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THE INTERSECTION OF TECHNOLOGY AND CAPITAL RAISING

U.S. Regulatory Considerations for the Sales, Trading and Custody of Digital Assets

2021 Update

By Barbara A. Stettner, Hilary Seo, Lena Kiely and Chelsea Pizzola1

I. INTRODUCTION

The U.S. financial regulatory framework is fragmented, with oversight and regulation divided and shared among various federal and state agencies, each with a specific mission, mandate and regulatory philosophy. Federal banking and financial markets regulators (including, among others, the U.S. Office of the Comptroller of the Currency (“OCC”)), the U.S. Securities and Exchange Commission (“SEC”), the U.S. Commodity Futures Trading Commission (“CFTC”) and others are currently in the process of defining the regulatory landscape for new technologies and digital assets in the United States and, indirectly, exerting significant influence over the landscape around the globe.

U.S. regulators are specifically focused on the rapid rise of “digital assets” being sold and traded in the U.S. financial markets and both the opportunities and risks they pose to U.S. investors. In recent years, digital assets and cryptocurrencies2 as an emerging feature of the global financial system, has commanded much attention. Since the first decentralized cryptocurrency, Bitcoin, was unveiled in 2009,3 both the overall value and variety of cryptocurrency in circulation have expanded dramatically. According to one estimate, the global market capitalization of cryptocurrencies exceeded $602 billion in the fourth quarter of 2017, before falling to approximately $350 billion in 2020.4 As of May 12, 2021, the total market value of cryptocurrencies approximated $2.5 trillion, before falling to $1.5 trillion +/- through August 6, 2021.5 Despite this rise and fall in value, cryptocurrencies and ICOs are increasingly becoming an important repository of personal wealth, and the number of cryptocurrencies are on the rise worldwide.

Below, we provide a framework of some of the key regulatory issues to be considered when raising capital with digital assets, including the related various and fast-evolving technologies being used to market, distribute, trade and custody them.

II. WHEN DIGITAL ASSETS ARE SECURITIES OR COMMODITIES

Digital assets are assets that are issued and transferred using distributed ledger or blockchain technology, including, but not limited to, so-called “virtual or

1 The authors wish to thank Bill Satchell, Jonathan Flynn, and Derek Manners for their contributions to this outline. 2 As defined by the Financial Asset Task Force (“FATF”), the term “cryptocurrency” refers to any “math-based, decentralised convertible virtual currency that ... incorporates principles of cryptography to implement a distributed, decentralised, secure information economy.” FATF, Virtual Currencies Key Definitions and Potential AML/CFT Risks (June 27, 2015), http://www.fatf-gafi.org/media/fatf/documents/reports/Virtual-currency-key-definitions-and-potential-aml-cft-risks.pdf. 3 Nakamoto, Satoshi, Bitcoin: A Peer-to-Peer Electronic Cash System (May 24, 2009), https://bitcoin.org/bitcoin.pdf. 4 Valuations according to Cryptocurrency Market Capitalizations, https://coinmarketcap.com/ (last updated Aug. 7, 2020). 5 CoinMarketCap, “Global Cryptocurrency Charts,” at https://coinmarketcap.com/charts/.

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crytocurrencies,” “coins,” “cryptoassets”, and “digital tokens”.6 Digital assets, including cryptocurrencies, may be determined by regulators to be securities, commodities, properties, or currencies (or a combination thereof) as well as other types of U.S. regulated financial instruments, depending on the characteristics of the asset.7 As a threshold matter, the regulatory status of a proposed digital asset should be determined before any issuances and distributions are made to U.S. investors to avoid potential regulatory and civil actions, rescission risks, and significant legal and technology (rebuild) costs.

A. Digital Assets as Securities

The U.S. Securities Act of 1933, as amended (the “Securities Act”), provides that every offer or sale of securities in the United States must be registered with the SEC or must be exempt from such registration. Persons involved in the offer or sale of such securities (registered or exempt)—including those involved with digital securities over online crowdsourcing, trading or digital finance (“DeFi”) platforms —should consider whether the activities that they are undertaking implicate registration requirements for broker-dealers under Section 15(a) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”); alternative trading systems with the SEC (“ATS”) under Exchange Act Rule 3a1-1(a) and Regulation ATS; national securities exchanges under Section 6 of the Exchange Act; or clearing agencies under Section 17A of the Exchange Act. These are significant regulatory obligations and therefore it is critical for issuers and market intermediaries, as well as the lawyers advising them, to first determine whether the digital asset is a security or something else.

1. Pursuant to Section 2(a)(1) of the Securities Act and Section 3(a)(10) of the Exchange Act, a security includes “an "investment contract.”8 The SEC and U.S. courts generally assess whether a particular cryptocurrency or related token is a security by applying the test for identifying an “investment contract” under SEC v. W.J. Howey Co. The Howey case and subsequent case law define the term “investment contract” as an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.9 In analyzing whether something is a security, “form should be disregarded for substance,”10 “and the emphasis

6 See generally, Eva Su, Cong. Research Serv., R46208, Digital Assets and SEC Regulation (2021). 7 SEC, “Leaders of CFTC, FinCEN, and SEC Issue Joint Statement on Activities Involving Digital Assets,” public statement,

Oct. 11, 2019, https://www.sec.gov/news/public-statement/cftc-fincen-secjointstatementdigitalassets 8 See 15 U.S.C. §§ 77b-77c. 9 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.”). This definition embodies a “flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” Howey, 328 U.S. at 299 (emphasis added). 10 Tcherepnin v. Knight, 389 U.S. 332, 336 (1967),

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should be on economic realities underlying a transaction, and not on the name appended thereto.”11

2. Offerings and other forms of capital raisings involving cryptocurrencies, tokens, or other types of digital assets can implicate U.S. securities laws, including broker-dealer and exchange registration requirements. Particularly when portrayed as a means of “crowdsourcing” startup costs, cryptocurrencies, tokens, or other types of digital assets may be viewed as investment contracts and, therefore, securities. Current SEC Chairman Gary Gensler and former Chairman Jay Clayton have further emphasized that a token or coin offering has the hallmarks of a security under U.S. securities law if it relies on marketing efforts that highlight the possibility of profits based on the entrepreneurial or managerial efforts of others, regardless of structure.12

3. On July 25, 2017, the SEC issued the DAO Report pursuant to Section 21(a) of the Exchange Act which cautioned market participants that the offer and sale of digital assets by virtual organizations are subject to the requirements of the federal securities laws.13 It emphasized that the test for whether a particular investment transaction involves the offer or sale of a security—regardless of the terminology or technology used—will depend on the facts and circumstances, including the economic realities of the transaction.14 It also reaffirmed that the test articulated in Howey applies to crypto assets.15 As stated in the report:

[I]ssuers of distributed ledger or blockchain technology-based securities must register offers and sales of such securities unless a valid exemption applies. Those participating in unregistered offerings also may be liable for violations of the securities laws. Additionally, securities exchanges providing for trading in these securities must register unless they are exempt.

4. On April 3, 2019, the SEC provided additional guidance by publishing the “Framework for “Investment Contract” Analysis of Digital Assets” (the

11 United Housing Found., 421 U.S. at 849; See, e.g., SEC, Release No. 81207, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (July 25, 2017) [hereinafter “The DAO Report”]. In cases where the digital asset is sold only to be used to purchase a good or service available through the network on which it is created, a digital asset originally offered in a securities offering can be later sold in a manner that does not constitute an offering of a security. See William Hinman, Div. of Corp. Fin., SEC, Remarks at the Yahoo Finance All Markets Summit: Crypto (June 14, 2018), https://www.sec.gov/news/speech/speech-hinman-061418; see also Letter from Jay Clayton, Chairman, SEC to Ted Budd, member of the House of Representatives (Mar. 7, 2019), https://coincenter.org/files/2019-03/clayton-token-response.pdf. 12 See, e.g., Jay Clayton, Chairman, SEC, Testimony on Virtual Currencies: The Roles of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission (Feb. 6, 2018), https://www.sec.gov/news/testimony/testimony-virtual-currencies-oversight-role-us-securities-and-exchange-commission; Jay Clayton, Chairman, SEC, Statement on Cryptocurrencies and Initial Coin Offerings (Dec. 11, 2017), https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11. 13 The DAO Report. 14 Id. 15 Id.; see also SEC v. W.J. Howey Co., 328 U.S. 293 (1946).

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“Framework”).16 The Framework provided a discussion of thirty-eight separate characteristics a market participant should consider when analyzing whether an offering of digital assets is likely a securities offering, especially with respect to the third prong of the Howey test: whether a purchaser of the digital asset would make the purchase with a reasonable expectation of profits to be derived from the efforts of others.17

5. In its ongoing lawsuit against Ripple Labs,18 the SEC alleged that Ripple marketed cryptocurrency XRP as an investment in a common enterprise and pooled the funds it raised in its offerings to fund its operations, including to finance building potential XRP use cases, paying others to assist in developing a use case, and constructing the digital platform it promoted. In the SEC’s view, “[t]he nature of XRP itself made it the common thread among Ripple, its management, and all other XRP holders.”19 The SEC alleged that XRP met the “expectation of profits” prong because Ripple worked to increase speculative demand and trading volume for XRP.20Reflecting the ongoing debate among regulators with respect to the treatment of digital assets, SEC Commissioner Hester Peirce recently suggested a safe harbor that would allow legitimate token offerings to move forward without having to answer the question of whether the token is a security for three years.21 Commissioner Peirce stated that this was motivated by the “complexity” of the above mentioned Framework and “resulting public confusion.”22 On April 13, 2021, Commissioner Pierce released an updated version of the safe harbor.23 Given the change in administration, it remains to be seen whether the SEC will move forward with the proposal.

