WSGR ALERT

Out with the Old, In with the New: A Review of WSGR's Publications on the Regulation of Digital Assets in 2018 and Predictions for 20191

January 10, 2019

Happy New Year from all of us in the WSGR Blockchain and Cryptocurrency Practice Group! The industry learned a lot about the regulation of digital assets in 2018, and we published some of our observations about those developments throughout the year. This alert provides a list and summaries of our publications on the regulation of blockchain and digital assets. As context, we also outline our understanding of the most important regulatory developments of the year and our thoughts on where we think the market is headed in 2019.

What Happened in 2018?

During 2018, regulators were increasingly active in regulating tokens, cryptocurrencies, and other digital assets (collectively, "tokens"), including offerings of tokens ("token offerings"). In addition, in our experience, investors became progressively more discerning about the types and terms of token offerings in which they would invest, and blockchain companies became increasingly aware of the need to address securities and other laws in structuring their platforms and tokens.

Over the course of the year, the Securities and Exchange Commission ("SEC") and its staff ("Staff") provided ongoing guidance on the regulation of tokens. As outlined in our previous publications, we now know the following:

  • At least for now, virtually all tokens besides Bitcoin and Ether are, in the view of the SEC and its Staff, securities.2
  • The SEC is still investigating and pursuing enforcement actions against token offerors that did not structure their offerings in compliance with the securities laws, and the penalties are getting harsher. While the earliest settlements involved almost no penalties beyond cease-and-desist orders, the most recent settlements have involved mandatory rescission offerings, monetary penalties, and significant remedial reporting requirements, among others.3
  • The SEC is not "grandfathering" token offerings from 2017 or earlier. Recent settlements with more onerous penalties have been against companies that engaged in offerings earlier than those first subject to enforcement actions with light penalties.4
  • The SEC and its Staff are also targeting other actors in the token market besides issuers, including those acting without registration as broker-dealers,5 exchanges or alternative trading systems,6 investment advisers,7 and investment companies.8 In addition, the SEC sanctioned a programmer who developed code that created a decentralized exchange that permitted illegal trading of tokens, even though the developer had no ongoing relationship with the exchange.9

Based on these and other developments, the market related to blockchain and tokens is changing. At the beginning of 2018, demand for token offerings was strong. By the end of 2018, some critics declared that the token offering bubble had burst.10 Nonetheless, our experience was and continues to be that attractive and well thought-out token offerings can still be funded.

The end of 2018 also saw some token issuers return funds to investors, offer rescission rights, or provide conversions to equity in an attempt to remedially comply with the securities laws.11 In addition, in recognition of the fact that most token issuers will need to treat tokens as securities, many blockchain companies and service providers have been working (and sometimes struggling) to structure their token-based platforms to comply with the securities and other laws, including those related to broker-dealers, exchanges and alternative trading systems, investment advisers, investment companies, money transmitters, anti-money laundering, and others.

The news isn't all bad though. As we discuss below, we think the market is and will continue to be recalibrating based on the SEC's regulatory requirements in a way that, over the long term, will provide greater certainty and, perhaps, long-term opportunities for issuers, investors, and the industry as a whole.

What Do We Expect for 2019?

In 2019, we expect the following trends to continue:

  • Enforcement Actions. We anticipate additional enforcement actions by the SEC and other regulators in 2019, probably with even harsher penalties where blockchain companies have failed to heed their warnings from 2018.
  • Private Litigation. We expect there to be more private litigation by investors that have received tokens in illegal token offerings and seek to recoup their investments.
  • Well-Structured Offerings. We expect to continue to see offerings of and investments in well-structured token offerings, as well as direct investments in companies developing innovative blockchain technology.
  • Investor Demands. We also anticipate continued demands by investors for governance rights over token issuers and their offerings and transparency into a company's approach to regulatory compliance.
  • More Sophisticated Structuring. We anticipate that token issuers will spend more time and effort earlier in the fundraising process structuring their platforms, tokens, and offerings in consideration of the federal securities laws. We expect that investors increasingly will require early-stage token issuers to develop a meaningful plan to address and comply with securities and other applicable laws, and especially with broker-dealer and other provisions that could cause significant limitations on the ability of the platform to operate as intended.

We also expect the following new developments, which we believe will help bolster the market for tokens and the ability of blockchain companies to function:

  • SEC-Qualified Token Offerings. We expect to see the first set of token offerings implemented under Regulation A+ under the Securities Act of 1933, a "mini" form of public offering, qualified by the SEC sometime in the first part of 2019.
  • Approvals of Alternative Trading Systems and Broker-Dealers. We believe the SEC and the Financial Industry Regulatory Authority ("FINRA") will authorize the first alternative trading systems and broker-dealers to facilitate and engage in trading in tokens in early 2019.
  • Market Differentiation. We anticipate the market to rapidly distinguish between token issuers and platforms that comply with the federal securities laws (and other laws) and those that do not.

All of this may mean that the token offerings that occur in 2019 will be better thought out and perhaps more enduring. We hope the list of publications below provides a useful reference point for token issuers and other market participants moving forward.

