or the technology employed to market and sell it, will depend on the particular circumstances, including the underlying economic realities of the transaction.
In its Report of Investigation, the SEC concluded that tokens solicited and sold by a “virtual” organization commonly known as “The DAO” were securities and thus governed by the requirements of the federal securities laws. The SEC Report further determined that issuers of distributed ledger or blockchain technology-based securities have a legal obligation to register such offerings, unless an exemption from registration exists. Registration would also extend and apply to securities exchanges that facilitate trading in these types of securities, unless they are lawfully exempt.
Registration under the federal securities laws is designed to ensure that investors receive all appropriate disclosures in connection with the purchase of a security, and to provide regulatory oversight for the protection of the investing public.
As the new Co-Director of the SEC Enforcement Division, Stephanie Avakian, stated: “The innovative technology behind these virtual transactions does not exempt securities offerings and trading platforms from the regulatory framework designed to protect investors and the integrity of the markets.”
The SEC’s recent pronouncements on the potential applicability of the federal securities laws to initial coin offerings is yet another example of the SEC’s long running battle in attempting to determine whether a particular financial product constitutes, as a matter of law, a security such that the SEC may exercise its enforcement jurisdiction. Beyond stocks and bonds, there are a multitude of investments — ranging from fractionalized interests in Ostrich farms to whiskey receipts — that the Courts historically have determined to be securities. While the United States Supreme Court laid out the basic elements of what constitutes a “security” for purposes of SEC jurisdiction in the seminal case of SEC v. Howey many years ago, the determination of what is, and what is not, a security under the securities laws is often ambiguous and subject to good-faith argument.
There are grave consequences for offering and selling a financial product or investment that is determined to be a security without first registering it, or selling it based upon an exemption from registration. Doing so would potentially violate Section 5 of the Securities Act of 1933, which would allow the SEC to seek civil penalties, penny stock bars, injunctions against future violations of the securities laws, and disgorgement (the return of all profits, for example, made from the securities offering). Even though the seller did not know it was violating the law, i.e., did not realize it was selling a security, this is no defense to a Section 5 violation, as intent is not a required element of the violation (unlike a fraud charge under Section 10(b) of the Securities Exchange Act of 1934, which does require proof of intent or “scienter”).
Moreover, any individual offering and selling a financial product determined by the SEC to be a security (whether its registered or not) runs the very real risk of being deemed an unregistered securities broker in violation of Section 15 of the Securities Exchange Act of 1934, thus subjecting him to enforcement action and possible civil charges and penalties. Just like a Section 5 violation, a Section 15 breach under the Securities Exchange Act of 1934 does not require intent (i.e., you don’t need to know you are violating the law) for purposes of SEC prosecution.
The takeaway is simple: notwithstanding the new technology and the fancy terminology, if an offering essentially involves the contribution of capital by individuals in a common enterprise who are generally passive and seek to profit predominantly from the efforts and expertise of others, typically the deal’s promoters, it is likely that the investment is a security subject to the requirements of the federal securities laws and the SEC’s jurisdiction.
There are, however, arguments to be made against a finding of a security and hence SEC jurisdiction, and courts over the years have, in fact, ruled against the SEC on such matters. It is in this grey area that we SEC defense lawyers make our livings.
David Chase,Esq.is a SEC defense attorney and principal of the SEC law firm, David R. Chase, P.A.,which is located in South Florida.His law firm represents individuals,financial advisors and companies in SEC investigations, FINRA inquiries and criminal securities investigations. Mr. Chase represents clients nationwide before the SEC, FINRA and state securities regulators.
