Source: https://www.globallegalinsights.com/practice-areas/blockchain-laws-and-regulations/14-aspects-of-state-securities-regulation
Timestamp: 2019-04-20 12:36:55+00:00

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State securities regulators have been very active in regulating cryptocurrency-related investment products and the sale of digital assets. In May of 2018, state securities regulators announced “Operation Cryptosweep,” a coordinated series of enforcement actions and public outreach focused on fundraising schemes often referred to as Initial Coin Offerings (“ICOs”) as well as other investment schemes involving digital currencies. The focus of the coordinated action was on protecting main street investors from securities fraud, which state securities regulators have been doing for more than 100 years, and raising public awareness of the risks associated with ICOs and cryptocurrency-related investment products. In this chapter, we examine: how state securities regulators have defined cryptocurrency, digital tokens and related terms; when the offer or sale of digital assets may be considered an offer of securities under state law; and the obligations that flow from that determination from a state law perspective.
State securities laws are generally similar but certain aspects vary significantly across jurisdictions. Many state securities statutes are derived from the Uniform Securities Act, mainly the 1956 version or the 2002 version. This Chapter refers to the most recent version of the Uniform Securities Act from 2002 (“USA 2002”) throughout many parts of the discussion to provide examples of certain concepts.
How do state securities regulators define cryptocurrency and digital tokens?
Recent enforcement actions by state securities regulators that include definitions of these terms provide a window into how state securities regulators are thinking about cryptocurrencies and digital tokens. The definitions used across states vary and may refer to definitions of these digital assets used in other parts of the state code outside of the securities laws. Understanding how an individual state regulator defines these terms may be key to determining whether, and to what extent, a digital asset may come within the ambit of that state’s securities laws.
(C) Using any combination of the methods specified in subparagraphs (A) and (B) of this paragraph.
This definition of “open blockchain token” contains several interesting features. First, an open blockchain token must be created in a specific way. Subsection (i)(A) relates to tokens created to reward participants for verifying transactions in blockchain systems such as miners verifying transactions in systems using “proof of work” consensus rules. Open blockchain tokens created pursuant to subsection (i)(B) are those created during a token-generation event in a new blockchain-based platform, presumably for the purpose of selling or distributing the tokens which will be integral components of the operation of that platform.
Second, an open blockchain token must be recorded on a digital ledger that is, among other things, decentralised. Whether and when a blockchain-based platform is or becomes decentralised has been the subject of much recent debate. In a recent June speech, William Hinman, the Director of the Division of Corporation Finance at the U.S. Securities Exchange Commission, discussed the concept of decentralisation in the context of determining when the offer or sale of a digital asset constitutes the offer or sale of a security and is subject to the securities laws.10 This speech laid the conceptual groundwork for the idea that a digital asset, once sold in a securities transaction, could later be sold in a non-securities transaction, and identified the degree of decentralisation of the blockchain-based platform as a key factor in that analysis.11 Following this logic, it is possible that a digital asset sold in Wyoming could be sold in a securities transaction at one time, and then later, once the blockchain-based platform has become decentralised and the digital asset meets the definition of an “open blockchain token,” sold again in a transaction that does not implicate the Wyoming securities laws.
(i) meets the definition of a security prescribed in this section.
(ii) the issuer elects to treat as a security by complying with section 44-1844, subsection a, paragraph 22.
(i) has not been marketed by the issuer as an investment.
Legislation was also introduced in Colorado during the last legislative session that sought to define “open blockchain token” using the Wyoming definition verbatim.14 This legislation was not passed.
How regulators define cryptocurrency, virtual currency, and other related concepts will continue to evolve as the regulatory landscape in this area gains clarity. For now, it is clear that there are many variations in the definitions applied to these concepts, and a lack of uniformity in approach.
Does the sale of a digital asset involve the sale of a security?
The threshold question to determine whether state securities laws apply to the offer or sale of a digital asset is whether it involves the offer or sale of a “security.” Security is a defined term in all state securities laws, with slight variation across states.17 For instance, in some states, viatical settlements and variable annuities are specifically included in the definition of security, and in others they are not.
