Tag: Banking

Are RIAs Eligible for PPP?

Posted on by Liam Mennitt

Is a Registered Investment Advisor (“RIA”) eligible to participate in the Payment Protection Program (the “PPP”) administered by the Small Business Administration (“SBA”)? The short answer is “yes.”

The PPP was promulgated as part of the recently enacted Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) which in part set aside hundreds of billions of dollars to help small businesses retain their employees during the COVID-19 crisis and the resultant work from home orders set forth by governors across the country.

Background

We understand that many RIAs applied for and were granted a loan under the CARES act, and that some of these RIAs may be unsure of whether they were granted the loan in error, how they may spend the loan funds or if they can spend the loan funds. The guidance below will hopefully answer some of these questions because applying for and receiving a PPP loan in a knowingly false fashion is a criminal offense, and we strongly encourage any RIA unsure of its PPP eligibility to seek particular legal advice.

The guidance below hinges on whether an RIA engages in speculative operations, holds any securities or other speculative assets, or is simply engaged in financial advisory services.

SBA Guidance

The SBA published an Interim Final Rule on April 2, 2020 (the “Interim Final Rule”). Specifically, the Interim Final Rule provides that “Businesses that are not eligible for PPP loans are identified in 13 CFR 120.110 and described further in SBA’s Standard Operating Procedure (SOP) 50 10, Subpart B, Chapter 2….” (the “SOP”).

Some of the ineligible financial markets and funds businesses listed in the SOP include, without limitation:

  • Banks;
  • Life insurance companies (but not independent agents);
  • Finance companies;
  • Investment companies;
  • Certain passive businesses owned by developers and landlords, which do not actively use or occupy the assets acquired or improved with the loan proceeds, and/or which are primarily engaged in owning or purchasing real estate and leasing it for any purpose; and
  • Speculative businesses that primarily “purchas[e] and hold[ ] an item until the market price increases” or “engag[e] in a risky business for the chance of an unusually large profit.”

On April 24, 2020, the SBA issued its Fourth Interim Final Rule on the PPP (the “Fourth Interim Final Rule”). The Fourth Interim Final Rule explicitly states that hedge funds and private equity firms are not eligible for a PPP loan.

Discussion

Ineligible Companies.

If the RIA is also a hedge fund or a private equity firm, then it may not be eligible to receive a PPP loan. If, however, the RIA is legally distanced from those entities through appropriate corporate structures, and the loan is only used for the RIA business, then the RIA should be eligible to receive the PPP funds.

Because most RIAs are not also banks or life insurance companies, the exclusions should not apply. However, as some RIAs also sell life insurance products, such individual situations may require more research.

Finance companies are also ineligible under the SBA guidelines to receive PPP funds. The SBA guidelines define a finance company as one “primarily engaged in the business of lending, such as banks, finance companies, and factors.” (Sec. 120.110(b) of the SBA’s Business Loans regulations). Thus, this exclusion should not apply. Similarly, an RIA may not be deemed an investment company, which is a company organized under the Investment Company Act of 1940, unless the RIA was in fact incorporated under that Act.

An RIA also may not meet the definition of a “speculative business” as defined above in the Interim Final Rule. If an RIA does not purchase or hold assets until the market price increases or engage in a risky business for the chance of an unusually large profit, then it will not meet this definition. Speculative businesses may also include: (i) wildcatting in oil, (ii) dealing in stocks, bonds, commodity futures, and other financial instruments, (iii) mining gold or silver in other than established fields, and (iv) building homes for future sale, (v) a shopping center developer, and (vi) research and development. (Sec 120.110(s) of the SBA’s Business Loans regulations, SBA Eligibility Questionnaire for Standard 7(a) Guaranty and SOP Subpart B D (Ineligible Businesses).  It is our understanding that an RIA that merely provides portfolio management services would not be deemed to be involved in a “speculative” business based on the examples of such businesses provided by the SBA. If the SBA had taken the position that financial advisory services are speculative, it could easily have so indicated by including such services in its lists of speculative services.

Financial Advisory Services.

Consistent with this view, the SBA has provided clear guidance that financial advisory services are eligible for SBA loans, including loans under the PPP. In the SBA’s SOP, the SBA provides the following: “A business engaged in providing the services of a financial advisor on a fee basis is eligible provided they do not use loan proceeds to invest in their own portfolio of investments.” (SOP Sec III(A)(2)(b)(v) pp.104-105) (emphasis added).

