By Daniel G. Viola, Partner of Sadis & Goldberg, LLP, a New York based law firm. Daniel is the Head of the Digital Asset and Compliance Groups at his firm and is also the founder of the Crypto Asset Webinars and the Blockchain Shift Conferences.

On May 1, 2018, the Wall Street Journal reported that while Bitcoin escaped government oversight as a security, regulators were examining whether other widely traded cryptocurrencies should be regulated as securities. In particular, Ether, the world’s second most valuable cryptocurrency after Bitcoin. This analysis typically turns on whether the founders of the virtual currency exert significant influence over their value, similar to the way a company’s stock price is dependent on its management team. Critics to this position argue that the analysis depends on how decentralized the organization is. For example, with Ether, since it has become highly decentralized, it should not be deemed a security because an owner of Ether is not relying on the efforts of the founders of Ether to experience a profit from their purchase of Ether.

On June 14, 2018, Mr. William Hinman, the Director of the Division of Corporation Finance at the U.S. Securities and Exchange Commission (the “SEC”) seemed to agree with the critics and concluded that Ether , the cryptocurrency of the Ethereum network, is likely not a security and is therefore likely not subject to the requirements of U.S. securities laws. Of course, a non-security can be offered and sold in a way that causes investors to have a reasonable expectation of profits based on the efforts of others. For example, when a Bank Certificate of Deposit, which is generally exempt from being treated as a security under Section 3 of the U.S. Securities Act of 1933 (the “Securities Act”), is sold as a part of a program organized by a broker who offers retail investors promises of liquidity and the potential to profit from changes in interest rates, then this instrument can be part of an investment contract and defined as a security, as set forth in Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 756 F.2d 230 (2d Cir. 1985).

Under Section 2(a)(1) of the Securities Act, a security includes “an investment contract.” See, 15 U.S.C. § 77b. An investment contract is 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, such as a founder or promoter of a company. 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. The test “permits the fulfillment of the statutory purpose of compelling full and fair disclosure relative to the issuance of ‘the many types of instruments that in our commercial world fall within the ordinary concept of a security.’” Id. In analyzing whether something is a security, “form should be disregarded for substance,” Tcherepnin v. Knight, 389 U.S. 332, 336 (1967), “and the emphasis should be on economic realities underlying a transaction, and not on the name appended thereto.” Forman, 421 U.S. at 849.

In order for an arrangement to be deemed an investment contract, it must qualify under all three (3) prongs of the Howey Test. See also, SEC v. SG Ltd., 265 F.3d 42, 48 (1st Cir. 2001), holding that all the factors must be present in order for an investment contract to meet the statutory definition of a “security.”

By Daniel G. Viola, Partner of Sadis & Goldberg, LLP, a New York based law firm. Daniel is the Head of the Digital Asset and Compliance Groups at his firm and is also the founder of the Crypto Asset Webinars and the Blockchain Shift Conferences.

Not all offerings of tokens are improper, and when conducted in accordance with federal and state securities laws, can be a positive source of capital for entrepreneurial start-up companies. The U.S. Securities and Exchange Commission (the “SEC”) continues to aggressively investigate fraudulent offerings and to protect investors from alleged wrongdoing. For example, on May 29, 2018, the SEC issued a press release announcing that it obtained a court order halting an ongoing fraud involving an initial coin offering (“ICO”) that raised as much as $21 million from investors in and outside the U.S. The SEC also convinced a court to approve an emergency asset freeze and appoint a receiver for Titanium Blockchain Infrastructure Services Inc. (“Titanium”), the firm behind the alleged scheme. Titanium was also the subject of a “wallet hack” in February 2018, resulting in a theft of a large supply of their token supply. Clearly, ICO issuers must impose proper security precautions to avoid site and wallet hacks. Investor confidence demands a secure environment in order to promote trust. Moreover, Titanium also highlights the importance of investor due diligence and presents a number of valuable marketing lessons that legitimate ICO issuers can learn from.

In general, ICO issuers should not use testimonials in their offering documents or otherwise. Testimonials are suspect for a number of reasons. You could easily misinterpret the tone of a testimonial or leave out important qualifications from a person’s testimony about your product or service even if you have the best of intentions. In addition, if you fail to obtain the written permission from the person providing the testimonial, then you could risk disclosing personal information about the person’s tastes or preferences in violation of privacy laws. Finally, SEC registered investment advisers are strictly prohibited from using client testimonials in their marketing materials as prescribed by specific SEC rules under the Investment Advisers Act of 1940, as amended. These rules would apply to investment advisers offering limited partnership interests or security tokens to investors.

In the SEC’s press release on Titanium, it reiterated warnings to ICO investors about the importance of conducting due diligence on ICOs and their principals and how a fraudulent ICO issuer can deceive investors using social media outlets. Note the following quotes from Robert Cohen of the SEC:

“This ICO was based on a social media marketing blitz that allegedly deceived investors with purely fictional claims of business prospects,” said Robert A. Cohen, Chief of the SEC Enforcement Division’s Cyber Unit. “Having filed multiple cases involving allegedly fraudulent ICOs, we again encourage investors to be especially cautious when considering these as investments.”

Lessons Learned: Issuers should only publish truthful representations in their marketing material, especially if they blast out their representations using social media. Issuers should also confirm, with securities counsel, the ability to market to the general public and the placement of proper risk disclaimers in their marketing material, prior to starting a marketing campaign, since some offering laws preclude an issuer from advertising the sale of securities to the general public. Avoiding testimonials and sales puffery can also help mitigate claims of offering fraud and violations of federal and state antifraud laws. Using industry logos without permission or promoting yourself as an expert without any actual certificates or degrees to support your claims will also attract negative regulatory scrutiny and will be viewed as unprofessional by prospective institutional investors. Finally, issuers must carefully consider the Howey Test when analyzing their offerings. The SEC also sued Titanium for not registering their offering or relying on a valid offering exemption. In the complaint against Titanium, the SEC requested the following sanctions: preliminary and permanent injunctions; return of allegedly ill-gotten gains plus interest and penalties; and a bar against the principal of Titanium to prohibit him from participating in offering digital securities in the future. If you have any questions, please call Dan Viola at 212–573–8038.