Publications from the WSGR Blockchain and Cryptocurrency Practice Group in 2018

ArticleTitleDate
1.The SEC Says Happy Thanksgiving to Token Issuers: What Airfox, Paragon, and a Joint Staff Statement Mean for the Crypto Markets

The article summarizes some of the key takeaways from a coordinated set of actions by the SEC and its staff that should help further clarify their views on the application of the federal securities laws to tokens and other cryptocurrencies. The authors conclude this article by urging the SEC to further help token issuers by improving its processes for approving Regulation A+ and public offerings for tokens, for approving platforms on which tokens can legally be traded, and for facilitating the ability of investment professionals to provide investment advice to retail and other token investors.
November 27, 2018
2.SEC Takes Action Against Developer of Crypto Exchange EtherDelta

The article discusses an SEC cease-and-desist order against Zachary Coburn, the founder of EtherDelta, a well-known online platform for trading Ether and ERC20-based tokens. The SEC found that EtherDelta violated Section 5 of the Exchange Act of 1934. The article discusses how this order is important in several ways and serves as a cautionary statement both to crypto exchanges specifically and more generally to developers of any tokens and token-related platforms.
November 9, 2018
3.Getting to a Fully Operational Token Platform

The article discusses recommended strategies for token issuers to finance and develop fully operational and legally compliant token platforms through financing efforts and token distribution plans that are structured early on to address a broad range of potential regulatory issues.
October 11, 2018
4.Regulation A+ Offerings for Tokens: What is the SEC Waiting For?

The article discusses key topics surrounding Regulation A+ token offerings and preparation of Form 1-A. While it is anticipated that the SEC and its Staff will permit token issuers to use Regulation A+ and Form 1-A as a vehicle through which they can publicly offer and sell tokens, that vehicle requires significant—and costly—modifications to work for a token offering.
September 26, 2018
5.SEC Thinks Most Tokens Are Securities and When the SEC Thinks a Token Might Stop Being a Security

This article sets forth reasons why the SEC considers most tokens to be securities and explains why under the Howey test—the principal test for analyzing whether most tokens are securities—issuers should typically treat their tokens as securities. The article also outlines the consequences of not doing so.
August 1, 2018
6.Rob Rosenblum—Testimony to the House Committee on Financial Services

This is WSGR Partner Rob Rosenblum's complete testimony before the Capital Markets, Securities and Investment Subcommittee of the House Committee on Financial Services. In his testimony, Mr. Rosenblum recommends that Congress pass legislation to modify or eliminate regulations that impede the innovation and capital formation opportunities that are offered by the development of blockchain and cryptocurrency technologies.
March 14, 2018
7.ICO Issuers: Fix the Problem Before the SEC Fixes It for You

In this article, which was published by CoinDesk, WSGR attorneys consider why the SEC issued a large number of subpoenas to token issuers and to gatekeepers who may have been involved in token transactions that may not have complied with federal securities laws. The authors conclude that, in the short term, token issuers should work with the SEC to tailor existing registration, reporting, trading and exchange rules to better reflect the nature of tokens and token platforms. In the long term, the authors suggest the crypto industry could work with the SEC, other regulators and Congress to develop a modified registration, reporting, and trading system that is designed specifically for cryptocurrency.
March 11, 2018
8.SEC Investment Management tells registered Fund Industry "No For Now" on Virtual Currencies

This article discusses a January 18, 2018 letter issued by the SEC's Division of Investment Management that details the division's concerns about potential investments by registered funds in virtual currencies.
February 2018