This guidance is clear that the focus of ineligibility is at the portfolio company level, not the advisory level, and this is consistent with the guidance noted above making hedge funds and private equity firms ineligible. Hedge funds and private equity firms make money based upon speculative investments and/or appreciation of the markets. An investment advisor operates at the consulting or services level. In other words, the SBA has distinguished between true speculative operations such as wildcatting, speculative real estate development and investing in securities, and service-based operations such as the investment advisory business. Assuming that an eligible RIA did not use any proceeds of the PPP loan at any investment level, such RIA should not be deemed a speculative business and is eligible for a PPP loan.

SEC Guidance

SEC guidance affirms that RIAs are eligible for PPP loans. While the SEC imparts certain burdens on RIAs that accept PPP loans, the fact that the SEC even acknowledges such burdens should give most RIAs confidence that a PPP loan is available to them.

For RIAs who are eligible to receive PPP funds under the SBA guidance set forth above, the SEC instructs that they must comply with their fiduciary duty under federal law and make a full and fair disclosure to their clients of all material facts relating to the advisory relationship. The SEC further posits that “If the circumstances leading you to seek a PPP loan or other type of financial assistance constitute material facts relating to your advisory relationship with clients, it is the staff’s view that your firm should provide disclosure of, for example, the nature, amounts and effects of such assistance.” An example of a situation the SEC would require such disclosures would be an RIA requiring PPP funds to pay the salaries of RIA employees who are primarily responsible for performing advisory functions for clients of the RIA. In this case the SEC would require disclosure as this may materially affect the financial well-being of an RIA’s clients.

The SEC additionally provides that “if your firm is experiencing conditions that are reasonably likely to impair its ability to meet contractual commitments to its clients, you may be required to disclose this financial condition in response to Item 18 (Financial Information) of Part 2A of Form ADV (brochure), or as part of Part 2A, Appendix 1 of Form ADV (wrap fee program brochure). (SEC Division of Investment Management Coronavirus (COVID-19) Response FAQs).

Summary

While the Cares Act and PPP are recently enacted, and there is some confusion surrounding the eligibility requirements for the PPP, the SBA had a clear opportunity to deem financial advisors ineligible in the Interim Final Rule and Fourth Interim Final Rule, but specifically chose not to do so. Instead, the SBA followed the direction of its historical eligibility requirements, holding to ineligibility at the fund and portfolio company level, but continuing to permit loans to firms operating at the advisory level.

While it is possible that the SBA could interpret its own rules and regulations inconsistently with the specific guidance provided in the Interim Final Rule and Fourth Interim Final Rule, the weight of the evidence strongly suggests that an investment advisor is eligible for a PPP loan as long as it does not use the proceeds for fund or portfolio company purposes.

A Brief Summary of Portions of the New CARES Act and What It Could Offer in Financial Relief to Churches and Other Tax-Exempt Organizations

Posted on by Liam Mennitt

It may be worth considering that many non-profits, including churches, might utilize provisions in the new Coronavirus Aid, Relief, and Economic Security Act or CARES Act (P.L. 116-136) to provide some economic relief. Potential applicants should review the new law in detail and discuss its requirements with their attorneys.

The new law sets aside about $349 billion for loans to various nonprofit organizations, including churches. The bridge period is from February 15, 2020 to June 30, 2020. It also includes a provision that can make the loans forgivable.  Employers with up to 500 employees are eligible.   Availability is first come, first served, so prompt application is recommended.

How the Loan May Be Used

Loan proceeds may be used for:

  • Payroll
  • Group health insurance, paid sick leave, medical and insurance premiums
  • Mortgage or rent payments
  • Utilities
  • Salary and wages
  • Vacation, parental leave, sick leave
  • Health benefits

Payroll includes:

  • Salary or wages, payments of a cash tip
  • Vacation, parental, family, medical, and sick leave
  • Health benefits
  • Retirement benefits
  • State and local taxes (excludes Federal Taxes)

 

Limited up to $100K annual salary or wages for each employee

The application to Pastoral housing allowances is presently unclear, so I suggest that this be included in payroll costs.

The lenders will likely include the organization’s current banker, as funding will be routed through the SBA. The term of the loan is two years (unless forgiven) and it has a .5% interest rate.