6. In recent remarks, Chairman Gensler stated that, the “test to determine whether a crypto asset is a security is clear” but there are “some gaps to prevent transactions, products, and platforms from falling between regulatory cracks” for which Congressional action may be required. For example, he observed that while many non-U.S. platforms may state they do not allow U.S. investors, “there are allegations that some unregulated foreign exchanges facilitate trading by U.S. traders who are using virtual private networks, or VPNs.”24 Chairman Gensler vowed to take the

16 SEC Framework for “Investment Contract” Analysis of Digital Assets (April 30, 2019), available at https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets. 17 Id. 18 SEC v. Ripple Labs, Inc. (Dec. 22, 2020), https://www.sec.gov/litigation/complaints/2020/comp-pr2020-338.pdf. 19 Id. 20 Id. 21 Hester Peirce, Commissioner, SEC, Running on Empty: A Proposal to Fill the Gap Between Regulation and Decentralization (Feb. 6, 2020), available at https://www.sec.gov/news/speech/peirce-remarks-blockress-2020-02-06. 22 Id. 23 See https://www.sec.gov/news/public-statement/peirce-statement-token-safe-harbor-proposal-2.0. 24 Gary Gensler, Chairman, SEC, Remarks Before the Aspen Security Forum (August 3, 2021), available at https://www.sec.gov/news/public-statement/gensler-aspen-security-forum-2021-08-03.

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SEC’s authorities “as far as they go” in policing digital assets trading platforms.

B. Digital Assets as Commodities

The CFTC is permitted to regulate “commodities” under the U.S. Commodity Exchange Act (the “CEA”), and has exclusive jurisdiction over “accounts, agreements […] and transactions involving swaps or contracts of sale of a commodity for future delivery”.25 The CFTC also has jurisdiction over fraud and manipulation involving spot market transactions relating to commodities which underlie futures or swaps.26

1. Under the CEA, a commodity includes virtually any product or service, physical or financial, that either is currently or could in the future underlie a derivative contract (i.e., a futures contract or a swap).27 This includes agricultural commodities (e.g., corn, wheat, soybeans), energy commodities (e.g., crude oil, natural gas, coal); metals (e.g., gold, silver, copper); financial products (e.g., interest rates, currencies, volatility indices); and various exotic products (e.g., weather events, renewable energy certificates).28 Only two products are specifically excluded from the definition of a “commodity” – box office receipts (from movies) and onions.29

2. In September 2015, the CFTC first concluded that Bitcoin and other virtual currencies are defined as “commodities” under the CEA in an enforcement action, In the Matter of: Coinflip, Inc., d/b/a Derivabit, and Francisco Riordan, CFTC Docket No. 15-29.30 According to the CFTC’s settlement order, market participants that had created a platform for the purchase and sale of Bitcoin options were “operating a facility for the trading or processing of swaps without being registered as a swap execution facility or designated contract market.”31 Federal courts have since confirmed the CFTC’s conclusion that virtual currencies are commodities under the CEA.32 The CFTC therefore determined: “The definition of a “commodity” is broad […] Bitcoin and other virtual currencies are encompassed in the definition and properly defined as commodities.”33 In October 2019, CFTC Chairman Heath Tarbert stated his view that Ether, the world’s second-largest cryptocurrency by market

25 7 U.S.C. § 2; V. Aravind & D. Lucking, Cryptocurrency as a Commodity: The CFTC’s Regulatory Framework, in Global Legal Insights Fintech Laws and Regulations 2019, 1st Ed. (Aug. 5, 2019) [hereinafter “GLI FinTech 1st Ed.”], available at https://www.globallegalinsights.com/practice-areas/fintech-laws-and-regulations/1-cryptocurrency-as-a-commodity-the-cftc-s-regulatory-framework. 26 GLI FinTech 1st Ed. 27 See 7 U.S.C. § 1a(9). 28 Id. 29 Id. 30 CFTC Docket No. 15-19, 2015 WL 5535736 (Sept. 17, 2015); GLI FinTech 1st Ed.. 31 Id. 32 See, e.g., CFTC v. McDonnell, 287 F. Supp. 3d 213 (E.D.N.Y. 2018); CFTC v. My Big Coin Pay, Inc., 334 F.Supp.3d 492, 496-98 (D. Mass 2018); In re Coinflip, Inc., d/b/a Derivabit, CFTC Docket No. 15-29 (Sept. 17, 2015). 33 Id.

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capitalization, is a commodity and would therefore fall under the CFTC’s jurisdiction together with Bitcoin.34

III. WHEN REGISTRATION IS REQUIRED

A. Broker-Dealer Registration

Once a digital asset is deemed to be a security, then the person(s) engaged in the sales or trading of such asset must then consider whether broker-dealer registration is required. For many years, issuers, technology providers, and other market participants have been using technology such as online platforms, websites, bulletin boards, social media, and other online or electronic “matchmaking” or communication venues to introduce potential investors to issuers seeking to raise capital through various forms of securities offerings. Whether a platform, its participants and operators, or persons associated with the issuer were required to register as broker-dealers was and continues to be determined by applying decades of SEC rules, regulations, interpretations, and guidance (mostly in the form of SEC staff no-action letters). Indeed, in 2012, the Jumpstart Our Business Startups Act (“JOBS Act”) did not revoke any of this prior guidance but rather added two conditional exemptions from full broker-dealer registration to this complex mosaic of broker-dealer status guidance (see Section III.A.4 below).

As a starting point, therefore, whether a person engaged in virtual or real-world capital raising is required to register as a broker-dealer, is determined by the SEC’s “Two-Part Test” which has developed over decades of no-action and other staff guidance.

1. The SEC’s “Two-Part Test”

a. Section 3(a)(4) of the Exchange Act broadly defines “broker” as any person engaged in the business of effecting transactions in securities for the account of others.35 The SEC relies on a two-part test to determine whether a person meets this definition. A person is a “broker” if such person is: (1) “effecting transactions” in securities; and (2) “engaged in [such] business.” Both parts of the test must be met in order for a person to meet the definition of “broker.”

b. While the SEC has not provided definitive guidance as to the factors that trigger broker-dealer registration, it has articulated a variety of “key” factors that it considers in determining broker-dealer status. These factors apply equally to both traditional and online securities activities.36 The SEC staff also looks at the

34 CFTC Release Number 8051-19, Chairman Tarbert Comments on Cryptocurrency Regulation at Yahoo! Finance All Markets Summit (Oct. 10, 2019), available at https://www.cftc.gov/PressRoom/PressReleases/8051-19; GLI FinTech 1st Ed.. 35 15 U.S.C. § 78c(a)(4). A “dealer” is defined in Section 3(a)(5) of the Exchange Act as “any person engaged in the business of buying and selling securities for such person’s own account through a broker or otherwise.” 15 U.S.C. § 78c(a)(5). 36 See, e.g., BondGlobe, Inc., SEC No-Action Letter (Feb. 6, 2001); Progressive Technology, Inc., SEC No-Action Letter (Oct. 11, 2000); MuniAuction, Inc., SEC No-Action Letter (Mar. 13, 2000); Transfer Online, Inc., SEC No-Action Letter (May 13, 2000); Oil-N-Gas, Inc., SEC No-Action Letter (June 8, 2000).

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“totality of the circumstances” when determining broker-dealer status, and a single hallmark of broker-dealer activity alone may or may not be sufficient to require registration, depending on the facts and circumstances. That said, the more hallmarks present, the greater the likelihood that registration will be required. Thus, the determination of broker-dealer status always requires a highly fact-specific analysis and a change in even one fact could alter the ultimate outcome.

i. “Effecting Transactions”

(i) A person, including an electronic platform, need not participate throughout the course of a transaction to be deemed a broker-dealer. Rather, the SEC considers a person to be effecting transactions if that person participates in securities transactions at “key” points in the chain of distribution.37 These key points include, but are not limited to: (1) identifying and soliciting current or potential investors; (2) negotiating and executing transactions;38 (3) handling or having access to funds and securities; (4) providing advice or making recommendations; or (5) holding out as a broker-dealer.

(ii) A salient factor in determining whether a person is “effecting transactions” is whether that person solicits potential investors to purchase securities. The term “solicitation” is interpreted very broadly by the SEC and its staff to include efforts by persons not only to effect securities transactions but also to “induce or attempt to induce the purchase or sale of any security.”39 Solicitation includes both efforts to induce a single transaction and efforts to develop an ongoing securities business relationship.40

ii. “Engaged in the Business”

(i) Factors that may determine whether a person is “engaged in the business” include, but are not limited to: (1) receiving transaction-based

37 See, e.g., Mass. Fin. Servs., Inc. v. Sec. Inv’r Prot. Corp., 411 F. Supp. 411, 415 (D. Mass.), aff’d, 545 F.2d 754 (1st Cir. 1976), cert. denied, 431 U.S. 904 (1977); SEC v. Nat’l Exec. Planners, Ltd., 503 F. Supp. 1066, 1073 (M.D.N.C. 1980). 38 See, e.g., Angel Capital Electronic Network, SEC No-Action Letter (Oct. 25, 1996). 39 See Registration Requirements for Foreign Broker-Dealers, Exchange Act Release No. 27017, 54 Fed. Reg. 30013, 30017-18 (July 18, 1989) (emphasis added). 40 Id. at 30018.

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compensation; and (2) participating in the securities business (e.g., solicitation) with some degree of regularity.

(ii) Historically, the receipt of transaction-based compensation has been an important indicator of engagement in the securities business because it gives a person a concrete economic stake in the consummation of a transaction.41 The SEC performs a functional—rather than a formal—analysis of economic arrangements to determine whether compensation is transaction based. While commissions are clearly transaction-related, other forms of compensation may be transaction-related as well, including referral fees based on the success of a securities transaction, as is usually the case with “finder” arrangements. Referral fees, which are calculated by looking back at the account activity in the referred account and adjusting the compensation accordingly, are also considered transaction related.