State securities laws specifically include “investment contracts” in the definition of security.18 At the federal level, an “investment contract” is also specifically enumerated within the definition of security.19 In SEC v. W.J. Howey Co.,20 the United States Supreme Court developed the test used to determine whether the sale of an interest constitutes an investment contract. The Howey test has several parts, each of which must be met for the transaction in question to involve the offer or sale of an investment contract: an investment of money, in a common enterprise, with an expectation of profit, derived solely, or substantially, from the efforts of others.21 The majority of states have adopted the Howey test in their own jurisdictions to determine when an investment contract is involved.
In many of these actions, state securities administrators determined that the offer or sale of a digital asset involved the offer or sale of a security by applying the Howey test, either explicitly or implicitly.
The risk capital test has not yet been applied in the context of the offer or sale of a digital asset, but it may have broader reach than an investment contract under the Howey test. Thus, even sales of digital tokens that do not satisfy the Howey test, and are not securities transactions for federal purposes, may nevertheless be deemed securities transactions in states that have adopted the risk capital test.
In some states, digital assets have been specifically excluded from the definition of a security through the legislative process. The Wyoming legislation, which defines an “open blockchain token,” also specifically excludes an “open blockchain token” from the definition of security.35 Accordingly, offers and sales of open blockchain tokens in Wyoming are not subject to the Wyoming securities laws because they are not offers or sales of securities.
In the Arizona legislation defining a “virtual coin” and a “virtual coin offering,” there is also a provision that excludes from the definition of a “virtual coin offering” the offer or sale of a virtual coin that both: “has not been marketed by the issuer as an investment; and grants to the purchaser, within ninety days after the purchaser’s receipt of the virtual coin, the right to use, contribute to the development of or license the use of a platform using blockchain technology . . . including a license to use a product or service on the platform or a discount against fees for use of the platform.”36 This language is evidence of an intent to exclude certain transactions in virtual coins from the definition of virtual coin offerings and, by implication, the definition of a security. Whether it accomplishes this intent is an open question, as it is not clear from a plain reading how this definition was intended to operate.
It is anticipated that more states will consider legislation like the Wyoming and Arizona legislation in the future to promote entrepreneurship and capital access for new blockchain-based platforms.
What obligations arise from the determination that the sale of a digital asset involves the sale of a security?
In each of the enforcement actions referenced above, the consequences of selling a security without complying with the applicable state securities laws is set forth and generally includes three categories of violations. First, securities offered for sale must be registered in the state in which they are offered for sale, or exempt from registration, or be federally covered securities. Second, the entities offering the securities for sale may need to be registered as a broker-dealer in each state in which they offer the security for sale. Finally, individuals recruited to sell the securities by the issuer or promoter may also need to be registered as broker-dealer agents or issuer agents in each state in which they offer the securities for sale if they are receiving compensation related to any such sales.
The review associated with an application for registration can differ significantly depending on the state. Some states are disclosure review states, meaning that if the issuer files the required disclosure documents with their application for registration, the application should become effective. Disclosure review does not address the substantive merits of the offering.
Other states conduct merit review of applications for registration of securities offerings. These states conduct a substantive review of a registration statement to determine if the offering will be fair to investors in their states. Where it is determined that an offer is unfair in certain respects, the merit review state may issue comments regarding the substance of the offering and can refuse to declare the registration statement effective in their state.
iii. transactions between issuers and underwriters.
v. offerings under Tier 2 of Regulation A of the Securities Act.
An issuer of a digital asset that is offered in a securities offering will need to comply with the registration requirements in each state in which the issuer intends to offer the digital asset for sale, and either make sure that there is an applicable exemption from registration or issue the digital assets in a federal-covered security. Federal-covered securities include securities offered under Section 4(2) and Rule 506 of Regulation D, and pursuing an offering of digital tokens in this way would allow an issuer to raise an unlimited amount of money selling to accredited investors, and could allow sales to 35 or fewer non-accredited investors depending on the circumstances. Federal-covered offerings of digital tokens pursuant to Tier 2 of Regulation A would permit an issuer to raise up to $50 million and sell to both accredited and non-accredited investors, subject to certain limitations on aggregate purchase amounts for non-accredited investors. Both Regulation D and Regulation A Tier 2 offerings may require notice filings at the state level.