Maximum loan amount is limited to:

  • Total average monthly payroll costs for the preceding 12 months (April 2019 to March 2020) multiplied by 2.5 or
  • $10,000,000 if you are a new church plant church or organization, use average payroll costs for January and February 2020 multiplied by 2.5.

No loan payments are due under this program for 6 months. No loan fees apply. No collateral or personal guarantees will be required.

Good Faith Certificate

Applicant organizations will need to provide a Good Faith Certification at Application and after coverage period – post July 2020.

  • Organization needs the loan to support ongoing operations during COVID19.
  • Support ongoing operations
  • Funds used to retain workers and maintain payroll or make mortgage, lease, and utility payments.
  • Have not and will not receive another loan under this program.
  • Provide lender documentation verifying information of funds used
  • Everything is true and accurate.
  • Submit tax documents and that they are the same submitted to IRS. Legal counsel should be involved here.
  • Lender will share information with the SBA and its agents and representatives.

Loan Forgiveness

The entire loan amount loan can be forgiven, if the borrower qualifies. In general, the loan is forgivable if the borrower employed the same number of people during the loan period as it did last year.

  • Full-Time Equivalent Employee (FTE) (as defined in section 45R(d)(2) of 11 the Internal Revenue Code of 1986)
  • The goal of this loan is for your 2020 FTEs to be equal to or greater than your 2019 FTEs. Essentially, the law provides that you must have equal to or more employees from February. 15, 2020, to June 30, 2020, as you did last year from February 15, 2019, to June 30, 2019.
  • If you will have fewer employees in 2020 than in 2019, then you need to complete a calculation:

Average FTEs per month in 2020 from February 15, 2020-June 30, 2020 / (divided by)

Average monthly FTEs from February 15, 2019-June 30, 2019 or Average monthly FTEs from January 1, 2020 to February 29, 2020.

Limitations on Forgiveness

  • Only so much of the loan as is used for the payroll costs, benefits, mortgage, rent, or interest on other debt obligations can be forgiven.
  • Not more than 25% of the forgiven amount may be for non-payroll costs.
  • Loan forgiveness will be reduced if the borrower decreases its full-time employee headcount.
  • Loan forgiveness will also be reduced if the borrower decreases salaries by more than 25% for any employee that made less than $100,000 in 2019.
  • Borrower has until June 30, 2020 to restore its full-time employment and salary levels for any changes between Feb. 15 to April 26, 2020

No collateral or personal guarantees will be required.

This note is intended only as an illustration of general legal principles and is not legal or tax advice. The reader is directed to discuss his or her specific circumstances with a qualified practitioner before taking any action.

Connecticut Approves Recovery Bridge Loan Program as of March 25, 2020

Posted on by Liam Mennitt

The State of Connecticut will immediately roll out a no-interest loan program, “The Connecticut Recovery Bridge Loan Program,” with assistance of up to $75,000 over an 18-month period for small businesses effected by the COVID-19virus (Coronavirus) crisis. “This plan is a meaningful and flexible plan, stated by David Lehman, Gov. Ned Lamont’s economics chief. Funding for the plan will be derived from the banking system, primarily because it is faster and would infuse cash into the economy rapidly for businesses. “The banks have the network, the relationships, and the ability to deploy the money efficiently,” stated Mr. Lehman. The program will be broken down into rounds of financing, the first of which will infuse a total of $20 – $25 million to small businesses, enough to finance about 600 businesses with a quick cash infusion in the range of $40,000 per business. The CT Recovery Bridge Loan Program is similar to those launched around the United States in the wake of the COVID-19 crisis. Similarly, Massachusetts has launched a program that is comparable in size (Dollar amount) and targeting small businesses. As per a Department of Economic and Community Development survey, approximately 90% of CT businesses have taken a hit to revenue. However, 50% are still working near full capacity.

This Statewide plan will be implemented in addition to the existing Loan Forbearance program, which 800 existing borrowers in the Small Businesses Expense Program received a 3-month reprieves for payments (a benefit worth approximately $5 million). In addition, the plan will fall under the legislative authorization Small Business Express Program and financed with paybacks from prior loans, reducing the need for legislation to be passed for the program. The CT program is in addition to the Federal Stimulus and Bailout which includes $50 billion for small businesses administration backed loans, which would infuse an additional $4 billion into the Connecticut economy in direct Federal aid alone. Major concerns for the CT Recovery Bridge Loan Program are related to banks’ lending more money to small businesses with current debt obligations, especially because the COVID-19 crisis has killed vast consumer and business spending. The federal and state stimulus in addition to unlimited Federal Reserve buying of Treasury Securities will have the effect of filling banks’ balance sheets with low or no-cost capital. Known as quantitative easing, or QU this practice could potentially drive down Treasury interest rates, which will provide private investors, businesses, and consumers to look for deals to help revive the economy.