(iii) Transaction-based compensation is not the sole marker of engagement in the securities business. Other factors, such as ongoing solicitation of flat fees or other forms of direct or indirect compensation may be evidence of regular and continuous solicitation activity sufficient to warrant broker-dealer registration.42

c. The two-part test applies equally to non-U.S. persons’ activities involving U.S. investors and/or activities taking place inside the United States. Exemptions from registration beyond the scope of this outline may apply to such non-U.S. persons depending on the facts and circumstances.43

41 See, e.g., John R. Wirthlin, SEC Denial of No-Action Request (Jan. 19, 1999) (reiterating that receipt of transaction-based compensation is a “hallmark of being a broker-dealer”). The SEC has previously stated that “[c]ompensation based on transactions in securities can induce high pressure sales tactics and other problems of investor protection often associated with unregulated and unsupervised brokerage activities.” Persons Deemed Not to Be Brokers, Exchange Act Release No. 20943 (May 9, 1984). 42 The SEC has previously noted that persons who market interests in a private fund on a regular basis may be subject to the registration requirements of Section 15(a)(1) under the Exchange Act. See, e.g., Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With less Than $150 Million in Assets Under Management, and Foreign Private Advisers, n.9, 76 Fed. Reg., 39,646 (July 6, 2011). 43 Rule 15a-6 of the Exchange Act provides exemptions from registration under the Exchange Act that permit non-U.S. broker-dealers to engage in certain activities in the United States and/or with U.S. persons without having to register with the SEC. See 17 CFR § 240.15a-6.

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2. Historical Application of the Two-Part Test to Online Securities Sales

The SEC’s Division of Trading and Markets staff had historically addressed the broker-dealer status of online securities offerings through various no-action letters issued since the 1980s. Guidance relating to online broker-dealer registration status addresses a number of scenarios and multiple variations of platforms, systems, functions, and related compensation structures within each scenario. The guidance in this area is extremely fact-specific, and we have highlighted below some common themes which have emerged over the many years of staff guidance in the online broker-dealer registration status space. In addition, the SEC would consider compliance of the online platform in the context of all of the securities laws, including the Securities Act and the Investment Company Act of 1940, as amended (the “Investment Company Act”).

a. Online “Finders” and Other Investor Referral Arrangements

Much staff guidance has been devoted to finders and other forms of referral arrangements, including those involving the use of electronic platforms designed to bring together prospective investors with issuers, broker-dealers or other persons seeking capital through the sale of securities.44 Such platforms can avoid broker-dealer registration provided they do not trigger the two-part test described above; however, this is commonly problematic for most real world45 or online “finders” or solicitors as they are typically “engaged in the business” of soliciting investors for securities transactions on behalf of issuers or broker-dealers for some kind of success, transaction-based, or other incentive-based fee.

Online platforms, portals and other systems being utilized by issuers, or broker-dealers and other affiliated or third-party intermediaries to solicit securities transactions with potential investors or to connect potential investors with issuers or intermediaries, need to be analyzed carefully to determine whether such sites are required to register as a broker-dealer and, if so, whether an exemption applies.

i. Capital Raising for Issuers

Issuers — including issuers of digital assets — engaged in the sale of their own securities should not trigger a broker-dealer registration requirement for the issuer because an issuer is not engaged in the business of effecting securities transactions for the account of others. Potential broker-dealer registration issues arise, however, for employees of the issuer, unlicensed control affiliates,

44 Platforms offering non-securities, such as commodities, traditional loans, real estate or other assets of an ongoing concern would not be required to register as broker-dealers, but may be required to obtain other federal or state licenses and exemptions. 45 The SEC has brought charges against a private equity firm for using an unregistered broker as a “finder” for the purpose of actively soliciting investors for private fund investments. See In the Matter of Ranieri Partners LLC and Donald W. Phillips, SEC Release No. 34-69091, Administrative Proceeding File No. 3-15234 (March 8, 2013); see also In the Matter of William M. Stephens, SEC Release No. 34-69090, Administrative Proceeding File No. 3-15233.

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or unaffiliated (and unlicensed) third parties who are working with the issuer to raise capital on behalf of the issuer.

(i) Issuer Sites - The “Issuer’s Exemption” – Because many issuers are active in the online capital raising space, it is worth noting an exemption under Exchange Act Rule 3a4-146—commonly referred to as the “issuer’s exemption”—which allows issuers to utilize their employees and other “associated persons”47 of the issuer to help the issuer raise capital under fairly limited circumstances, without those associated persons having to register as broker-dealers. 48

Under Rule 3a4-1, an associated person of an issuer of securities is not deemed to be a broker solely by reason of his or her participation in the sale of securities of the issuer provided that he or she:

a. is not subject to a statutory disqualification49 at the time of his or her participation;

b. is not compensated in connection with his or her participation by the payment of commissions or other transaction-based compensation;

c. is not an associated person of a broker or a dealer; and

d. meets at least one of the following three conditions:

(i) the associated person restricts his or her participation to transactions involving offers and sales of securities to broker-dealers and certain other highly-sophisticated

46 17 C.F.R. § 240.3a4-1. 47 Associated persons of an issuer include any natural person who is a partner, officer, director, or employee of: (1) the issuer; (2) the general partner of the issuer (if the issuer is a limited partnership); (3) an entity that controls, is controlled by, or is under common control with the issuer; or (4) a registered investment adviser to the issuer, if the issuer is an investment company registered under the Investment Company Act. 17 C.F.R. § 240.3a4-1(c)(1). 48 While beyond the scope of this article, this issue comes up frequently with private funds utilizing their own employees for their (often) continuous fundraising efforts and has been the focus of some attention by SEC staff in recent years. See Speech of David Blass, then Chief Counsel of the SEC’s Division of Trading and Markets, before the ABA Trading and Markets Subcommittee (April 5, 2013). 49 “Statutory disqualification” is defined in Section 3(a)(39) of the Exchange Act. 15 U.S.C. § 78c(a)(39).

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institutional investors, such as registered investment companies, insurance companies, banks, and trust companies;50

(ii) the associated person: (1) primarily performs, or is intended primarily to perform at the end of the offering, substantial duties for or on behalf of the issuer other than in connection with transactions in securities; (2) was not a broker-dealer or an associated person of a broker-dealer within the preceding 12 months; and (3) does not participate in selling an offering of securities for any issuer more than once every 12 months; or

(iii) the associated person restricts his or her participation to one or more of the following activities: (1) preparing or delivering written communications through means that do not involve oral solicitation by the associated person (provided that the content of the communication is approved by a partner, officer, or director of the issuer); (2) responding to inquiries of potential purchasers in communications initiated by the potential purchasers (provided that the content of such responses are limited to information contained in a registration statement filed

50 Offers and sales by the associated person to qualified institutional buyers or “QIBs” as defined under Rule 144A of the Securities Act may not satisfy this condition.

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under the Securities Act or other offering document); and (3) performing ministerial and clerical work involved in effecting a transaction.

(ii) In the online world, the use of associated persons to raise funds for the issuer may not be required. For many issuer platforms, the site is typically administered by the issuer directly (with employees only acting administratively) and, therefore, broker-dealer registration is not typically triggered for the issuer. If, however, associated persons are used by the issuer to bring potential investors to the site or are otherwise interacting with potential investors directly through the site to raise capital, then the foregoing broker-dealer registration and “issuer’s exemption” analysis may be required. If the associated person meets all of the foregoing requirements of the issuer’s exemption, then he or she will not be required to register as a broker-dealer.

b. Broker-Dealers – Limitations on the Use of Finders

Broker-dealers are generally prohibited under SEC guidance and FINRA rules from using and paying fees to unlicensed persons engaged in activities on behalf of the broker-dealers—through online platforms or otherwise—which would require them to be registered broker-dealers under the two-part test (or licensed associated persons of a registered broker-dealer).51

c. Non-U.S. Finder and Referral Arrangements

The broker-dealer status of non-U.S. finders and offshore platforms engaged in capital raising with U.S. issuers or certain U.S. institutional investors would require the same analysis discussed in this article but, in addition, such non-U.S. persons may also rely on relevant exemptions under Exchange Act rule 15a-6.52

d. Online Referrals through Internet Portals and Links

The staff has granted no-action relief from the broker-dealer registration requirement to internet service providers that have no involvement in the

51 FINRA Rule 2040(a)(1). See also Section III.A.1. 52 See 17 CFR § 240.15a-6(a)(3), (4).

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brokerage services being provided—systems that find investors for, or link them to, registered broker-dealers, provided that such service providers may not, among other things: (1) recommend or endorse specific securities; (2) execute securities transactions; (3) route orders for customers to markets for execution, or otherwise participate in brokerage services; (4) answer questions related to securities transactions; or (5) handle customer funds or securities.53 Furthermore, the staff clarified that the service provider’s compensation could consist of a nominal flat fee for each order transmitted on the platform, provided it did not depend on the number of shares or their value, or on whether the order resulted in an executed trade.

e. Other U.S. Securities Law Considerations

When establishing an online platform for sales or purchases of securities in reliance on the issuer’s exemption (or on any other guidance such as reliance on the “bulletin board” no-action letters as discussed in Section III.A.3.a below), compliance with the Securities Act as well as Exchange Act Section 6 (exchange registration) should also be considered. State laws also will apply in most cases where residents of that state are approached for investment opportunities, including through digital means.