1 Authored by partner Robert Rosenblum and associates Amy Caiazza, Tyler Kirk, and Julie Krosnicki at Wilson Sonsini Goodrich & Rosati. This article reflects the views of the authors, and does not necessarily represent the views of Wilson Sonsini Goodrich & Rosati or other lawyers at the firm. This article is not, and cannot be relied upon as, legal advice to any person or entity.
2 See William Hinman, Director, Division of Corporation Finance, Digital Asset Transactions: When Howey Met Gary (Plastic) (Jun.14, 2018) ("Director Hinman Speech"), https://www.sec.gov/news/speech/speech-hinman-061418 (stating that Bitcoin and Ether are not securities due to the state of decentralization of those tokens and that other systems may also meet that standard in the future). For more information on the status of tokens as securities, please read our article, WSGR Practitioner Insight: Why the SEC Thinks Most Tokens Are Securities and When the SEC Thinks a Token Might Stop Being a Security (Aug. 1, 2018), https://www.wsgr.com/WSGR/Display.aspx?SectionName=publications/PDFSearch/Practitioner-Insight-tokens.htm.
3 Compare In the Matter of CarrierEQ, Inc., d/b/a Airfox, SEC Order Instituting Cease-and-Desist Proceedings Pursuant to Section 8A of the Securities Act of 1933 (Nov. 16, 2018) ("Airfox Order"), https://www.sec.gov/litigation/admin/2018/33-10575.pdf (requiring mandatory rescission and remedial reporting requirements and imposing civil monetary penalties) and In the Matter of Paragon Coin, Inc., SEC Order Instituting Cease-and-Desist Proceedings Pursuant to Section 8A of the Securities Act of 1933 (Nov. 16, 2018) ("Paragon Order"), https://www.sec.gov/litigation/admin/2018/33-10574.pdf (same) with In the Matter of Munchee Inc., SEC Order Instituting Cease-and-Desist Proceedings Pursuant to Section 8A of the Securities Act of 1933 (Dec. 11, 2017) ("Munchee Order"), https://www.sec.gov/litigation/admin/2017/33-10445.pdf (settling without any civil monetary or other penalties imposed); SEC Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Rel. No. 81207 (July 25, 2017) ("DAO Report"), https://www.sec.gov/litigation/investreport/34-81207.pdf (same). For more information on the Airfox Order and Paragon Order, please read our article, WSGR Alert: The SEC Says Happy Thanksgiving to Token Issuers: What Airfox, Paragon, and a Joint Staff Statement Mean for the Crypto Markets (Nov. 26, 2018), https://www.wsgr.com/WSGR/Display.aspx?SectionName=publications/PDFSearch/wsgralert-sec-token-issuers.htm.
4 While the Airfox Order and Paragon Order were released by the SEC after the Munchee Order, the token offerings by CarrierEQ, Inc. (d/b/a Airfox) and Paragon Coin, Inc. each occurred between August and October 2017, both before the token offering by Munchee, Inc., which occurred between October and November 2017. Compare Munchee Order (forgoing penalties, based in part on the company's cooperation with the SEC's enforcement Staff, in December 2017) with Airfox Order (imposing various penalties and remedial actions in November 2018) and Paragon Order (same).
5 In the Matter of TokenLot, LLC, SEC Order Instituting Administrative and Cease-and-Desist Proceedings, Pursuant to Section 8A of the Securities Act of 1933 (Sep. 11, 2018) ("TokenLot Order"), https://www.sec.gov/litigation/admin/2018/33-10543.pdf (finding that TokenLot, LLC solicited investors, took thousands of customer orders for tokens, processed investor funds, received transaction-based compensation and, as a result of these activities, was an illegally unregistered broker-dealer).
6 In the Matter of Zachary Coburn, SEC Order Instituting Cease-and-Desist Proceedings Pursuant to Section 21C of the Securities Exchange Act of 1934 (Nov. 8, 2018) ("EtherDelta Order"), https://www.sec.gov/litigation/admin/2018/34-84553.pdf (finding that the EtherDelta platform operated as a marketplace for bringing together the orders of multiple buyers and sellers in tokens that included securities and, as a result, was an illegally unregistered exchange). For more information on the EtherDelta Order, please read our article, WSGR Alert: SEC Takes Action Against Developer of Crypto Exchange EtherDelta (Nov. 9, 2018) ("WSGR Alert: EtherDelta"), https://www.wsgr.com/WSGR/Display.aspx?SectionName=publications/PDFSearch/wsgralert-etherdelta.htm.
7 In the Matter of Crypto Asset Management, LP and Timothy Enneking, SEC Order Instituting Administrative Proceedings Pursuant to Sections 203(e), 203(f), and 203(k) of the Investment Advisers Act of 1940 and Section 9(f) of the Investment Company Act of 1940 (Sep. 11, 2018) ("CAM Order"), https://www.sec.gov/litigation/admin/2018/33-10544.pdf (finding that the manager of a fund that invested in tokens was an unregistered "investment adviser" providing advice with respect to securities and, in that role, violated the anti-fraud provisions of the Investment Advisers Act of 1940).
8 See CAM Order (finding that a fund that held tokens held, through those holdings, a sufficient amount of securities to meet the definition of an "investment company" for purposes of the Investment Company Act of 1940).
9 See EtherDelta Order (holding Zachary Coburn, the developer of and programmer for EtherDelta, liable for violations by EtherDelta of federal securities laws).
10 Simon Seojoon Kim, The Biggest Problem for ICOs? In 2018, It Was Their Own Investors, COINDESK (Jan. 6, 2019), https://www.coindesk.com/the-biggest-problem-for-icos-in-2018-it-was-their-own-investors ("Despite the burst of the ICO bubble, the blockchain craze in Asian markets is not waning"); Tracy Alloway, A Year After the Crypto Bubble Burst, Will Bitcoin Ever Recover?, BLOOMBERG (Dec. 13, 2018), https://www.bloomberg.com/news/features/2018-12-13/where-does-bitcoin-go-from-here (describing the rise and fall of Bitcoin prices as "what could prove one of the most dramatic economic bubbles in world history"); Oscar Williams-Grut, 'Unsustainable' crypto startup funding bubble has burst, YAHOO! FINANCE (Nov. 15, 2018), https://uk.finance.yahoo.com/news/unsustainable-crypto-startup-funding-bubble-burst-080005455.html?guccounter=1 ("The 'initial coin offering' (ICO) funding market is being crushed by the 'crypto winter'").
11 Future efforts along these lines may be further inspired by the recent Airfox Order and Paragon Order, each of which required the applicable token issuer to provide investors a method to recover their investment in tokens with interest pursuant to Section 12(a) of the Securities Act.