Pastore & Dailey Retained by One of World’s Largest Investment Management Firms

Posted on by Liam Mennitt

Pastore & Dailey has added one of the world’s largest research and investment management firms as a client. The client joins some of the largest broker dealers and insurance companies as clients of the Firm, where we represent them in many aspects of their businesses. In this case, the Firm is providing securities regulatory advice and cybersecurity advice.

Cryptocurrency in Capital Markets: From ICOs to STOs

Posted on by Liam Mennitt

In the wake of chronic price volatility and a series of enforcement actions against the chaotic and unregulated market for Initial Coin Offerings (ICOs), alternative financial instruments have recently been developed to help investors share in the precipitous growth of cryptocurrency and blockchain technology. At first, the ICO – an instrument that Investopedia.com defines as “the cryptocurrency space’s rough equivalent to an IPO in the mainstream investment world” – constituted the primary vehicle for investment in cryptocurrency.1 Under the terms of an average ICO, investors purchase an emergent cryptocurrency either with traditional currency or another, established cryptocurrency in the hopes that the emergent cryptocurrency will enter widespread usage and increase in value.2

Despite their seeming promise, many ICOs have faced regulatory headwinds and practical challenges from the start. In fact, several high-profile ICOs have been shut down because their issuers failed to comply with SEC securities regulations. In SEC v. Howey (1946), the Supreme Court set forth a canonical test for classifying financial products as securities, asserting that financial products should be regulated as securities when they constitute an “investment of money” as part of a “common enterprise” which entails “an expectation of profits [generated by a] promoter or third party.”3 Armed with this binding precedent, the SEC has classified cryptocurrencies as securities and has not shied away from clamping down on unregistered offerings. As recently as June 4th, 2019, the commission filed suit against the instant-messaging service Kik on the grounds that the company had “sold [cryptocurrency] tokens to U.S. investors without registering their offer and sale as required by[…]U.S. securities laws.”4 At issue in the Kik case was not just the company’s failure to register the offering with the SEC, but also the disconnect between cryptocurrency’s avowed purpose as a mode of exchange and its practical role as a store of value.5 That is to say, it becomes harder and harder to claim that cryptocurrencies are not securities when investors primarily acquire them in order to capitalize on price fluctuations.

Even though many ICOs have been registered after the fact to comport with securities regulations,6 they still constitute less than stable investment opportunities. According to a study conducted by Ernst and Young, “a lack of fundamental valuation and the due diligence process by potential investors is leading to extreme volatility of the initial coin offering (ICO) market,” trends which would presumably render them unacceptably risky choices for most investors.7

Faced with high levels of risk and the possibility of SEC enforcement, some investors are turning to Security Token Offerings (STOs) in order to acquire securitized cryptocurrency on capital markets. STOs typically offer securitized cryptocurrency “backed by real assets or things that have established value,” a characteristic that tends to immunize them against the price volatility of ICOs.8 STOs also have several key legal advantages over ICOs. Because the cryptocurrency offered is pegged to an identifiable group of revenue-generating assets, the issuers of the STO do not have to make the facile claim that their financial product is a mode of exchange and not merely a store of value. That is to say, as long as they are registered with the SEC and otherwise comply with securities regulations, STOs can be placed in essentially the same legal category as regular securities,5 a status which does not exempt them from federal oversight but can clear the way for the buying, selling, and trading of cryptocurrency on the open market. In this sense, STOs constitute safer, far less legally dubious vehicles for investors eager to take advantage of the cryptocurrency boom.