3. Online Offering and Trading Platforms

Prior to the JOBS Act, which permits crowdfunding by funding portals54 and internet platforms to make offerings under Rule 506 (see Section III.A.4 below), the staff had provided much guidance on a host of issues raised by the offer, sale and execution of securities through online platforms, including whether such platforms were required to register as broker-dealers.55 Some key staff guidance on the broker-dealer status of various online platforms includes no-action letters pertaining to:

a. Online Bulletin Boards – The SEC has given no-action relief from broker-dealer registration to a number of passive third party-provided “bulletin board systems” making available lists of buyers and sellers of securities, along with other information such as quantity (desired to be bought/sold) and price. Common conditions for relief included, among other things, that: (1) no transactions could be effected by the systems themselves, for example, by

53 Charles Schwab & Co., Inc., SEC No-Action Letter (Nov. 27, 1996); Charles Schwab & Co., Inc., SEC No-Action Letter (Sept. 18, 1997); see also SEC Portals Roundtable: Relationship between Broker-Dealers and Internet Websites (May 23, 2001). 54 A funding portal is a recent regulatory category only applicable to a crowdfunding offering. The registration requirements for funding portals are less extensive and costly than for broker-dealers. However, a funding portal’s activities are more limited than those of a broker-dealer. For more details, see SEC, Frequently Asked Questions Regarding Regulation Crowdfunding and Intermediary Requirements (Sept. 25, 2018), https://www.sec.gov/divisions/marketreg/tmcompliance/cfportal-faqs.htm [hereinafter “Regulation Crowdfunding FAQs”]. 55 Such issues included, but are not limited to, securities registration status under Section 5 of the Securities Act, investment adviser registration status under the Investment Advisers Act of 1940, and exchange registration status under Section 6 of the Exchange Act. These and other related issues are beyond the scope of this article.

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matching buy and sell orders; (2) the platform providers cannot receive transaction-based compensation; (3) the platform may not characterize itself as being a “broker”, a “dealer” or an “exchange”; (4) the platform may not be involved in any purchase or sale negotiations arising from the platform; (5) the platform may not directly or indirectly facilitate the clearance or settlement of any securities transactions, including by referring any participant to a third party to clear or settle such transactions (other than a bank as defined in Section 3(a)(6) of the Exchange Act); (6) the platform and its provider may not receive, transfer, or hold funds or securities as an incident of operating the platform; or (7) the platform (and platform providers) could not recommend or provide advice on securities transactions.56 Analogous to true bulletin boards in the real world — with pins and posters offering items for sale (or offers to purchase) — all resulting transactions should take place away from the bulletin board, and directly between the issuer and the buyer/seller without intermediation from the platform provider or others. In addition, it is important to note that most of the “bulletin board” no-action letters address exclusively securities (i) of issuers that were in each case reporting companies under Sections 12 and 13 of the Exchange Act,57 and (ii) eligible for sale under Section 4(a)(1) of the Securities Act.58

b. Online Trading/Execution Platforms – Technology Providers

i. The staff has exempted, from the broker-dealer registration requirements, service providers that simply maintain the software and systems technology for the online platforms, provided that such service providers do not: (1) exercise any discretion or authority over the system (other than technological) or its contents; (2) solicit transactions in securities or recommend or endorse specific securities; (3) participate in brokerage services or answer questions related to securities transactions; (4) handle customer funds or securities; or (5) market the website portal to potential

56 See, e.g., Real Goods Trading Corp., SEC No-Action Letter (June 24, 1996); Perfect Data Corp., SEC No-Action Letter (Aug. 5, 1996); Flamemaster Corp., SEC No-Action Letter (Oct. 29, 1996); Portland Brewing Co., SEC No-Action Letter (Dec. 14, 1999); Internet Capital Corp., SEC No-Action Letter (Jan. 13, 1998). 57 In the letters addressing issuer bulletin boards (i.e., bulletin boards for indications of interest in the platform provider’s own securities), the SEC staff indicated that the issuer may continue to operate the bulletin board even if it ceases to be registered and reporting under Sections 12 and 13, so long as the issuer undertakes to make the information required of reporting companies available to platform participants. When dealing with a bulletin board listing indications of interest in securities issued by third parties, the SEC did not raise the possibility that the platform provider could undertake to disseminate such information on behalf of any third-party issuers listed on the platform that were not Section 12 registrants. Rather, the platform provider represented that it would not permit postings with respect to issuers that had ceased to be Section 12 registrants, and the SEC staff found this policy acceptable. See Internet Capital Corp., SEC No-Action Letter (Jan. 13, 1998). 58 Section 4(a)(1) of the Securities Act, 15 USC 77d(a)(1), permits “transactions by any person other than an issuer, underwriter, or dealer,” bearing in mind that securities sold by issuers, affiliates of issuers and persons who are deemed to acquired securities from an issuer in an unregistered offering with a view to resale would not be eligible to rely on this provision.

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issuers or investors or otherwise engage in solicitation related to the platform. The providers may receive fees for use of the software and system technology and maintenance of the website portal.59

ii. Similarly, an online platform need not register as a broker-dealer in order to offer a matching site that will allow a broker-dealer to communicate buy and sell orders to other broker-dealers on the platform with whom the sending broker has a pre-existing brokerage relationship if the platform provider only provides services to registered broker-dealers, not public customers.60 Additionally, the service provider may not: (1) exercise discretion over the routing destination of an order or make any decisions on behalf of the broker-dealer participants regarding order execution; (2) be affiliated with any registered broker-dealer or hold itself out as a broker-dealer; (3) provide any advice about the merits of securities; (4) participate in any negotiations related to securities transactions or have any role in effecting or settling securities trades; (5) hold investor funds or securities; (6) receive transaction-based compensation; or (7) facilitate the sharing or splitting of commissions by broker-dealers. Such a platform may not charge fees for communicating orders but may be paid fees for access to the platform and software updates.61

iii. A pass-through communication system, such as a phone line or other form of electronic or digital media, used by a registered broker-dealer to solicit securities transactions typically would not itself be required to register as a broker-dealer, provided that the system does not, among other things: (1) send the solicitation on behalf of the broker-dealer (i.e., acting solely as the “pipes” through which investors and broker-dealers communicate their respective submission and acceptance of orders); (2) solicit, advise, recommend, describe or endorse securities transactions or broker-dealers; (3) hold, handle or otherwise have access to securities or transaction-related funds resulting from the solicitation; (4) otherwise become involved in effecting securities transactions resulting from the solicitation, including, among other things, through the opening, maintenance, administration or closing of accounts with broker-dealers, or the solicitation, processing

59 Prescient Markets, Inc., SEC No-Action Letter (Apr. 2, 2001). 60 S3 Matching Technologies LP, SEC No-Action Letter (July 19, 2012). 61 Id.

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or facilitation of transactions of any kind relating to such accounts; (5) participate in the negotiations between the parties to a transaction on the system; or (6) receive compensation that is based, directly or indirectly, on the size, value or occurrence of any resulting securities transactions.62

iv. Nevertheless, without registration, an online service provider may not provide a website allowing broker-dealers to trade with one another where the provider accepts fees for communicating orders, matches orders, conducts auctions and reverse auctions, allows users to apply for brokerage accounts on its website, and permits public customers to check the status of their brokerage accounts and to enter and modify orders.63

v. Common and similar themes emerge for technology providers in the securities markets – no transaction-based compensation for transactions conducted on or through their platforms, no discretion as to where orders are routed, and no ability to execute or settle transactions or hold funds or securities. For technology providers to avoid broker-dealer registration requirements, it is critical to avoid becoming intertwined in the securities business of their regulated participants.

4. The Jobs Act and Regulation Crowdfunding

The JOBS Act provided two separate exemptions from broker-dealer registration for intermediaries engaged in crowdfunding activities. Section 201 permits a person to participate solely in Rule 506 offerings without registering as a broker-dealer, provided that certain conditions are met. Such person may also conduct general solicitation or advertising activities to market the securities under this exemption. Section 304, on the other hand, provides for the registration of funding portals as an alternative to broker-dealer registration for those that engage in a limited version of investment crowdfunding as is described in the SEC’s Regulation Crowdfunding.64 Although Regulation Crowdfunding provides an option for intermediaries to register as funding portals as an alternative to broker-dealer registration, there are relatively few registered funding portals to date.65

62 See Evare, LLC, SEC No-Action Letter (Nov. 30, 1998); e-Media, LLC, SEC No-Action Letter (Dec. 14, 2000); InvestScape, Inc. SEC No-Action Letter (May 21, 1997). 63 SEC Denial of No-Action Request, BondGlobe, Inc. (Feb. 6, 2001). 64 See Crowdfunding, Exchange Act Release No. 76324, 80 Fed. Reg. 71,388 (Nov. 16, 2015) [hereinafter “Crowdfunding Release”]. Crowdfunding offerings are subject to certain investment limits and investor qualifications. 65 As of August 7, 2020, 55 funding portals have registered and become members of the Financial Industry Regulatory Authority (“FINRA”). See FINRA, Funding Portals We Regulate, http://www.finra.org/about/funding-portals-we-regulate. However, the majority of initiated and completed offerings were conducted through the three largest funding portals. See SEC Report to the

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a. Title II of the JOBS Act

Title II of the JOBS Act created a new safe harbor, promulgated by the SEC in new Rule 506(c) under the Securities Act. Rule 506(c) allows an issuer to engage in “general solicitation” in an unregistered securities offering, provided that the issuer takes reasonable steps to verify that all investors meet the definition of “accredited investor.”66 In addition, an issuer may use the Internet or other media to advertise its securities offerings without registering as a broker-dealer, provided that the investors in the offering are all accredited investors. Specifically, Section 201 of the JOBS Act added Section 4(b) (now Section 4(c)) of the Securities Act, which exempts an online platform participating in a Rule 506 offering from the broker-dealer registration requirement, allowing it to: (1) offer, sell, purchase, or negotiate securities; or (2) conduct general solicitation and advertisements (the “Title II Exemption”).

In order for an online platform to rely on the Title II Exemption, the platform must not: (1) receive compensation in connection with the purchase or sale of such securities; (2) have possession of customer funds or securities in connection with the purchase or sale of such securities; or (3) be subject to a statutory disqualification as defined in Section 3(a)(39) of the Exchange Act. In addition, all of the investors on the online platform must be accredited investors. There is no limitation on the size of the transaction or on the size of investment by each investor.

