Op Ed: SEC’s Latest Declaration Creates Legal Minefield for Digital Assets
On November 16, 2018, the U.S. Securities and Exchange Commission (SEC) issued a public statement clarifying its intent to regulate activities involving the issuance and trading of digital assets. The SEC’s Statement on Digital Asset Securities Issuance and Trading pronounces that three categories of financial services that utilize blockchain or other distributed ledger technologies (DLTs) are within the purview of the SEC and require registration with the SEC unless exempt. This broad, authoritative declaration is not unexpected, as, to date, the SEC has stated that all digital assets — regardless of whether they function as alt coins or utility tokens — are securities at least initially and, thus, subject to its jurisdiction.
As to which specific activities fall under the purview of the SEC, the SEC statement provides that the following three categories will trigger SEC scrutiny:
Initial offers and sales of digital asset securities, including those issued in initial coin offerings (ICOs)
Issuers of digital assets, including sponsors of ICOs, are subject to SEC regulations. Therefore, any initial offering or ICO must be registered with the SEC under Section 12(g) of the Securities Exchange Act of 1934 (“Exchange Act”), unless exempt from such registration as a private placement.
Investment vehicles investing in digital asset securities and those who advise others about investing in these securities
Investment vehicles that hold digital assets and investment advisors who advise on investing in digital assets, including investment vehicle managers, are subject to the registration, regulatory and fiduciary obligations under the Investment Company Act of 1940 and the Investment Advisers Act of 1940.
Secondary market trading of digital asset securities
The SEC statement provides that secondary market trading of digital assets generally requires registration as a national securities exchange or registration as a broker or dealer unless exempt.
With respect to exchange registration, any entity that provides a marketplace for bringing together buyers and sellers of digital assets must determine if its activities satisfy the definition of an “exchange” under the federal securities laws (in particular, Exchange Act Rule 3b-16, which provides a functional test to determine if an entity satisfies the definition of an “exchange” under Section 3(a)(1) of the Exchange Act). Any entity that meets this definition must register with the SEC as a national securities exchange or be exempt from registration, such as by operating as an alternative trading system in compliance with Regulation ATS.
With respect to broker-dealer registration, any entity that facilitates the issuance of digital assets in ICOs and secondary trading in digital assets may be acting as a “broker” or “dealer” and must register with the SEC, as well as become a member of a self-regulatory organization, such as FINRA.
The SEC statement is yet another example of the manifold, complex layers of regulation that market participants must navigate in the United States, where digital assets currently are regulated not only as securities by the SEC, but also:
- as commodities by the CFTC;
- as capital assets by the IRS;
- by FinCEN under its AML regulations;
- by certain self-regulatory bodies, such as FINRA; and
- by state financial services regulators under their respective money transmitter regulations and digital asset licensing schemes (e.g., the New York State Department of Financial Services’ BitLicense).
The resulting regulatory environment has stymied the growth of digital asset business in the United States and starkly contrasts with other growth-focused jurisdictions. For example, on the opposite end of the spectrum, the government of Bermuda has sought to foster the development of digital assets and the broader fintech ecosystem by implementing a consistent regulatory scheme. In August 2018, the government of Bermuda passed the Initial Coin Offering Act and the Digital Asset Business Act, which together establish a comprehensive and prudential regulatory framework that is designed to create a supportive environment for the development of fintech. To facilitate the growth of this burgeoning sector, the government of Bermuda also recently passed the Restricted Banks Act, which creates a novel, restricted banking license to encourage banks to provide financial services to fintech companies.
The United Kingdom, comparatively, is reportedly prepared to take a moderate, middle ground approach as it seeks to regulate cryptocurrencies and digital assets. U.K. authorities may focus on protecting small, retail investors, while simultaneously not inhibiting the development of blockchain and other DLTs upon which cryptocurrencies and digital assets are built. A recent task force report co-issued by Her Majesty’s Treasury, the Bank of England and the Financial Conduct Authority promised detailed proposals in 2019, which may specify if additional cryptocurrencies and digital assets will be subject to regulation, establish new AML rules that exceed current European Union directives, and restrict or ban the sale of cryptocurrency-based derivatives to retail investors.
In conclusion, the SEC statement and the latest announcements by other regulatory bodies that seek to regulate digital assets, while further legitimizing this asset class, have created a legal minefield that must be cautiously traversed with the assistance of counsel.