___________________________________________________________________________________

  1. https://www.investopedia.com/terms/i/initial-coin-offering-ico.asp
  2. Ibid.
  3. https://consumer.findlaw.com/securities-law/what-is-the-howey-test.html
  4. https://www.sec.gov/news/press-release/2019-87
  5. https://selfkey.org/stos-vs-icos-a-comprehensive-introduction-for-2018/
  6. https://www.clearyenforcementwatch.com/2019/02/sec-issues-first-ico-enforcement-action-against-a-self-reporting-token-issuer/#_ftn3
  7. https://www.ey.com/en_gl/news/2018/01/big-risks-in-ico-market–flawed-token-valuations–unclear-regulations-heightened-hacker-attention-and-congested-networks
  8. https://gomedici.com/2018-recap-move-over-icos-its-time-for-stos

New DECD Commissioner

Posted on by Liam Mennitt

Connecticut’s former head of the Department of Economic Community Development (DECD), Catherine Smith invested over a billion dollars in major projects and programs that aimed to jumpstart job creation and retention in the State of Connecticut. During her tenure, Smith credited the agency with making strides by supporting job growth in major industries including: advanced manufacturing and technology, and science, technology, engineering and mathematics (STEM) education.

Governor Ned Lamont has recently appointed former Goldman Sachs executive David Lehman as Commissioner of the DECD and the Governor’s Senior Economic Advisor. Lehman, a Greenwich native, most recently led Goldman Sachs’ public sector and infrastructure finance group. Lehman spent over 15 years with Goldman and brings valuable business and financial experience to state government. Gov. Lamont and Lehman look to lead an “aggressive” strategy to recruit businesses through state agency collaborations and managing long-term strategies, including implementing new “opportunity zones,” emphasizing long-term financial sustainability and success of the state and its residents.

Initial Coin Offerings: The New (Controversial) Way to Raise Capital

Posted on by Liam Mennitt

With Bitcoin exploding in market value to over $19,000 per coin at the close of 2017, investors are intrigued by the alluring concepts of cryptocurrency, blockchain, and the decision of whether to invest in startup companies utilizing cryptocurrency.[1] Recently, initial coin offerings (ICOs) have been the primary way for cryptocurrency startup companies to raise capital, and most notably, avoid the high costs associated with the traditional initial public offering (IPO). In 2017, over $4 billion was raised through the use of initial coin offerings, and that figure was forecasted to rise significantly.[2] This article will summarize what an initial coin offering is, why it is controversial, and what the near future may hold regarding regulation for this method of raising capital.

What is an Initial Coin Offering?

An initial coin offering is a means for cryptocurrency startup companies to raise capital through crowdfunding. There are two primary reasons to create an initial coin offering: first, to create a new kind of cryptocurrency (different from Bitcoin) that has its own blockchain, or, second, to fund a project that requires a new unique currency to be effective. Most ICOs involve the second type, known as token generation events (TGE). To begin the process of an ICO, the issuing company publishes a whitepaper detailing their company business model, projections, fundraising goals, what type of currency is accepted in the offering, company timelines, and other information to incentivize investors. Upon making the decision to participate in the ICO, investors use cryptocurrency (or fiat currencies like U.S. dollars (hereinafter, “cash”), in some cases) to purchase coins, or “tokens,” from the coin issuing company. Bitcoin is the most commonly used form of cryptocurrency by investors in ICOs. Tokens purchased by the investor do not necessarily represent shares of ownership in the company, but they are similar in varying respects. Technically, they reflect a percentage of the total amount of the initial cryptocurrency produced and can be redeemed or sold on secondary markets for cash value (or Bitcoin) once the issuing company meets its funding benchmarks and launches the venture.

In a nut shell, investors are simply being offered the opportunity to “get in on the ground floor” and purchase coins for a significantly lower price than the coin is projected to reach in the whitepaper. Should the company not meet its funding benchmarks, these tokens are supposed to be refunded for the principle price paid in the currency used by the investor. Ultimately, the decision to invest in an ICO depends on the investor’s prediction on whether the issuing company will successfully attain funding milestones to produce a viable cryptocurrency that will increase in value over time, or at least will be able to return all investments made by the investor should the benchmarks not be reached.

Ethereum is an example of a successful ICO that generated a substantial return on investment for those who participated.  Ethereum uses Ether as its cryptocurrency, which was issued in 2014 at $.40 per Ether, translating to roughly $18 million in Bitcoin at the time.[3] Ethereum’s project went live in 2015, and as of today the cryptocurrency trades at $873.72 per Ether, and is the second most successful cryptocurrency to date behind Bitcoin.[4] Returns like Ethereum make headlines across the nation, and are a focal point in driving investors to take a hard look into the “cryptocurrency bubble.”