5. Title III of the JOBS Act and Regulation Crowdfunding

a. Title III of the JOBS Act added Securities Act Section 4(a)(6), which provides an exemption from registration for certain crowdfunding transactions and required the SEC to adopt rules to exempt, either conditionally or unconditionally, “funding portals” from having to register as a broker-dealer pursuant to Exchange Act Section 15(a) (“Title III Exemption”).

b. Regulation Crowdfunding was adopted by the SEC and became effective on May 16, 2016. Regulation Crowdfunding sets forth the general requirements for an issuer to rely on the Title III Exemption (e.g., investment limits, maximum amount an issuer can raise, and exclusion of certain issuers).67 The main differences

Commission, Regulation Crowdfunding, https://www.sec.gov/files/regulation-crowdfunding-2019_0.pdf [hereinafter “SEC Staff Report on Crowdfunding”]. 66 For specific examples of “taking reasonable steps to verify,” see Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, 78 Fed. Reg. 44,778 (July 24, 2013). 67 Rule 301(a) of Regulation Crowdfunding requires that intermediaries must have a reasonable basis to believe that an issuer seeking to rely on the crowdfunding exemption complies with the requirements of Section 4A(b) and Regulation Crowdfunding, and has established means to keep accurate records of the holders of securities. The rule allows an intermediary to rely on issuer representations unless the intermediary has reason to question the reliability of those representations. The Commission also stated that, when an intermediary seeks to rely on representations to form a reasonable basis, it should have policies and procedures

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between the types of offerings for the Title II and Title III Exemptions, Rule 506 offerings, and crowdfunding offerings, respectively, are: (1) type of eligible investors; (2) limits on capital raised; (3) limits on investments; and (4) restrictions on general solicitation and advertising.

6. Platforms Established by Investment Advisers

a. The SEC has given no-action relief to a registered investment adviser and a venture capital adviser for establishing an internet platform to market investments in private funds so long as: (i) the platform is restricted to Rule 506 offerings to accredited investors and the adviser does not solicit investors outside of the website itself; (ii) the adviser provides only traditional advisory and consulting services and does not handle investor money or securities; (iii) compensation and administrative fees are fully disclosed to the investors at the time of investment; and (iv) all investment money and any administrative fees paid to any third parties are kept in a separate custodial account that cannot be accessed by the venture capital investment adviser for its own use. The adviser may not receive transaction-based compensation, but traditional investment advisory compensation, such as a carried interest would be permissible under these letters.68

b. An online venture capital firm may use its website to offer and sell interests in special purpose vehicles created by such adviser to invest in specific private companies, if it prevents an investor from accessing information regarding specific investment opportunities until it has developed a substantive relationship with that investor through communications designed to assess the investor’s financial circumstances and sophistication in order to determine whether he or she qualifies as an accredited investor.69

B. Exchange Registration

1. Section 3(a)(1) of the Exchange Act defines the term “exchange” to mean:

any organization, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities (including digital securities) or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as that

regarding the circumstances under which it can reasonably rely on such representations and when additional investigative steps may be appropriate. See Regulation Crowdfunding FAQs. 68 Angel List LLC and Angel List Advisors LLC, SEC No-Action Letter (Mar. 28, 2013); Funders Club Inc. and Funders Club Management LLC, SEC No-Action Letter (Mar. 26, 2013). 69 Citizen VC, Inc., SEC No-Action Letter (Aug. 6, 2015).

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term is generally understood, and includes the market place and the market facilities maintained by such exchange.

2. Exchange Act Rule 3b-16 (“Rule 3b-16”) was adopted in 1998 to address the then emerging “alternative trading systems” (“ATSs”) by establishing guidance in the form of a two-part test for determining what constitutes an exchange.70 Under Rule 3b-16, an organization, association, or group of persons will be considered to constitute, maintain, or provide “a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange,” as those terms are used in Section 3(a)(1) of the Exchange Act, if such organization, association, or group of persons:

i. brings together the orders for securities of multiple buyers and sellers; and

ii. uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of a trade.71

3. With respect to the first prong of this two-part test, Rule 3b-16 defines the term “order” to mean “any firm indication of a willingness to buy or sell a security, as either principal or agent, including any bid or offer quotation, market order, limit order, or other priced order.”72 With respect to the second prong of this two-part test, a key component is the requirement that the system uses “established, non-discretionary methods . . . under which such orders interact with each other and the buyers and sellers entering orders agree to the terms of the trade.” In the Regulation ATS Adopting Release, the SEC stated that a system may use “established non-discretionary methods” either by providing a trading facility or by setting rules governing trading among subscribers.73 This includes “any methods that dictate the terms of trading among the multiple buyers and sellers entering orders into the system. Such methods include those that set procedures or priorities under which open terms of a trade may be determined.”74 Significantly, the SEC stated that a requirement that the trade subsequently be “ratified” does not mean that a system does not use “non-discretionary” methods.75 For example, the SEC stated that “a system that trades limited partnership units might use

70 See Regulation of Exchanges and Alternative Trading Systems, 63 Fed. Reg. 70844 (Dec. 22, 1998) (“Regulation ATS Adopting Release”), available at https://www.govinfo.gov/content/pkg/FR-1998-12-22/pdf/98-33299.pdf. 71 Rule 3b-16(a) under the Exchange Act. 72 Rule 3b-16(c) under the Exchange Act. 73 Regulation ATS Adopting Release at 70850. 74 Id. 75 Id. at 70851.

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established, non-discretionary methods even though approval from the general partner is required prior to settlement.”76

4. Many digital platforms refer to themselves as “exchanges,” which can give “the misimpression to investors that they are regulated or meet the regulatory standards of a national securities exchange.”77 While some platforms may be selective or have strict standards, they “should not be equated to the listing standards of national securities exchanges.”78 Likewise, while some platforms may have trading protocols, “investors should not assume the trading protocols meet the standards of an SEC-registered national securities exchange.”79

5. Where an online trading platform may not meet the definition of an exchange under the federal securities laws, but directly or indirectly offers trading or other services related to digital assets that are securities, these platforms may be subject to other registration requirements under the federal securities laws, including broker-dealer registration requirements.

6. The SEC has also reminded issuers of digital asset securities of the registration requirement under the Securities Act and market participants who advise others about investing in digital assets, including managers of investment vehicles, of the registration, regulatory, and fiduciary obligations under the Investment Company Act and the Investment Advisers Act of 1940.

7. In addition, FINRA has issued a regulatory notice to encourage its member firms to promptly notify FINRA if they, or their associated persons or affiliates, currently engage, or intend to engage, in any activities related to digital assets, such as cryptocurrencies and other virtual coins and tokens.80 FINRA will require such firms to file a continuing membership application if such activities result in a material change in the firm’s business operations. 81

C. CFTC’s Role in Regulating Digital Assets

1. To determine whether a digital asset is subject to the CFTC’s regulatory jurisdiction, market participants must ascertain whether such digital asset is 1) a commodity under the CEA (as discussed in Section II.B. above) and 2) a “futures contract” or a “swap”.

2. The CEA and CFTC regulations do not provide a definition of a “futures contract,” however, the term is generally understood to include any

76 Id. 77 See SEC, Div. of Trading and Mats, Statement on Potentially Unlawful Online Platforms for Trading Digital Assets (Mar. 7, 2018), available at https://www.sec.gov/news/public-statement/enforcement-tm-statement-potentially-unlawful-online-platforms-trading. 78 Id. 79 Id. 80 See FINRA Reg. Notice 18-20 (July 6, 2018), http://www.finra.org/sites/default/files/notice_doc_file_ref/Regulatory-Notice-18-20.pdf. 81 Id.

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agreement to purchase or sell a commodity for delivery in the future: (1) at a price that is determined at initiation of the contract; (2) that obligates each party to the contract to fulfill the contract at the specified price; (3) that is used to assume or shift price risk; and (4) that may be satisfied by delivery or offset. 82

3. The CEA and CFTC regulations define a “swap” as:

a. An executory agreement for exchange of payments based on value of property, rate or quantitative measure and that transfers financial risk of future change in that value without also conveying ownership interest in an asset/liability that incorporates that risk (e.g., rate swap, index swap);

b. Option on virtually anything (other than a security);

c. An agreement for purchase, sale, payment or delivery that is dependent on the occurrence, non-occurrence or extent of occurrence of an event or contingency associated with potential financial, economic or commercial consequences (e.g., a credit default swap); or

d. Any combination or permutation of the above.

4. If a digital asset is excluded from the definition of “futures contract” and “swap”, then such digital asset is a physical commodity and it is not regulated by the CFTC (or the SEC). Beyond instances of fraud or manipulation, the CFTC generally does not oversee “spot” or cash market exchanges and transactions involving digital assets that do not utilize margin, leverage, or financing.83 Conversely, if a digital asset is classified as either a futures contract or swap then such digital asset would be subject to the full oversight and jurisdiction of the CFTC.

5. The following are examples of U.S. futures exchanges (termed designated contract markets, or “DCM”) and swap execution facilities (“SEF”) listing derivatives referencing digital assets:

a. The CME, a DCM and registered derivatives clearing organization (“DCO”), lists cash-settled Bitcoin futures and options and Ether futures.

b. ICE Futures US, a DCM and DCO, lists physically settled and cash-settled Bitcoin futures.

82 CFTC Glossary, available at https://cftc.gov/LearnAndProtect/EducationCenter/CFTCGlossary/glossary_f.html. 83 CFTC Primer on Virtual Currencies (Oct. 17, 2017), available at https://www.cftc.gov/sites/default/files/idc/groups/public/%40customerprotection/documents/file/labcftc_primercurrencies100417.pdf.

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c. LedgerX, LLC, a SEF and DCO, lists digital currency options, futures, and swaps.84 Trading on a SEF platform is limited to “eligible contract participants” under Section 1a(18) of the CEA, a type of sophisticated trader, which includes various financial institutions and persons, with assets above specified statutory minimums.

d. Eris Exchange, a DCM and DCO, lists cash-settled Bitcoin and Ether futures.

