A First in Crypto-Regulation: SEC Settles Charges and Imposes Civil Penalties Against the Founder of Token Trading Platform EtherDelta and Two ICO Sponsors
The Securities and Exchange Commission (“SEC”) this month announced a settlement with the founder of EtherDelta — a platform that facilitates secondary market trading of blockchain-based Initial Coin Offering (or “ICO”) tokens — over charges that EtherDelta was operating as an unregistered securities exchange. While the SEC has previously brought enforcement actions relating to unregistered broker-dealers and unregistered ICOs, the EtherDelta settlement marks the Commission’s first enforcement action against a crypto-asset trading platform.1
In announcing that EtherDelta founder Zachary Coburn will pay $388,000 to settle charges, the SEC cited its 2017 DAO Report of Investigation,2 in which the Commission proclaimed that certain crypto-assets are securities and that platforms that facilitate the trading of such assets are subject to exchange-registration requirements.
Consistent with the Commission’s approach in EtherDelta that at least some crypto-assets are securities, the SEC last week announced settlements involving two other companies, CarrierEQ Inc. (Airfox) and Paragon Coin Inc.; both had sold unregistered digital tokens through ICOs.3 But unlike an earlier enforcement action involving unregistered digital tokens, the SEC imposed civil penalties on Airfox and Paragon Coin; the settlements thus mark the first time that the Commission has imposed such penalties solely for ICO securities offering registration violations. Taken together, these three recent settlements remove doubt that the SEC views many crypto-assets as securities and reflect increased regulatory enforcement attention to securities violations involving crypto-assets.
A Secondary Market for ICO Tokens
The EtherDelta platform allows users to exchange blockchain-based tokens with other users. The specific type of token traded on EtherDelta — the ERC20 Token — is commonly used as the unit of account in ICOs.4 Thus, EtherDelta facilitates a secondary market for users who wish to buy or sell ICO tokens.
While some ICO investors purchase tokens expecting to use them in payment for goods or services in the future (buying so-called “Utility Tokens”)5, many investors purchase ICO tokens hoping to sell the tokens in the future at a profit. In its DAO Report, the SEC announced that tokens that fall into the latter category (commonly known as “Security Tokens” or “Equity Tokens”) may qualify as securities and trigger registration requirements.6
The EtherDelta settlement builds upon the DAO Report. Because EtherDelta facilitated the exchange of Security Tokens, and did so without registering as a securities exchange or obtaining an exemption, the Commission determined that the platform operated as an unregistered national securities exchange, and that the developer of the platform could accordingly be held liable for violating the federal securities laws.
Likewise, with the Airfox and Paragon Coin settlements, the Commission — citing its DOA Report — announced that those companies had sold unregistered securities through their respective ICOs and did so without registering their ICOs or obtaining an exemption to registration requirements.7
In the Crypto Space, Regulators Value Cooperation
The SEC recognized and considered Coburn’s cooperation in determining not to impose a greater penalty. “We are witnessing a time of significant innovation in the securities markets with the use and application of distributed ledger technology,” said Steven Peikin, Co-Director of the SEC’s Enforcement Division. “But to protect investors, this innovation necessitates the SEC’s thoughtful oversight of digital markets and enforcement of existing laws.”
What You Need to Know
Investigations and enforcement actions related to crypto-assets will likely accelerate in the near future. It should come as no surprise if ICOs — having attracted more than $20 billion8 in capital investment in 2018 alone — remain a particular focus of government regulators. The EtherDelta, Airfox, and Paragon Coin settlements reflect this. Further, the EtherDelta settlement makes clear that decentralized secondary markets are not immune to regulatory scrutiny. Indeed, enforcement actions against both ICO sponsors (e.g., Airfox, Paragon Coin, Munchee) and secondary markets (e.g. EtherDelta) reflect the emergence of a consistent regulatory approach to crypto-assets, with the SEC viewing Security Tokens as securities.
While we can expect more regulatory activity going forward, the SEC and other agencies9 have signaled that they value industry cooperation and will weigh an individual’s or entity’s cooperation when considering penalties.
2 “DAO” is an abbreviation for “decentralized autonomous organization.” The SEC’s DAO Report of Investigation can be found at: https://www.sec.gov/litigation/investreport/34-81207.pdf.
4 In other words, when an investor buys “coins” as part of an initial coin offering, they are often actually buying ERC20 Tokens.
5 A utility token can be thought of as a digital coupon for the issuer’s goods and services. For example, the blockchain data storage network Filecoin raised $257 million over one month by selling tokens that provide token holders with early access to its cloud storage platform. See https://www.coindesk.com/257-million-filecoin-breaks-time-record-ico-funding.
6 In the DAO Report, the SEC announced that it would apply the Supreme Court’s fact-based Howey test to determine if an asset constitutes a security. See SEC v. Edwards, 540 U.S. 389, 393 (2004); SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946); see also United Housing Found., Inc. v. Forman, 421 U.S. 837, 852-53 (1975) (The “touchstone” of an investment contract “is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”).
7 The Airfox and Paragon Coin settlements were not the first in which the SEC viewed the sale of ICO tokens as the sale of an unregistered security. They were, however, the first in which civil penalties were imposed. In October and November 2017, Munchee, Inc. (“Munchee”) had offered and sold digital tokens to investors to raise operating capital. In connection with the offering, Munchee described that its tokens could increase in value as a result of Munchee’s efforts and stated that the tokens would be traded on secondary markets. The SEC commenced enforcement proceedings, claiming that Munchee had sold unregistered securities in violation of the federal securities laws. In settling the case, however, the Commission did not impose a civil penalty against Munchee. Instead, it resolved the case for a cease-and-desist order. Significantly, Munchee had stopped its offering before delivering any tokens and promptly returned proceeds to investors. See https://www.sec.gov/litigation/admin/2017/33-10445.pdf.
8 See https://www.coinschedule.com/stats.html.
9 In a recent talk at the Annual GITEX Technology Week Conference, Commodity Futures Trading Commission Commissioner Brian Quintenz expressed his personal preference for “engagement instead of enforcement,” and noted that the CFTC “is open to engaging with innovators to understand new technological infrastructures and applications and to work to ensure these activities are undertaken in a manner compliant with the law.” See https://www.cftc.gov/PressRoom/SpeechesTestimony/opaquintenz16.
This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.