On September 11, 2018, capital markets regulators announced a series of cases that are the first of their kind in the digital assets space.
The SEC announced its first case charging unregistered broker-dealers for selling digital tokens. According to the SEC’s order, the defendants operated a self-described “ICO Superstore” that solicited investors, took thousands of customer orders for digital tokens, processed investor funds, and handled more than 200 different digital tokens in connection with both ICOs and the defendants’ own secondary market activities. The defendants also promoted the sale of approximately 40 digital tokens in exchange for marketing fees paid by digital token issuers. Because the digital tokens issued in the ICOs and traded by defendants included securities under the SEC’s DAO Report, the SEC concluded that the defendants’ market activities required broker-dealer registration with the SEC.
In what we believe is another first-of-its-kind case, the SEC also announced charges against a digital asset hedge fund manager who failed to register with the SEC and misrepresented his status as a registered entity. The SEC’s order cites provisions of the Investment Company Act of 1940, which defines “investment company” as any issuer who “is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 percent of the value of such issuer’s total assets (exclusive of government securities and cash items) on an unconsolidated basis.”
For readers unfamiliar with this law, the Investment Company Act is the same statute that governs the operations of mutual funds that comprise most 401(k) plans and IRAs. The SEC concluded that the defendants engaged in the business of investing, holding and trading certain digital assets that were investment securities having a value exceeding 40 percent of the value of the fund’s total assets (exclusive of government securities and cash items). Although the fund met the definition of “investment company,” it did not register with the SEC as such, meet any statutory exemptions or exclusions from the definition of an investment company, or seek an order from the SEC declaring that it was primarily engaged in a business other than that of investing, reinvesting, owning, holding or trading in securities, or exempting it from complying with any provisions of the Investment Company Act or the rules thereunder. Thus, the fund should have registered with the SEC as an investment company.
The defendants also negligently misrepresented to actual and prospective investors in certain marketing materials that the fund was the “first regulated crypto asset fund in the United States” and had filed a registration statement with the SEC. Thus, the SEC determined that the defendants also failed to take reasonable steps to ensure the accuracy of these statements before disseminating them to actual and potential investors.
In both of these cases, the defendants immediately ceased operations and cooperated with the SEC when contacted by the SEC’s enforcement attorneys. As a result, the SEC assessed relatively light sanctions and penalties against them. But the cases serve as a reminder that the SEC continues to police the burgeoning digital asset marketplace and will continue to bring cases against parties who operate in an unregistered or otherwise unlawful manner.
Finally, FINRA announced its first disciplinary action against a registered representative involving cryptocurrencies. According to FINRA’s complaint, the respondent attempted to attract investors into a penny stock company he controlled by offering interests in what he advertised as the “the first minable coin backed by marketable securities.” As its primary business struggled, FINRA alleges that the respondent acquired the rights to a cryptocurrency named HempCoin and attempted to repackage HempCoin as a security backed by the publicly traded penny stock. The respondent also marketed HempCoin as “the world’s first currency to represent equity ownership” in a publicly traded company. On this basis, FINRA further alleges that investors mined more than 81 million HempCoin securities through late 2017 and traded the security on two cryptocurrency exchanges. Accordingly, FINRA alleges that the respondent engaged in the unlawful distribution of HempCoin as an unregistered security and that he made several misrepresentations to OTC Markets Group concerning the nature of the company’s business. Furthermore, the respondent never disclosed these transactions to his broker-dealer employer. Thus, FINRA asserts that the defendant violated a series of SEC and FINRA regulations.