6. The following are examples of CFTC prohibited activities:

a. Price manipulation of a virtual currency traded in interstate commerce;

b. Pre-arranged or wash trading in an exchange-traded virtual currency swap or futures contract;

c. A virtual currency futures or option contract or swap traded on a domestic platform or facility that has not registered with the CFTC as a SEF or DCM; and

d. Certain schemes involving virtual currency marketed to retail customers, such as off-exchange financed commodity transactions with persons who fail to register with the CFTC.85

IV. THE OCC – BACKGROUND AND RECENT DEVELOPMENTS

The OCC — the regulator of the largest banks in the U.S. — has been active in integrating digital means into its regulatory framework for national banks. Particularly during the recent tenure of former Acting Comptroller of the Currency Brian P. Brooks, the OCC took several notable actions clarifying the legal authority of national banks and federal savings associations (referred to collectively in this section as “national banks”) to engage in cryptocurrency activities. Below is a brief summary of relevant background and more recent developments from the OCC.

A. OCC Interpretive Letter No. 1170: Authority of a National Bank to Provide Cryptocurrency Custody Services for Customers

On July 22, 2020, the OCC published Interpretive Letter No. 1170 clarifying national banks’ authority to provide cryptocurrency custody services for customers.86 National and state banks and thrifts have long provided safekeeping and custody services, including both physical objects and electronic assets. In the letter, the OCC concluded that providing cryptocurrency custody services, including holding unique cryptographic keys associated with cryptocurrency, is

84 Id. 85 Id. 86 OCC, Interpretive Letter No. 1170, Authority of a National Bank to Provide Cryptocurrency Custody Services for Customer (July 22, 2020), available at https://www.occ.gov/topics/charters-and-licensing/interpretations-and-actions/2020/int1170.pdf.

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a modern form of traditional bank activities related to custody services. Crypto custody services may extend beyond passively holding “keys.” 87

1. As stated in the letter:

The OCC recognizes that, as the financial markets become increasingly technological, there will likely be increasing need for banks and other service providers to leverage new technology and innovative ways to provide traditional services on behalf of customers. By providing such services, banks can continue to fulfill the financial intermediation function they have historically played in providing payment, loan and deposit services. Through intermediated exchanges of payments, banks facilitate the flow of funds within our economy and serve important financial risk management and other financial needs of bank customers.

The OCC makes clear however, that the risks associated with an individual account should be addressed prior to acceptance and the due diligence process should include an anti-money laundering review. Banks should have effective information security infrastructure and controls in place to mitigate hacking, theft, and fraud. Importantly, the letter suggests that a national bank “consult with OCC supervisors as appropriate prior to engaging in cryptocurrency custody.”

B. OCC Interpretive Letter No. 1172: Authority of a National Bank to Take Deposits that Serve as Reserves for Fiat-Based Stablecoins

On September 21, 2020, the OCC published Interpretive Letter No. 1172, confirming that national banks may take deposits that serve as reserves for fiat-based stablecoins.88

1. Noting that national banks are expressly authorized to receive deposits, and receiving deposits is recognized as a core banking activity, the OCC concluded that national banks may receive deposits from stablecoin issuers, including deposits that constitute reserves for a stablecoin associated with hosted wallets.89 The OCC further indicated that, in connection with such activities, national banks may also engage in any activity incidental to receiving deposits from stablecoin issuers.

2. The OCC further pointed out that, as with any deposit product, national banks should provide accurate and appropriate disclosures regarding deposit insurance coverage and must ensure that their deposit activities comply with applicable laws and regulations, including those relating to

87 OCC, Press Release, Federally Chartered Banks and Thrifts May Provide Custody Services For Crypto Assets (July 22, 2020), available at https://www.occ.gov/news-issuances/news-releases/2020/nr-occ-2020-98.html. 88 OCC Interpretive Letter No. 1172, OCC Chief Counsel’s Interpretation on National Bank and Federal Savings Association Authority to Hold Stablecoin Reserves (Sept. 21, 2020) available at https://www.occ.gov/topics/charters-and-licensing/interpretations-and-actions/2020/int1172.pdf. 89 The OCC expressly stated that Interpretive Letter No. 1172 did not address the authority of a national bank to support stablecoin transactions involving unhosted wallets.

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the Bank Secrecy Act (“BSA”) and anti-money laundering. In particular, national banks must ensure that they establish and maintain procedures reasonably designed to assure and monitor compliance with the BSA and its implementing regulations, including but not limited to customer due diligence requirements under the BSA and the customer identification requirements under section 326 of the USA PATRIOT Act. In addition, national banks must identify and verify the beneficial owners of legal entity customers opening accounts, and must comply with applicable federal securities laws.

3. The OCC went on to point out that national banks should consider all relevant risk factors, including liquidity risk and compliance risk, before entering any agreement or relationship with a stablecoin issuer, and that particular attention should be paid to having appropriate contractual arrangements with the stablecoin issuer governing the terms and conditions of the services provided by the bank to the issuer. The OCC also reminded banks that new bank activities should be developed and implemented consistently with sound risk management principles and should align with a bank’s overall business plans and strategies.

C. OCC Interpretive Letter No. 1174: Authority of a National Bank to Use Independent Node Verification Networks and Stablecoins for Payment Activities

On January 4, 2021, the OCC published Interpretive Letter No. 1174 discussing the authority of national banks to participate in the independent node verification networks (“INVNs”) and to use stablecoins to facilitate payment activities and other bank functions in line with legal requirements and safe and sound banking practices.90

1. The OCC has long recognized that bank-permissible activities may be conducted with new and evolving technologies. Banks may use electronic means or facilities to perform any function, or provide any product or service, as part of an authorized activity, and the OCC has explicitly permitted national banks to adopt new technologies as a means of executing payment services, consistent with safe and sound banking practices and applicable law.91 Noting that INVNs and related stablecoins represent new technological means of carrying out bank-permissible payment activities, the OCC concluded that a bank may validate, store, and record payments transactions by serving as a node on an INVN and may use INVNs and related stablecoins to carry out other permissible payment activities, including facilitating payment transactions for

90 OCC Interpretive Letter No. 1174, OCC Chief Counsel’s Interpretation on National Bank and Federal Savings Association Authority to Use Independent Node Verification Networks and Stablecoins for Payment Activities (Jan. 4, 2021) available at https://www.occ.gov/news-issuances/news-releases/2021/nr-occ-2021-2a.pdf [hereinafter “Interpretive Letter No. 1174”]. The OCC described an INVN as consisting of a shared electronic database where copies of the same information are stored on multiple computers, and noted that one common form of an INVN is a distributed ledger on which cryptocurrency transactions are recorded. An INVN’s participants, known as nodes, typically validate transactions, store transaction history, and broadcast data to other nodes. 91 See Interpretive Letter No. 1174.

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customers by issuing a stablecoin and by exchanging that stablecoin for fiat currency.

2. The OCC went on to note that stablecoins function as a mechanism of payment in the same way that debit cards, checks, and electronically stored value (“ESV”) systems convey payment instructions. OCC regulations expressly provide that a national bank may offer ESV systems.92 Like ESV cards, stablecoins can serve as electronic representations of U.S. dollars, whereby instead of value being stored on an ESV card, the value is represented on the stablecoin. The OCC views this distinction as technological in nature, rather than affecting the permissibility of the underlying activity. Furthermore, the OCC noted that, just as banks may buy and sell ESV as a means of converting the ESV into dollars (and vice versa) to complete customer payment transactions, banks may buy, sell, and issue stablecoin to facilitate payments.93

3. The OCC further pointed out that banks should evaluate the appropriateness of INVNs and stablecoin participation in order to ensure their continuing ability to provide payment services to their customers in a manner that reflects changing demand. Although the use of INVNs may provide certain advantages over other technologies, it may also present new risks, and banks should ensure that they understand these risks, as well as the risks generally associated with the underlying activity. Banks must conduct the activities in a safe and sound manner and should also conduct a legal analysis to ensure the activities will be conducted consistent with all applicable laws, including applicable BSA/AML and consumer protection laws and regulations. Moreover, the OCC cautioned that payment activities involving cryptocurrencies could increase operational risks, including fraud risk, and, depending on the nature of the payment activity, could also entail significant liquidity risks. The OCC advised banks to consult with OCC supervisors, as appropriate, prior to engaging in these new payment activities.94

D. OCC Conditional Approvals for National Trust Banks Engaged in Cryptocurrency Activities

1. In January 2021, the OCC granted a Conditional Approval for the conversion of Anchorage Trust Company, a South Dakota state-chartered trust company, to a national trust bank charter (“Anchorage Digital Bank”),95 marking the first grant of a national trust bank charter to a

92 See 12 C.F.R. § 7.5002(a)(3). 93 See Interpretive Letter No. 1174. 94 Id. 95 OCC, Press Release: OCC Conditionally Approves Conversion of Anchorage Digital Bank (Jan. 13, 2021), available at https://www.occ.treas.gov/news-issuances/news-releases/2021/nr-occ-2021-6.html.

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cryptocurrency firm.96 Anchorage Digital Bank’s services include custody of digital assets; custody of fiat currency (using a sub-custodian); on-chain governance services; operating validator nodes, providing staking as a service and enabling clients to delegate staking to third-party validators; and digital asset settlement services.

2. Just a month later in February 2021, the OCC granted a Conditional Approval for the conversion of Protego Trust Company, a Washington state-chartered trust company, to a national trust bank charter (“Protego Trust Bank”).97 As described in the Conditional Approval, Protego Trust Bank plans to provide cryptocurrency custody services along with the following ancillary services: determining whether a customer should claim forked assets; staking its customers’ assets to earn rewards; and participating in the governance of certain blockchains that permit participants to use their digital assets to cast votes for decisions regarding blockchain protocols. Protego Trust Bank plans to expand its service offering in the future to include the following services: a client-to-client trading platform for assets it holds under custody; a client-to-client lending platform for which Protego Trust Bank will act as a financial intermediary; and a platform for the origination and issuance of new digital assets whereby asset owners can digitize existing and prospective assets.

