Two cases in a New York federal courthouse – the US District Court for the Eastern of New York – have the potential to dramatically shape the future of cryptocurrency regulation.
In one case, an EDNY judge recognized the CFTC's authority to regulate virtual currencies. In the other case, a different EDNY judge will decide whether digital tokens offered during ICOs are securities subject to SEC regulation.
On March 6, 2018, Judge Jack Weinstein of the US District Court for the Eastern of New York (EDNY) ruled that virtual currencies are commodities subject to US Commodity Futures Trading Commission (CFTC) regulation. The ruling was issued in response to a pro se motion to dismiss in CFTC v. McDonnell and is the first judicial endorsement of the CFTC's long-held position that the Commodities Exchange Act (CEA) authorizes it to regulate virtual currencies.
Nearly two months later, on May 8, 2018, Judge Raymond J. Dearie of the EDNY heard oral arguments in a different case – the criminal prosecution of Maksim Zaslavskiy – where the defendant is challenging the government's position that digital tokens offered through initial coin offerings (ICOs) are securities. While this case was brought by the US Department of Justice (DOJ), the issue has significant implications for the US Securities and Exchange Commission (SEC), which has brought parallel civil proceedings against Zaslavskiy in the EDNY and asserted broad regulatory authority over ICOs on the theory that cryptocurrencies are securities.1
These issues of first impression have far-reaching implications for the cryptocurrency regulatory landscape and may impact enforcement actions in the pipeline.
McDonnell decision affirming CFTC authority
On January 18, 2018, the CFTC filed a complaint accusing Patrick K. McDonnell and CabbageTech, Corp. of fraud and misappropriation in connection with the purchase and trading of two cryptocurrencies – Bitcoin and Litecoin – and the failure to provide purported "virtual currency trading advice," such as "entry and exit prices for day trading of certain virtual currencies." According to the CFTC, the defendants "used their fraudulent solicitations to obtain and then simply misappropriate customer funds." McDonnell responded with a pro se motion to dismiss the charges that challenged the CFTC's "enforcement jurisdiction."
In its response to the motion to dismiss, the CFTC directed the court to a prior filing in which it argued that virtual currencies are commodities. The CFTC asserted that the CEA's "definition of commodity is expansive in scope" and extends to "intangible commodities" ranging from "renewable energy credits and emissions allowances" to virtual currencies. As explained by the CFTC, "virtual currencies . . . fall within the [CEA's] category of 'all other goods and articles'" and "the rights and interests that inhere to each unit of virtual currency constitute 'rights [or] interests . . . in which contracts for future delivery are presently . . . dealt in.'"
The Chicago Mercantile Exchange filed an amicus curiae letter in support of the CFTC's virtual-currencies-are-commodities argument, cautioning that "a determination that a virtual currency such as Bitcoin is not a commodity . . . . would put in jeopardy [the Chicago Mercantile Exchange] and its market participants' expectation to rely on the CEA and the CFTC's regulatory protections for commodity derivatives contracts based on virtual currencies." The Chicago Mercantile Exchange has offered a Bitcoin futures product for trading since December 18, 2017.
In the first federal court decision affirming the CFTC's authority to regulate virtual currencies, Judge Weinstein rejected McDonnell's jurisdictional challenge He concluded that the CFTC has the authority to regulate virtual currencies. In his March 6, 2018 order, Judge Weinstein explained, "[v]irtual currencies can be regulated by CFTC as a commodity" because they "are goods exchanged in a market for a uniform quality and value" and "fall within the CEA's definition of 'commodities' as 'all other goods and articles . . . in which contracts for future delivery are presently or in the future dealt in.'" The order did not differentiate between "digital coins" – such as Bitcoin and Litecoin – that use and operate on their own platforms, and "digital tokens" – such as those at issue in the Zaslavskiy case – which are built on top of existing blockchain and typically represent an asset or utility. McDonnell did not draw this distinction in his pro se filing, and we predict this issue will be raised in a future CFTC case.
In his decision, Judge Weinstein left the door open to concurrent regulation by other government regulators, noting that "[t]he jurisdictional authority of [the] CFTC to regulate virtual currencies as commodities does not preclude other agencies from exercising their regulatory power when virtual currencies function differently than derivative commodities." As a result, in Judge Weinstein's view, other government bodies – including the SEC, the DOJ, the US Department of the Treasury, and the Internal Revenue Service as well as state agencies – can seek to regulate virtual currencies "without displacing CFTC's concurrent authority." As the Zaslavskiy prosecution and other enforcement actions demonstrate, these regulators have not hesitated to assert their authority.
Zaslavskiy proceedings challenging SEC jurisdiction.
Last fall, the DOJ and SEC brought parallel proceedings against Maksim Zaslavskiy for securities fraud in connection with two ICOs. In its September 2017 complaint, the SEC alleged that Zaslavskiy's companies – RECoin Group Foundation, LLC (RECoin) and DRC World, Inc. (DRC) – sold digital tokens in a pair of ICOs that qualified as unregistered offerings of securities and that Zaslavskiy made false or misleading representations and omissions in connection with both token sales.
