During the first quarter of 2018, U.S. regulatory agencies and a federal district court issued statements and took actions that are likely to significantly affect the U.S. regulatory landscape for digital assets, including cryptocurrencies, initial coin offerings, and digital asset trading platforms. This article is intended to serve as a summary of the recent key regulatory developments that apply to organizations operating in the U.S. digital asset space.
Cryptocurrencies and the Investment Company Act of 1940
The heightened regulatory activity of 2018 was first signaled by the U.S. Securities and Exchange Commission (“SEC”) in a letter ("Staff Letter”) to the Investment Company Institute (“ICI”) and the Securities Industry and Financial Markets Association (“SIFMA”) issued on January 18. The Staff Letter principally highlighted the SEC staff’s questions concerning how mutual funds and ETFs holding cryptocurrencies would satisfy the requirements of the Investment Company Act of 1940 if they were permitted to register thereunder. The Staff Letter is discussed in an ACA Alert available here.
Cryptocurrencies as Commodities
The U.S. Commodity Futures Trading Commission (“CFTC”) first announced, in a September 2015 cease and desist order against Coinflip, Inc., its view that bitcoin and other virtual currencies were commodities under the Commodity Exchange Act (“CEA”).
Recently, a U.S. District Court was presented with an opportunity to affirm or reject the CFTC’s position. The District Court case concerned a CFTC action against cryptocurrency operator Patrick Kerry McDonald and his company, CabbageTech Corp. In January 2018, the CFTC sued CabbageTech and McDonald for allegedly defrauding investors and misappropriating assets. McDonald filed a motion to dismiss the CFTC’s complaint, claiming, among other things, that the CFTC lacked jurisdiction over CabbageTech’s virtual currency activities.
The CFTC’s jurisdiction over commodities historically has not extended to cash transactions, but only to transactions involving leverage, including commodity futures and other derivatives. There is an exception to this jurisdiction in the case of fraud or market manipulation, where, under the Dodd-Frank Wall Street Reform and Consumer Protection Act, most observers acknowledge the CFTC was granted this authority.
On March 6, 2018, New York federal judge Jack Weinstein denied CabbageTech’s motion to dismiss, and on the question of jurisdiction, explicitly ruled in favor of the CFTC. The court affirmed the CFTC’s authority over spot commodity markets in cases of fraud or manipulation. Furthermore, on the question of whether digital currencies were commodities, the court again sided with the CFTC, stating that they fall “well within” both the common definition and the CEA’s definition of commodities.
Notably, the court stated that its decision was not meant to establish exclusive CFTC jurisdictional authority “to regulate virtual currencies as commodities [and] does not preclude other agencies from exercising their regulatory power when virtual currencies function differently than derivative commodities.” Provided cryptocurrencies are commodities, the court’s language here seems to allude to the question, and the ongoing dispute, over which digital assets are securities. As noted below, the SEC first tackled this question in its July 2017 report on the DAO. In that report, the agency conducted a detailed analysis under the Howey test and concluded DAO tokens were securities and their sale was in violation of U.S. securities laws. However, some observers remain unconvinced that many digital assets (or most ICOs) are securities and take comfort in the report’s conclusion that such a determination will depend on the facts and circumstances of each transaction.
ACA examined the question of which digital assets may meet the definition of a security in a September 2017 article available here.
Digital Asset Trading Platforms as Exchanges
On March 7, 2018, the SEC’s Enforcement Division and Trading and Markets Division issued a “Statement on Potentially Unlawful Online Platforms for Trading Digital Assets” (“Statement”). The Statement expressed the agency’s view that “a number of these digital asset platforms provide a mechanism for trading assets that meet the definition of a ‘security’ under the federal securities laws.” The Statement affirmed, moreover, that “a platform [that] offers trading of digital assets that are securities and operates as an ‘exchange,’ as defined by the federal securities laws…must register with the SEC as a national securities exchange or be exempt from registration.”