3. In April 2021, the OCC granted Preliminary Conditional Approval of the application to charter Paxos National Trust as a national trust bank (“Paxos National Trust”).98 As described in the Preliminary Conditional Approval, Paxos National Trust will provide a range of services associated with digital assets that are permissible for a national bank, including custody services for digital assets; custody and management of USD stablecoin reserves; payment, exchange, and other agent services; other cryptocurrency services, such as trading services and enabling partners to buy and sell cryptocurrency; and “know your customer” as a service, which includes customer identification, sanctions screening, enhanced due diligence, customer risk rating, and other related services.

96 Another notable aspect of the OCC’s Conditional Approval was its reliance on the new OCC Chief Counsel’s Interpretation, released as OCC Interpretive Letter No. 1176 just a few days earlier on January 11, 2021, in which the OCC reversed its previous longstanding position and determined that activities of a national trust bank include activities permissible for a state trust bank or company even if those activities, authorized under state law, are not necessarily considered fiduciary in nature under 12 U.S.C. § 92a and the OCC’s regulations in 12 C.F.R. Part 9. See OCC Interpretive Letter No. 1176, OCC Chief Counsel’s Interpretation on National Trust Banks (Jan. 11, 2021) available at https://occ.gov/topics/charters-and-licensing/interpretations-and-actions/2021/int1176.pdf. 97 OCC, Press Release: OCC Conditionally Approves Conversion of Protego Trust Bank (Feb. 5, 2021), available at https://www.occ.treas.gov/news-issuances/news-releases/2021/nr-occ-2021-19.html. 98 OCC, Press Release: OCC Conditionally Approves Chartering of Paxos National Trust (Apr. 23, 2021), available at https://www.occ.treas.gov/news-issuances/news-releases/2021/nr-occ-2021-49.html.

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E. OCC Actions Under Current Acting Comptroller of the Currency Michael J. Hsu

Following the resignation of Acting Comptroller of the Currency Brian P. Brooks in January 2021 and the appointment of current Acting Comptroller of the Currency Michael J. Hsu in May 2021, Acting Comptroller Hsu has requested OCC staff to review the OCC’s recent interpretations on the authority of national banks to engage in crypto custody activities and the OCC’s updated framework for chartering national banks and trust companies.99 While highlighting the OCC’s focus on encouraging responsible innovation, Acting Comptroller Hsu noted in particular his concerns that the OCC’s actions were not taken in full coordination with all stakeholders and did not appear to have been part of a broader regulatory strategy.100 In his recent testimony before the Senate Banking Committee, Acting Comptroller Hsu noted that, as a first step to increase interagency coordination, the OCC, the Federal Deposit Insurance Corporation (“FDIC”), and the Board of Governors of the Federal Reserve System (“Federal Reserve”) have established a Digital Assets Sprint Initiative to provide greater clarity and collaboration around digital assets, including cryptocurrencies, and focus on providing an active, coordinated and timely response to questions and issues raised by rapid growth in that space.101 He also noted that, while recognizing the OCC’s unique authority to grant charters, the OCC must find a way to consider how fintechs and payments platforms fit into the banking system, explore the appropriate use of sandboxes to encourage responsible innovation, and coordinate with the FDIC, the Federal Reserve, and the states to limit regulatory arbitrage and races to the bottom.102

F. Special Purpose National Bank Charters for Fintech Companies

In July of 2018, the OCC adopted guidance providing for the charter of for special-purpose national bank charters from non-depository fintech companies engaged in the business of lending.103 In practice, fintech companies that would apply, qualify for and receive special purpose national bank charters would be supervised in the manner of similarly situated national banks, to include capital, liquidity and financial inclusion commitments as the OCC deems appropriate. However, the statutory authority of the OCC to issue the special charters has been challenged in litigation brought by both the Conference of State Bank Supervisors (“CSBS”)104 and the New York Department of Financial Services (“NYDFS”).105 While the CSBS case was dismissed for lack of standing and ripeness,106 on October 21, 2019, the District Court for the Southern District of New York entered a final judgment against the OCC following the court’s May 2, 2019 decision precluding the agency from granting special-purpose national bank charters.107 Following the

99 Statement of Michael J. Hsu, Acting Comptroller of the Currency, Committee on Financial Services, U.S. House of Representatives (May 19, 2021), available at https://www.occ.gov/news-issuances/congressional-testimony/2021/ct-occ-2021-56-written.pdf. 100 Id. 101 Statement of Michael J. Hsu, Acting Comptroller of the Currency, Committee on Banking, Housing, and Urban Affairs, U.S. Senate (Aug. 3, 2021), available at https://www.occ.gov/news-issuances/congressional-testimony/2021/ct-occ-2021-79-written.pdf. 102 Id. 103 OCC, Press Release: OCC Begins Accepting National Bank Charter Applications From Financial Technology Companies (July 31, 2018), available at https://www.occ.gov/news-issuances/news-releases/2018/nr-occ-2018-74.html. 104 Complaint, CSBS v. Otting, No. 1:18-cv-02449 (D.D.C. Oct. 25, 2018). 105 Complaint, Lacewell v. Otting, No. 1:18-cv-08377 (S.D.N.Y. Sept. 14, 2018). 106 Id. 107 Vullo v. Office of Comptroller of Currency, 378 F. Supp. 3d 271 (S.D.N.Y. 2019).

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OCC’s appeal of the District Court’s decision to the Court of Appeals for the Second Circuit, on June 3, 2021, the Second Circuit reversed the District Court’s ruling, holding that NYDFS lacked standing to challenge the special-purpose national bank charter and instructing the District Court to dismiss the case without prejudice.108 While the Second Circuit concluded that NYDFS’s claims were unripe and lacked standing, it did not address the District Court’s holding on the merits that the “business of banking” under the National Bank Act requires receipt of deposits. Accordingly, the legality of the OCC’s authority to issue special-purpose national bank charters to non-depository institutions remains uncertain, likely to be resolved through future litigation.

The very largest U.S. banks — Bank of America, Citibank, JPMorgan Chase and Wells Fargo — are chartered as national banks, and a significant percentage of those in the next tier are also national banks. While state banks are increasingly free to branch and conduct business on a national basis, as federally chartered entities, national banks enjoy the right to engage in business on a nationwide basis subject to the exclusive administrative oversight of the OCC. In contrast, without some sort of national fintech charter, non-bank financial service providers are subject to costly state-by-state licensing, opaque rules and fragmented and sometimes politicised oversight. Thus, special purpose national banks offer the most likely alternative to confusing and often ineffective state supervision of financial services and products.

G. Advance Notice of Proposed Rulemaking – Digital Activities

Former Acting Comptroller of the Currency Brian Brooks embraced technology both as a tool to be used by the OCC in the supervision of banks, and a critical element in the modernisation of the delivery and administration of products and services and improvements in internal controls. On June 4, 2020 - very shortly after Mr. Brooks became Acting Comptroller - the OCC issued an advanced notice of proposed rulemaking (the “ANPR”) seeking public comment guiding the OCC in its development of rules and guidance with respect to digital activities of national banks. The ANPR invites comment on the OCC’s digital activities rules and other banking issues related to digital technology or innovation, including:

1. Whether the existing rules are sufficiently flexible and clear in light of the technological advances that have transformed the financial industry over the past two decades.

2. Whether these legal standards create unnecessary hurdles or burdens to innovation by banks.

3. Whether there are digital banking activities or issues that are not covered by existing rules that the OCC should address (e.g., digital finders’ activities, certain software and correspondent services).

4. What activities related to cryptocurrencies or crypto-assets are financial services companies or bank customers engaged in and what are the barriers or obstacles to further adoption of crypto-related activities in the banking industry.

108 Lacewell v. Office of Comptroller of Currency, 999 F.3d 130 (2d Cir. 2021).

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5. How is distributed ledger technology used or potentially used in activities related to banking.

6. How are artificial intelligence and machine learning techniques used or potentially used in activities related to banking.

7. What new payments technologies and processes should the OCC be aware of and what are the potential implications of these technologies and processes for the banking industry.

8. What new or innovative tools do financial services companies use to comply with regulations and supervisory expectations (i.e., Regtech).

V. CUSTODY

A. Joint Staff Statement on Broker-Dealer Custody of Digital Asset Securities

1. On July 18, 2019, the SEC and FINRA issued a joint statement titled Joint Staff Statement on Broker-Dealer Custody of Digital Asset Securities (the “Joint Statement”) which focuses on issues around how firms or their custodians will comply with the SEC’s Customer Protection Rule109 as applied to digital asset securities.110 The Customer Protection Rule requires broker-dealers to safeguard customer assets and to keep customer assets separate from the firm’s assets.111 The SEC has yet to publicly articulate how it expects firms that are subject to the rule to comply with this requirement in the context of private keys, wallets, and distributed ledger technology.112

2. The Joint Statement also indicated that, “[g]enerally speaking, noncustodial activities involving digital asset securities do not raise the same level of concern among the [SEC or FINRA staffs], provided that the relevant securities laws, SRO rules, and other legal and regulatory requirements are followed.”113 The statement goes on to provide a few examples of non-custodial activities that do not raise the same concerns:

a. Secondary market transactions involving a broker-dealer introducing a buyer to a seller of digital asset securities through a trading platform where the trade is settled directly between the buyer and seller. For instance, a broker-dealer that operates an ATS could match buyers and sellers of digital asset securities and the trades would either be settled directly

109 17 CFR § 240.15c3-3. 110 SEC and FINRA, Joint Staff Statement on Broker-Dealer Custody of Digital Asset Securities (July 8, 2019), https://www.sec.gov/news/public-statement/joint-staff-statement-broker-dealer-custody-digital-asset-securities [hereinafter the “Joint Statement”]. 111 Id. 112 Id. (“The specific circumstances where a broker-dealer could custody digital asset securities in a manner that the Staffs believe would comply with the Customer Protection Rule remain under discussion…”). 113 Id.