In October 2017, the DOJ filed a criminal complaint charging Zaslavskiy with securities fraud conspiracy for similar misconduct – engaging in illegal unregistered securities offerings and making material misstatements to deceive investors in connection with the ICOs. Federal prosecutors accused Zaslavskiy of marketing RECoin as "The First Ever Cryptocurrency Backed by Real Estate" and touting DRC as an "exclusive and tokenized membership pool" that was hedged by physical diamonds despite knowing that "no real estate or diamonds were actually backing the investments." The SEC suit was stayed pending the outcome of the DOJ action.
In February 2018, Zaslavskiy filed a motion to dismiss the criminal case, arguing that securities laws do not apply to cryptocurrencies and that Zaslavskiy's token sales do not constitute "investment contracts" under the Supreme Court's Howey test – the long-recognized standard for determining if an investment instrument is a security. Zaslavskiy also argued that securities laws are void for vagueness as applied to cryptocurrency and token sales.
Both the DOJ and the SEC opposed Zaslavskiy's motion. The DOJ characterized Zaslavskiy's brief as a failed attempt to recast REcoin and DRC tokens as "currencies" rather than securities, while both tokens constituted "prototypical investment contract[s]" under Howey. The SEC agreed, characterizing Zaslavskiy's token ICOs as "old-fashioned fraud dressed in a new-fashioned label." Both regulators encouraged the court to focus on the economic reality of the investments as they were advertised – rather than the terminology – to evaluate the character of the token offerings.
Zaslavskiy responded by accusing the government of "advanc[ing] a vision of nearly limitless regulatory jurisdiction by the SEC" and requesting "carte blanche to regulate industries whether it has the legal authority to do so or not." Zaslavskiy challenged the government's interpretation of Howey as applied to REcoin and DRC, arguing that the regulators failed to satisfy two prongs of the four-prong test. In addition, Zaslavskiy warned of a "regulatory agency goldrush" in which "every American regulatory agency that has considered its jurisdiction of cryptocurrencies has concluded it has the authority to regulate cryptocurrencies."
During a hearing last week, Judge Dearie expressed uncertainty about how to treat digital tokens but was openly critical of Zaslavskiy's conduct, which he characterized as a "grand misrepresentation." At one point, the judge read from Zaslavskiy's marketing materials, which promised investors profits based on the tokens being backed by real estate assets, and observed that the language "sounds like an investment contract." When Zaslavskiy's attorney noted that Judge Weinstein recently concluded that cryptocurrencies are commodities subject to CFTC regulation, Judge Dearie suggested – similar to his colleague – that digital tokens could be subject to concurrent jurisdiction by multiple regulators. While Judge Dearie has yet to rule on the motion to dismiss, the questions reportedly posed during oral argument suggest that his decision will include an analysis of whether the tokens at issue satisfy the Howey test.
Impact on future cryptocurrency enforcement
Regulators have turned up the heat on cryptocurrency companies in recent months, issuing subpoenas, document requests, and cease-and-desist orders. Examples include a December 2017 enforcement action to halt a $15 million ICO by a California-based social-networking restaurant review app, a January 2018 enforcement action to halt a Texas-based bank from proceeding with an ICO and an April 2018 enforcement action against the co-founders of a financial services startup for an allegedly fraudulent ICO that raised more than $32 million.
The McDonnell cryptocurrencies-are-commodities ruling allows the CFTC to assert jurisdiction over companies engaged in "pump-and-dump" schemes and other forms of market manipulation. Meanwhile, a Zaslavskiy cryptocurrencies-are-securities finding may embolden federal regulators to look increasingly beyond instances of egregious conduct and expand their focus on registration issues – a potential tripwire for hundreds of companies that have launched, or plan to launch, ICOs without complying with SEC registration requirements or conducting offerings that are exempt from those requirements. As noted by SEC Cyber Unit Chief Robert Cohen at a securities conference last week, the SEC is currently investigating a number of ICOs for "purely registration issues."
The McDonnell and Zaslavskiy actions are initial cases where government regulators are testing their jurisdictional theories. They will help chart the course for future CFTC and SEC enforcement in an industry where the law has struggled to keep pace with technology.
Find out more about the implications of these cases by contacting either of the authors.
An earlier version of this alert appeared on Law360 on May 16, 2018.
1 See SEC Chairman Jay Clayton, "Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission," U.S. Senate Committee on Banking, Housing, and Urban Affairs (Feb. 6, 2018), available here ("I believe every ICO I've seen is a security"); but see SEC Director of the Division of Corporation Finance, "Oversight of the SEC's Division of Corporation Finance" U.S. House of Representatives Financial Services Committee (Apr. 26, 2018), available here (remarking in an exchange with Rep. Tom Emmer (R-MN6) that some utility tokens on decentralized networks may not qualify as securities).