18 September 2018

One-Two-Three Punch: SEC and FINRA Announce Actions Against Unregistered Broker, Digital Asset Manager and FINRA Registered Person

On September 11, the Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) separately announced three “first of their kind” enforcement actions against participants in the digital asset (or “token”) market:

  • In the Matter of TokenLot LLC. The SEC took action against a token sale website for operating as an unregistered broker-dealer in violation of the federal securities laws.
  • In the Matter of Crypto Asset Management, LP. The SEC entered an order against a digital asset hedge fund manager for failing to register its fund as an investment company and offering and selling its fund’s securities in an unregistered offering.
  • Department of Enforcement vs. Timothy Tilton Ayre. In its first disciplinary action involving digital assets, FINRA filed a complaint alleging that a registered person of a member firm violated federal securities laws and FINRA rules in its offering of a blockchain token as an unregistered security.

The Jab: “ICO Superstore” Required Registration as a Broker-Dealer

Until now, the SEC’s enforcement focus on digital assets has been predominately limited to fraudulent initial coin offerings (ICOs).1 However, the SEC previously signaled that those who directly or indirectly offer trading or other services related to digital assets that are securities must comply with the federal securities laws.2

According to the SEC’s order, TokenLot effected unregistered securities transactions as an unregistered broker-dealer. The SEC held that TokenLot promoted and sold digital assets through the following activities:

  1. TokenLot “actively and broadly” solicited the general public to use the TokenLot platform to purchase tokens. TokenLot earned marketing fees for soliciting investors through its own website, social media postings and forums, emailed newsletters and third-party token sale website. The marketing materials included information prepared by TokenLot, along with whitepapers prepared by token issuers.
  2. TokenLot facilitated securities transactions through its platform for nine ICOs. TokenLot handled purchase orders and instructed transfer of investor funds to their own digital wallet and digital tokens to investors. As compensation, TokenLot earned transaction-based fees for these services.
  3. TokenLot acted as a dealer in connection with secondary market transactions, purchasing tokens in TokenLot’s name (often directly from an issuer at a discount in an ICO) and then immediately reselling for a profit. In some cases, TokenLot accepted investors’ orders placed on the TokenLot platform and then forwarded the orders to the issuer to fulfill with the issuer’s unsold digital tokens from an earlier ICO based upon prearranged agreements with the token issuers.

The SEC highlighted TokenLot’s prompt cooperation and remedial actions. In addition to discontinuing selling efforts and refunding pending orders, TokenLot decided to wind down its business. Further, TokenLot engaged an independent third party to take possession of and destroy the remaining tokens in TokenLot’s inventory. The order to destroy digital assets is an unusual remedy in an SEC enforcement case.

Unlike respondents in many of the SEC’s ICO enforcement actions, TokenLot was not alleged to have committed fraud. The SEC is no longer solely focused on taking action against ICO fraudsters. In the press release accompanying the order, the SEC invited digital asset trading businesses to discuss registration and other securities law requirements with staff. The SEC has clearly “taken off the gloves” and is expanding beyond ICO issuers to the intermediaries engaged in securities law violations.

The Hook: Digital Asset Hedge Fund Operated as an Unregistered Investment Company

On the same day as the TokenLot order, the SEC issued another first: an order finding violations of the registration requirements of the Investment Company Act by a hedge fund formed to invest in digital assets.

According to the SEC order, the fund at issue is a pooled investment vehicle formed for the purpose of investing in digital assets. The SEC found that the fund’s manager engaged in a general solicitation of unregistered securities (outside of SEC Regulation D Rule 506(c)) and thus violated the registration provisions of the Securities Act of 1933 and the Investment Company Act. The SEC also found various other violations of the Securities Act and Investment Advisers Act.

The press release announcing the order warned that hedge funds focused on digital assets “continue to proliferate” and that investment advisers must be sure that offered funds adhere to applicable regulatory requirements under the securities laws.