In each of the state enforcement actions referenced in this chapter, the primary cause of action was for the sale of unregistered securities. In each case, the offer or sale of the digital asset in question was determined to be the offer or sale of a security, and in each case none of the securities were registered, exempt from registration, or federally covered.
At the federal level there is a similar requirement that brokers, persons engaged in the business of effecting securities transactions for the account of others, register pursuant to §15(a) of the Securities Exchange Act. “Issuers generally are not brokers because they sell securities for their own accounts and not for the accounts of others.”48 To the extent that agents of an issuer could be brokers and required to register, there is an exemption that applies in Rule §240.3a4-1 related to associated persons of an issuer deemed not to be brokers. It is possible that such issuer agents would still need to register at the state level depending on individual state issuer agent registration rules and exemptions.
State securities regulators have the authority to enforce the Commodities Exchange Act (“CEA”).49 The Commodities Futures Trading Commission (“CFTC”) has primary jurisdiction to enforce the CEA. The CFTC has asserted jurisdiction over virtual currencies as commodities subject to regulation pursuant to the CEA.50 “Section 1a(9) of the Act defines ‘commodity’ to include, among other things, ‘all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in.’”51 “Bitcoin and other virtual currencies are encompassed in the definition and properly defined as commodities.”52 The CEA provides general anti-fraud and manipulation enforcement provisions with respect to the spot commodities markets, and broad regulatory authority over derivative commodities markets. Accordingly, state securities regulators may bring actions related to virtual currencies for violations of the CEA when there is evidence of fraud in the spot market or more broadly with respect to the derivative markets.
State securities regulators have been very proactive in asserting their authority with respect to the sale of digital tokens and investment schemes involving virtual currency. The enforcement actions to date, including those outlined in this paper, have been focused on protecting retail investors from fraud and have targeted investments in this area that most clearly run afoul of state securities laws – strengthening the crypto ecosystem for all. As the regulatory landscape in this area evolves, it remains to be seen whether state securities regulators will turn their attention towards the regulation of digital assets intended primarily to provide consumer utility and how they will be treated.
If the recent Wyoming legislation provides an indication, we may see more state securities regulators consider exempting the sale of digital assets with certain characteristics from the definition of security. For now, when an instrument is offered for sale that involves virtual currency or a digital asset, care should be taken to determine if the offer constitutes the offer of a security. If it does, compliance with state securities laws in each of the states in which the securities will be offered will be necessary.
The Authors would like to thank their colleagues Lewis R. Cohen, Esquire and Jacob Shulman for their editorial contributions to this chapter.
1. NASAA Reminds Investors to Approach Cryptocurrencies, Initial Coin Offerings and Other Cryptocurrency Related Investment Products with Caution, NASAA (January 4, 2018) available at: http://www.nasaa.org/44073/nasaa-reminds-investors-approach-cryptocurrencies-initial-coin-offerings-cryptocurrency-related-investment-products-caution/.
2. Enforcement Report: Widespread Fraud Found in Cryptocurrency Offerings, Texas State Securities Board (April 10, 2018) available at: https://www.ssb.texas.gov/sites/default/files/CRYPTO%20SWEEP%20report%20April%2010%202018%20FINAL.pdf.
5. FATF Report, Virtual Currencies, Key Definitions and Potential AML/CFT Risks, Financial Action Task Force (June 2014), available at: http://www.fatf-gafi.org/media/fatf/documents/reports/Virtual-currency-key-definitions-and-potential-aml-cft-risks.pdf. See, e.g., In the Matter of: Blue Vase Mining, Consent Order, Docket No. E-2018-0018, available at: http://www.sec.state.ma.us/sct/current/sctbluevase/MSD-Blue-Vase-Consent-Order-E-2018-0018.pdf; In the Matter of Caviar and Kirill Bensonoff, Administrative Complaint, Docket No. E-2017-120, available at: https://www.sec.state.ma.us/sct/current/sctbensonoff/Administrative-Complaint-E-2017-0120.pdf.
7. In the Matter of Adosia LLC and Kyle E. Solomon, Final Consent Order, File No. 18 ADM 007, available at: https://www.sosnc.gov/vs2010/Soskb.Web.Content/media/1614/2018-05-10-adosia-final-consent-order_redacted.pdf.