Securities Regulation of ICOs

ICOs are quite similar to a traditional IPO, save for one major aspect: enforced regulation. On July 25th, the SEC issued its first sweeping statement (a “21(a) Report”) regarding the transfer and sale of digital currency like “tokens” sold in ICOs, declaring that the federal securities laws may apply to ICOs after its investigation into The DAO.[5]

The DAO was a decentralized autonomous organization (“dao”) that used distributed ledger or blockchain technology to operate as a virtual entity, and sold tokens representing interests in the company to investors in exchange for cryptocurrency. In the 21(a) Report, the SEC confirmed that cryptocurrency in the form of tokens or “coins” sold in ICOs can be a security, and that ICO issuers and  ICOs may be subject to federal securities regulation law.[6] How these laws will be applied and when further enforcement will go into effect are uncertain at this time, but the signs of SEC movement on the issues of cryptocurrency transactions are present.

At the Senate Committee on Banking, Housing, and Urban Affairs hearing on February 9, 2018, SEC Chairman Jay Clayton was quoted as saying, “You can call it a coin, but if it functions like a security, then it’s a security,” and, most notably, “A note for professionals in these markets: those that engage in semantic gymnastics … are squarely within the crosshairs of our Enforcement Division.”[7] In most types of ICOs listed today, if one were to apply the “Howey test” (from the landmark 1946 U.S. Supreme Court decision that helped clarify what defines an “investment contract,” which itself is part of the definition under the Securities Act of 1933 of a “security”), the tokens offered would most likely be interpreted by the SEC to be securities, in that they are “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”[8]

Clayton’s comments in February echo the sentiments of his statement  from December 11, 2017regarding cryptocurrency’s treatment under the Howey test and the 21(a) Report, in which he stated, “In the 21(a) Report, the Commission applied the longstanding securities law principles to demonstrate that a particular token constituted an investment contract and therefore was a security under our federal securities laws. Specifically, we concluded that the token offering represented 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.”

Recently, there has been a growing number of public statements from prominent figures regarding online market trading regulation, which indicates a possible regulatory turf war between the SEC and the CTFC. On March 7, 2018, the SEC published a statement detailing considerations both investors and market participants should assess regarding online market exchanges for ICO-based coins and tokens.[9] In addressing investor considerations, the SEC urged investors to utilize national exchanges, broker dealers, or other traditional platforms that are heavily regulated. Specifically, the SEC made it clear that even though many of these online trading markets call themselves “exchanges,” they are, in fact, not as heavily regulated at this present time the same way as traditional national exchanges. Regarding whether or not all online trading exchanges shall be subject to regulation, the SEC states:

“Some online trading platforms may not meet the definition of an exchange under the federal securities laws, but directly or indirectly offer trading or other services related to digital assets that are securities.  For example, some platforms offer digital wallet services (to hold or store digital assets) or transact in digital assets that are securities.  These and other services offered by platforms may trigger other registration requirements under the federal securities laws, including broker-dealer, transfer agent, or clearing agency registration, among other things.  In addition, a platform that offers digital assets that are securities may be participating in the unregistered offer and sale of securities if those securities are not registered or exempt from registration.” (Id.)

This statement suggests that certain circumstances and types of transactions occurring in the online market platforms will determine what kinds of regulation requirements will be enforced, but most importantly, that there will be forthcoming enforcement on a large scale.

The SEC’s statement was issued on the heels of an opinion from the District Court for the Eastern District of New York, which on March 6, 2018 held that the CTFC had standing to bring a lawsuit for fraud and to oversee cryptocurrency (including Bitcoin and the similar Litecoin, but not necessarily including ICO-based coins and tokens), for it is within the plain language definition of a “commodity.”[10] The CTFC initially determined in 2015 that cryptocurrency was a commodity, and this Federal District Court holding strengthens the CTFC’s claim to regulatory jurisdiction over cryptocurrency.

Both the SEC and the CTFC will issue regulations on cryptocurrency, and the turf war over this hot topic will ensue for the foreseeable future as the market for virtual currency continues to grow. On March 14, Congress held its first hearing on ICOs, where “House Financial Services Committee members asked questions about such topics as hacking, use of digital currencies by criminals, defining securities, and protecting investors.”[11] Also of note, the Governor of the Bank of England gave a statement in which he said, “The time has come to hold the crypto asset ecosystem to the same standards as the rest of the financial system. Being part of the financial system brings enormous privileges, but with them great responsibilities…In my view, holding crypto asset exchanges to the same rigorous standards as those that trade securities would address a major underlap in the regulatory approach.”[12]