The SEC’s reasoning is straightforward and follows logically from the agency’s prior positions, including the July 2017 Section 21(a) Report stating that tokens issued by former investor-directed venture capital fund, The DAO, were securities, the July 2017 Investor Bulletin on Initial Coin Offerings, and Chairman Clayton’s December 2017 Statement on Cryptocurrencies and Initial Coin Offerings.
The Statement did not identify by name any digital asset venues that the SEC believed to be in violation of federal securities laws. Instead, it reminded platform operators of the obligations of operating a registered exchange, including becoming a member of and subject to the governance of a self-regulatory organization (“SRO”), which enforces compliance with federal securities laws and the rules of the SEC. In addition, the Statement discussed the requirements of operating an alternative trading system, namely registering as a broker-dealer (and becoming subject to broker-dealer requirements) and becoming a member of an SRO.
Finally, the Statement acknowledged that though some online trading platforms may not meet the definition of an “exchange,” certain aspects of their businesses, such as offering digital wallet services, “may trigger other registration requirements under the federal securities laws, including broker-dealer, transfer agent, or clearing agency registration, among other things.”
Crypto Asset Fund Inquiry
On March 14, 2018, various news outlets reported, and ACA is able to confirm, that the SEC sent information requests to investment advisers managing funds containing digital assets. The SEC’s demands concerned these advisers’ practices in areas including marketing, valuation, investor disclosure, and compliance with the custody rule. Bloomberg reported that funds had received requests for information from both the SEC’s OCIE and Division of Enforcement.
Certain requests addressed whether advisers’ fundraising efforts took the form of an “offering” of securities and whether such offerings should be registered under the Securities Act of 1933. If an adviser was raising capital for a private fund, the information requests inquired as to whether the adviser was complying with the terms of the relevant private placement exemption, including whether fund investors were accredited and if the adviser had engaged in general solicitation.
Digital assets managers and investors continue to wrestle with the issue of custody, and in particular the SEC requirement that registered investment advisers hold “client funds and securities” over which they have custody with a qualified custodian. ACA addressed this issue in detail in its January 2018 Alert, and highlighted the SEC’s questions posed to digital asset advisers in the Staff Letter. Many of these questions remain unanswered, including whether the SEC is currently aware (and supportive) of custodians providing custodial services in the cryptocurrency space and how these service providers can meaningfully help investors “validate [the] existence, exclusive ownership and software functionality” of digital asset holdings.
ACA is currently working with investment advisers, digital asset platforms, and other institutional investors seeking to address the SEC’s questions and establish digital asset advisory, as well as other businesses that are looking to meet SEC regulations and institutional best practices in the digital asset arena.
About the Author
Mike Seery is a Senior Principal Consultant at ACA Compliance Group. He helps hedge fund, private equity fund, and other SEC-registered investment advisers create and maintain best-in-class regulatory compliance programs. Mike advises clients on complex regulatory issues, including portfolio valuation, expense allocation, soft dollars, and expert networks.
 Commodity Futures Trading Commission v. Coinflip, Inc., d/b/a Derivabit, and Francisco Riordan (E.D.N.Y. Sept. 17, 2015).
 Commodity Futures Trading Commission v. Patrick K. McDonnell, and CabbageTech Corp, d/b/a Coin Drop Markets (E.D.N.Y. Mar, 6, 2018).
 SEC v. W. J. Howey Co., 328 U.S. 293, 301 (1946).
 U.S. Securities and Exchange Commission Statement on Potentially Unlawful Online Platforms for Trading Digital Assets (Mar. 7, 2018).
 U.S. Securities and Exchange Commission Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (July 25, 2007).
 U.S. Securities and Exchange Commission Investor Bulletin: Initial Coin Offerings (July 25, 2017).
 U.S. Securities and Exchange Commission Statement on Cryptocurrencies and Initial Coin Offerings, SEC Chairman Jay Clayton (Dec. 7, 2017).
 Bloomberg News. Hedge Funds Draw SEC Scrutiny in Crypto Coin Review (Mar. 14, 2018).