10. William Hinman, Director, Division of Corporation Finance, “Digital Transactions: When Howey Met Gary (Plastic),” (June 14, 2018) available at: https://www.sec.gov/news/speech/speech-hinman-061418.
12. A.R.S.§44-1801(31) (effective August 3, 2018).
14. HB18-1426, Colorado General Assembly, Second Regular Session, 71st General Assembly and SB18-277, Colorado General Assembly, Second Regular Session, 71st General Assembly.
15. See §§8-7a-2(8) and 8-7a-2(10).
17. See e.g., §102(28) of the USA 2002.
18. See §102(28) of the USA 2002.
19. §2(a)(1) of the Securities Act of 1933; §3(a)(10) of the Securities Exchange Act of 1934.
20. SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
22. See State and Provincial Securities Regulators Conduct Coordinated International Crypto Crackdown, NASAA, (May 21, 2018) available at: http://www.nasaa.org/45121/state-and-provincial-securities-regulators-conduct-coordinated-international-crypto-crackdown-2/.
23. In the Matter of Swiss Gold Global, Inc. and Genesis Mining, Ltd. Administrative Order to Cease and Desist, File No. 17021 (Administrative Proceeding Before the Securities Commissioner of South Carolina, March 9, 2018) available at: http://2hsvz0l74ah31vgcm16peuy12tz.wpengine.netdna-cdn.com/wp-content/uploads/2018/03/01621904.pdf.
25. In the Matter of Broad Investments, LLC and Guoyong Liu, Verified Petition for Order to Show Cause, Case No. 2018-CDS-021 (Before the Colorado Securities Commission, May 2, 2018) available at: https://drive.google.com/file/d/1mV8IX5YKb3Vx4regOG0L77q9PIPxVLfp/view.
27. In the Matter of Browser Labs, LLC, Summary Order to Cease and Desist and Order to Show Cause, Case NO. 2018-0312 (Maryland Securities Commissioner May 21, 2018) available at: http://www.marylandattorneygeneral.gov/Securities%20Actions/2018/Browsers_Lab_ICO_SO_OSC_052118.pdf.
28. In the Matter of Chain Group Escrow Service, Cease and Desist Order, Administrative Order No. CD-2018-0003, Alabama Securities Commission (April 20, 2018) available at: http://www.asc.state.al.us/Orders/2018/CD-2018-0003.pdf.
29. See e.g., In the Matter of USI-Tech Limited, et al., Order No. ENF-17-CDO-1753 (Texas State Sec. Board, December 20, 2017) available at: https://www.ssb.texas.gov/sites/default/files/USI-Tech%20ENF-17-CDO-1753.pdf; In the Matter of BitConnect, Order No. ENF-18-CDO-1754 (Texas State Sec. Board, January 4, 2018) https://www.ssb.texas.gov/sites/default/files/BitConnect_ENF-18-CDO-1754.pdf; In the Matter of Caviar and Kirill Bensonoff, Administrative Complaint, Docket No. E-2017-120, available at: https://www.sec.state.ma.us/sct/current/sctbensonoff/Administrative-Complaint-E-2017-0120.pdf.
30. 55 Cal.2d 811 (1961).
36. A.R.S.§44-1801(32) (effective August 3, 2018).
37. See, e.g., §102(28) of the USA 2002.
38. See §301 of the USA 2002.
39. See §§303 and 304 of the USA 2002.
40. See §303 of the USA 2002.
41. See §304 of the USA 2002.
42. See §305 of the USA 2002.
43. See §§201 and 202 of the USA 2002.
44. See §102(4) of the USA 2002.
45. See §102(2) of the USA 2002.
46. See §402(a) of the USA 2002.
47. See §402(b) of the USA 2002.
48. See Investor Publications, Guide To Broker-Dealer Registration, Division of Trading and Markets, U.S. Securities and Exchange Commission (April 2008) available at: https://www.sec.gov/reportspubs/investor-publications/divisionsmarketregbdguidehtm.html#II.
49. 7 U.S.C. §13a–2 (2012).
50. See In the Matter of Coinflip, Inc., Order Instituting Proceedings, CFTC Docket No. 15-29 (Sept. 17, 2015) available at: https://www.cftc.gov/sites/default/files/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfcoinfliprorder09172015.pdf.
51. Id. (citing 7 U.S.C. §1a(9)).

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