This regulatory crackdown by the SEC and the CTFC comes as no surprise, as there are numerous market factors that triggered the initial SEC and CFTC investigations and that continue to command the regulators’ attention, including the explosion of token offering companies and investors participating in ICOs, the exponential increase in value of cryptocurrencies, and ICO scams that defraud investors.[13]

ICO Scams Defraud Investors

ICO scams are of particular concern to the SEC, as the underlying premise of the federal securities laws are to protect investors from being deceived, by mandating public companies to file numerous types of disclosures for investor transparency. These scams occur when news spreads that startup cryptocurrency companies forecasting massive growth are preparing to launch an ICO, which prompts scammers into setting up fake website domains and portals that deceive investors. The scammers will utilize social media sites like Facebook and Twitter to quickly capture non-sophisticated investors who are researching the ICO. Once the investor submits their cryptocurrency investment into the scammer’s system, any effort to try and reclaim that investment is futile as it recedes into the dark web.

Telegram is a current example of immense market backlash from scammers hijacking ICO market anticipation. Telegram is hosting a widely anticipated ICO beginning in March, but already has faced a prominent scam that stole millions of dollars worth of cryptocurrency from investors who thought they were buying into Telegram’s ICO. English and Russian versions of the actual whitepaper were leaked, and hosted by these scammer websites, of which Gramtoken.io was the most prominent. Gramtoken.io posted project road maps, copies of the whitepaper, and information regarding the ICO to trick investors into depositing their cryptocurrency into their system. Once Gramtoken.io reached its fundraising goal of $5 million dollars, the website went dark, and the investments through Gramtoken.io cannot be located.

The difficulty in protecting cryptocurrency investments is the driving force behind these scams and is a serious concern for investors. Cryptocurrency transactions are tremendously hard to track for several reasons. First, traditional financial institutions are not involved with cryptocurrency transactions, making traceability of the flow of currency unusual. Second, cryptocurrency transactions are happening on an international scale, which restricts what information the SEC, CFTC and/or other federal and state regulators can compile on the transactions, depending on where the issuing entity is located. Third, there is no central authority or market for cryptocurrency transactions and collection of user information at this time. Finally, law enforcement has no current ability to freeze any cryptocurrency transactions, as cryptocurrency is encrypted and cannot be held by a third-party custodian like a traditional security. Together, these factors significantly impede federal, state and private legal actions and remedies for investors in cryptocurrency transactions.

Celebrity ICO Endorsements and Differing Perspectives

On February 27th, Microsoft founder Bill Gates was asked for his opinion on cryptocurrency during a question and answer session on the popular website Reddit, and responded with, “The main feature of cryptocurrencies is their anonymity. I don’t think this is a good thing. The government’s ability to find money laundering and tax evasion and terrorist funding is a good thing. Right now, cryptocurrencies are used for buying fentanyl and other drugs, so it is a rare technology that has caused deaths in a fairly direct way. I think the speculative wave around ICOs and cryptocurrencies is super risky for those who go long.”[14] Other high-profile individuals have made public statements that appeared to be endorsing specific ICOs, especially pop culture celebrities. Floyd Mayweather, DJ Khaled, Paris Hilton, Jaime Foxx, and other celebrities have made public social media endorsements of a variety of ICOs.[15] These endorsements are problematic and could potentially lead to violations of securities law regarding proper disclosures and solicitations of investors if these celebrities are interpreted to be promoters of the ICO.

Conclusion

Initial coin offerings have become the most prevalent way for cryptocurrency companies to raise capital. With the advent of cryptocurrency (including ICO-based coins and tokens) taking markets by storm, it appears they are here to stay for the foreseeable future as well. The SEC’s statements are clear that securities regulation law will be applied to coins and tokens arising out of ICOs, but numerous investor rights issues regarding traceability, jurisdiction, and lack of central authority over all cryptocurrency render enforcement challenging. While ICOs in their current form are a hot ticket item for now, a massive legal and regulatory overhaul for United States cryptocurrency transactions is undoubtedly in the works.