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between the buyer and seller, or the buyer and seller would give instructions to their respective custodians to settle the transactions. In either case, the ATS would not guarantee or otherwise have responsibility for settling the trades and would not at any time exercise any level of control over the digital asset securities being sold or the cash being used to make the purchase.

b. A broker-dealer could send the trade-matching details to the buyer and issuer of a digital asset security—similar to a traditional private placement—and the issuer would settle the transaction bilaterally away from the broker-dealer.

c. A broker-dealer could facilitate over-the-counter secondary market transactions in digital asset securities without taking custody of, or exercising control over, the digital asset securities.114

3. With respect to custodial arrangements, the SEC and FINRA noted some of the factors that it considers obstacles for firms to comply with the Customer Protection Rule. “If, for example, the broker-dealer holds a private key, it may be able to transfer such securities reflected on the blockchain or distributed ledger. However, the fact that a broker-dealer (or its third party custodian) maintains the private key may not be sufficient evidence by itself that the broker-dealer has exclusive control of the digital asset security (e.g., it may not be able to demonstrate that no other party has a copy of the private key and could transfer the digital asset security without the broker-dealer’s consent). In addition, the fact that the broker-dealer (or custodian) holds the private key may not be sufficient to allow it to reverse or cancel mistaken or unauthorized transactions.”115

4. Additional challenges noted by the SEC and FINRA include (i) “evidenc[ing] the existence of digital asset securities for the purposes of the broker-dealer’s regulatory books, records, and financial statements;” and (ii) certain digital assets may not meet the definition of security under the Securities Investor Protection Act (“SIPA”).116 Thus, in the event of the failure of a carrying broker-dealer, SIPA protection likely would not apply and holders of those digital asset securities would have only unsecured general creditor claims against the broker-dealer’s estate.”117

5. The ability of SEC-registered broker-dealers to act as custodians of digital assets such as the Digital Bonds is uncertain and evolving. SEC staff have been

114 Id. 115 Id. 116 The Securities Investor Protection Act of 1970, Public Law No. 91-598, 84 Stat. 1636 (Dec. 30, 1970). 15 U.S.C. §§ 78aaa et seq. 117 The Joint Statement, supra note 87.

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engaging with the digital asset community to address concerns regarding compliance with the SEC’s Customer Protection Rule, Rule 15c3-3, in the context of digital assets. The Commission recently released a statement taking the position that “special purpose broker-dealers”—i.e., broker-dealers solely engaged in activities with respect to digital asset securities—may custody digital asset securities for customers, subject to the conditions set forth in the statement.118 This relief will expire after five years and, as noted, applies only to broker-dealers that limit their business exclusively to “dealing in, effecting transactions in, maintaining custody of, and/or operating an ATS for” digital asset securities.119

VI. RELEVANT SEC ENFORCEMENT ACTIONS

A. SEC Enforcement Actions

In the last few years, the staff has brought charges against firms for acting as unregistered broker-dealers or exchanges on online crowdfunding platforms, and has recently picked up the pace on actions involving digital assets and crypto under the anti-fraud provisions of the Exchange Act.

1. In the Matter of Blockchain Credit Partners d/b/a DeFi Money Market, Gregory Keough, and Derek Acree. On August 6, 2021, the SEC charged a decentralized finance (DeFi) lender and its top executives for unregistered sales of more than $30 million of securities using smart contracts and DeFi technology, and for misleading investors concerning the operations and profitability of their business, called the DeFi Money Market.120 The settlement order found that they used smart contracts to sell two types of digital tokens: mTokens that could paid 6.25% interest, and DMG “governance tokens” that allegedly gave holders voting rights, a share of excess profits, and the ability to profit from DMG governance token resales in the secondary market. The SEC’s order finds that the mTokens were notes and were also offered and sold as investment contracts, the DMG governance tokens were offered and sold as investment contracts, and the respondents violated the Securities Act by conducting unregistered offers and sales of securities. The SEC’s order also finds that Respondents violated the antifraud provisions of Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act.

2. In the Matter of Telegram Group Inc. et al. On March 24, 2020, the U.S. District Court for the Southern District of New York granted the SEC’s motion for preliminary injunction against Telegram Group Inc. and TON Issuer Inc. (collectively, “Telegram”) preventing the distribution of

118 SEC, Commission Statement: Custody of Digital Asset Securities by Special Purpose Broker-Dealers, 86 Fed. Reg. 11627 (Feb. 26, 2021), https://www.govinfo.gov/content/pkg/FR-2021-02-26/pdf/2020-28847.pdf. 119 Id. at 11629. 120 See https://www.sec.gov/news/press-release/2021-145

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“Gram” digital tokens.121 In 2018, Telegram sold $1.7 billion worth of “Gram Purchase Agreements” to 175 sophisticated initial investors with an agreement to deliver Grams upon the launch of Telegram’s TON Blockchain. The SEC argued that the sale and distribution of Grams to initial purchasers was a single transaction that constituted an investment contract subject to federal securities laws. The court agreed with the SEC that the Gram Purchase Agreements, planned distribution of Grams to initial purchasers, together with the probable public distribution of the Grams thereafter constituted a “disguised public distribution” of unregistered securities. The decision supports the SEC’s position that a security can be comprised of an entire transaction consistent with the Howey test. On June 26, 2020, the SEC announced that it obtained court approval of a settlement whereby Telegram agreed to return more than $1.2 billion to investors and pay an $18.5 million civil penalty.122

3. In the Matter of Zachary Coburn.123 In November 2018, the SEC instituted cease-and-desist proceedings against Zachary Coburn for violating the Securities Exchange Act of 1934. Coburn ran a website, EtherDelta, that was an online platform for buyers and sellers to trade digital assets, and the platform resembled online securities trading platforms. The website allowed access to the order book, displayed the current and top 500 firm bids and offers by price, and showed account information for platform users. The SEC charged that Coburn violated Section 5 of the Exchange Act because he did not register EtherDelta as a national securities exchange under Section 6 of the Exchange Act. According to the SEC, EtherDelta was an exchange when assessed under the Exchange Act Rule 3b-16(a)’s functional test and therefore must be registered as a national securities exchange under Section 6 of the Exchange Act or operate under an exemption.

4. In the Matter of TokenLot, LLC, Lenny Kugel, and Eli L. Lewitt.124 In September 2018, the SEC instituted cease-and-desist proceedings against TokenLot and its operators, Kugel and Lewitt. The SEC classified TokenLot as an unregistered broker-dealer, as Kugel and Lewitt (Respondents) advertised and sold securities (via digital tokens) to retail investors through Tokenlot’s website. They solicited investors, took customer orders for digital tokens, and processed investor funds. Respondents received compensation of approximately $471,000. The digital tokens included securities, and the SEC alleged that Respondents were unregistered dealers because they purchased discounted tokens from issuers and resold to investors for profit. Thus, the Respondents violated

121 SEC v. Telegram Group Inc., No. 1:19-cv-09439-PKC (S.D.N.Y. March 24, 2020). 122 SEC Press Release, Telegram to Return $1.2 Billion to Investors and Pay $18.5 Million Penalty to Settle SEC Charges (June 26, 2020), available at https://www.sec.gov/news/press-release/2020-146. 123 See In the Matter of Zachary Coburn, Exchange Act Release No. 84553 (Nov. 8, 2018). 124 See In the Matter of TokenLot, LLC, Lenny Kugel, and Eli L. Lewitt, Exchange Act Release No. 84075 (Sept. 11, 2018).

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Section 15(a) of the Exchange Act by conducting unregistered securities transactions as unregistered broker-dealers.

5. SEC v. Jon E. Montroll and BitFunder.125 In February 2018, the SEC charged a former Bitcoin-denominated platform and its operator with operating an unregistered securities exchange and defrauding the users of that exchange. BitFunder and its founder, Jon E. Montroll, allegedly operated BitFunder as an unregistered online securities exchange and defrauded exchange users by misappropriating their Bitcoins which resulted in the theft of more than 6,000 Bitcoins.

6. In the Matter of BTC Trading, Corp. and Ethan Burnside.126 In 2014, the SEC sanctioned a computer programmer for operating two online venues that traded securities using Bitcoin or Litecoin without registering the venues as broker-dealers or stock exchanges. According to the SEC’s order, Burnside and BTC Trading Corp. actively solicited the public to open accounts by advertising the websites for both of their stock exchanges on the Bitcoin Forum and other websites dedicated to virtual currency in violation of Section 15(a) of the Exchange Act. Burnside and BTC Trading Corp. consented to cease and desist from committing or causing any future violations of the registration provisions. Burnside also agreed to be barred from the securities industry with the right to reapply after two years, and he was ordered to pay $58,387.07 in disgorgement and prejudgment interest plus a civil penalty of $10,000.

VII. CONCLUSION

It is imperative that market participants properly identify a digital asset as a security, commodity or something else, such as a utility, before engaging in capital raising, trading or custody activities for such securities. Market participants must subsequently apply the appropriate regulatory regime and legal framework with respect to such digital asset and related activities.

125 See SEC v. Jon E. Montroll and Bitfunder, 18-cv-1582 (S.D.N.Y.) (Feb. 21, 2018). The case is currently pending with the Southern District Court of New York. The defendant pled guilty to securities fraud and obstruction of justice on July 23, 2018. 126 See In the Matter of BTC Trading, Corp. and Ethan Burnside, Exchange Act Release No. 73783 (Dec. 8, 2014).