As mentioned above, it is not new for the SEC to police instances of fraud in the context of digital assets. In this case, however, the SEC found that the fund was “engaged in the business of investing, holding and trading certain digital assets that were investment securities, as defined in Section 3(a)(2) of the Investment Company Act, having a value exceeding 40 percent of the value of [the fund’s] total assets,” thereby causing the fund to meet the statutory definition of an investment company. Because of the general solicitation (outside of Rule 506(c)), no exclusion or exemption was available to the fund, and it should have been registered with the SEC as an investment company. This is also the first instance in which the SEC has found that certain digital assets are investment securities for purposes of the Investment Company Act.

The order may have implications beyond traditional fund structures: Given that companies involved in the digital asset space may have balance sheets heavily weighted toward certain of such assets, these companies should be aware of the risk of becoming an “inadvertent investment company.”

The Uppercut: FINRA’s First Digital Asset Compliant Charges Registered Person With Fraud and Distribution of Unregistered Securities

Following on the heels of recent SEC actions against token issuers, FINRA’s first foray into policing token sales completes an eventful round of digital asset enforcement activity. FINRA’s complaint follows a Regulatory Notice issued in July 2018 requesting that member firms report any current or planned digital asset-related activities.

The respondent (Respondent), a FINRA-registered person, was also president and director of Rocky Mountain Ayre, Inc. (RMTN), a public company quoted on the over-the-counter markets. In 2015, RMTN purchased a majority of the total outstanding amount of the cryptocurrency HempCoin in exchange for RMTN stock. RMTN promised to back 100 percent all HempCoins with RMTN common stock for the benefit of HempCoin holders, at a ratio of one share of RMTN stock to 10 HempCoins. In doing so, he transformed the digital currency into a security (as an instrument convertible into equity securities).

During the relevant period, FINRA found that “nearly every statement filed” with over-the-counter markets contained a false statement regarding RMTN. In addition to the false statements, Respondent and RMTN engaged in the unlawful offering and distribution of unregistered securities by creating a HempCoin website, promoting HempCoin on RMTN’s website and issuing press releases touting HempCoin as the “world’s first currency to represent equity ownership.” FINRA alleges that these activities violated SEC Rule 10b-5 and FINRA Rule 2010, among others. In addition to the unregistered securities offerings and fraudulent activities, FINRA alleges that Respondent violated FINRA Rule 3280 by engaging in private securities transactions without prior written approval from the member firm.

FINRA previously warned investors regarding risks related to cryptocurrencies and has been actively collecting information from member firms related to digital assets. This case marks its first disciplinary action. The complaint alleges what appear to be clear violations of FINRA rules, fraudulent activity and an unregistered securities offering. Notably, the member firm was not named in the complaint. Nonetheless, securities industry professionals should be aware that regulators will hold them accountable for misconduct.

Conclusion

In the 14 months since the SEC issued the DAO report, regulators have repeatedly stressed the need for compliance with the securities laws when transacting in digital assets that are securities. In particular, regulators have made clear in public statements that the securities laws apply to all market participants, including specific warnings addressed to brokers and other gatekeepers. These first-of-their kind enforcement actions show that companies and securities professionals will not be “saved by the bell” merely because they don’t commit fraud.


1 See our prior post, The Sheriffs Are in Town: Recent Developments in Initial Coin Offerings (ICO) Enforcement and Investor Education.

2 In the SEC’s 2017 DAO Report concluding that that blockchain tokens may constitute securities, the SEC noted that it is unlawful for unregistered brokers, dealers and exchanges to effect transactions in securities. In March 2018, the SEC Divisions of Enforcement and Trading and Markets issued a joint statement directed at online trading platforms emphasizing that if the digital assets being traded are securities, online trading platforms may trigger a variety of registration requirements under the federal securities laws, including registration as a national securities exchange, broker-dealer, transfer agent or clearing agency (unless an exemption applies).

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