 

[1] Coindesk, Bitcoin (USD) Price (last visited Feb. 26, 2018) https://www.coindesk.com/price/

[2] Forbes, ICOs In 2017: From Two Geeks And A Whitepaper To Professional Fundraising Machines (Dec.18, 2017) https://www.forbes.com/sites/outofasia/2017/12/18/icos-in-2017-from-two-geeks-and-a-whitepaper-to-professional-fundraising-machines/#40e99c4e139e

[3] Investopedia, Breaking Down Initial Coin Offerings (ICO) (Feb 26, 2018) https://www.investopedia.com/terms/i/initial-coin-offering-ico.asp

[4] EthereumPrice, Ethereum (USD) Price, (last visited Feb 26, 2018) https://ethereumprice.org/

[5] Divisions of Corporation Finance and Enforcement, Statement by the Divisions of Corporation Finance and Enforcement on the Report of Investigation on The DAO (July 25, 2017) https://www.sec.gov/news/public-statement/corpfin-enforcement-statement-report-investigation-dao

[6] Id.

[7] Joseph Young, SEC Hints at Tighter Regulation for ICOs, Smart Policies for “True Cryptocurrencies”(Feb. 9, 2018) https://cointelegraph.com/news/sec-hints-at-tighter-regulation-for-icos-smart-policies-for-true-cryptocurrencies

[8] “In other words, an investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.” S.E.C. v. W.J. Howey Co., 328 U.S. 293, 66 S. Ct. 1100, 1104, 90 L. Ed. 1244 (1946)

[9] Divisions of Enforcement and Trading and Markets, Statement on Potentially Unlawful Online Platforms (Mar. 7, 2018) https://www.sec.gov/news/public-statement/enforcement-tm-statement-potentially-unlawful-online-platforms-trading

[10] Brenden Pierson, Virtual currencies are commodities, U.S. judge rules, THOMPSON REUTERS (Mar. 6, 2018) https://www.reuters.com/article/us-usa-cftc-bitcoin/virtual-currencies-are-commodities-u-s-judge-rules-idUSKCN1GI32C

[11] Kia Kokalitcheva, Congress holds first hearing on initial coin offerings, AXIOS (Mar. 14, 2018) https://www.axios.com/crypto-ico-congress-1521059028-8807c852-22de-461a-8c9e-8a8a9f85d452.html

[12] John D’Antona Jr., BoE Push for Cryptocurrency Regulation Can Boost Markets, TRADERS (Mar. 14, 2018) http://www.tradersmagazine.com/news/cryptocurrencies/boe-push-for-cryptocurrency-regulation-can-boost-markets-117387-1.html?ET=tradersmagazine:e3646:1189431a:&st=email

[13] Jon Russell, Scammers are cashing in on Telegram’s upcoming ICO, TECHCRUNCH (Jan. 20, 2018) https://techcrunch.com/2018/01/20/telegram-ico-scammers/

[14] Reddit, I’m Bill Gates, Co-chair of the Bill and Melinda Gates Foundation. Ask Me Anything (Feb. 28, 2018) https://www.reddit.com/r/IAmA/comments/80ow6w/im_bill_gates_cochair_of_the_bill_melinda_gates/

[15] Jonathan Burr, The Bubble in Celebrity Cryptocurrency Endorsements, CBS NEWS (Nov. 6, 2017) https://www.cbsnews.com/news/bitcoin-celebrity-endorsements-cryptocurrency-sec-warning/

Pastore & Dailey Represented Mortgage Services Company in Financing Transaction

Posted on by Liam Mennitt

Pastore & Dailey represented a mortgage servicing company in a financing transaction designed to allow the company to service a multinational bank.   The transaction required expert and careful drafting and negotiation as it involved affiliates as well.   Goodwin Proctor’s San Francisco office represented the lender.

 

Suspension of Trading for Hong Kong Blockchain Firm

Posted on by Liam Mennitt

Last week, on January 8, 2018, the Securities and Exchange Commission (“SEC”) suspended trading of UBI Blockchain Internet, Ltd. (“UBI”) stock until January 22, 2018.[1] UBI, formerly JA Energy, is a Hong Kong-based technology firm focusing on the Blockchain technology underlying cryptocurrency.[2] Coincidently, one of the focuses of this over-the-counter traded company is on the application of the distributed ledger technology to trace food and drug products from the producer to the consumer.[3] According to UBI’s legal counsel, the motivation behind this innovation is to prevent counterfeit products.[4]

The erratic behavior of UBI shares caught the eyes of the SEC in early December as the company’s stock sky-rocketed in price. On December 1, 2017, shares of UBI were trading at $6.12, and just eighteen days later, the value had swiftly rose to $83.00 per share, and even selling as high as $115.00 per share.[5] The subsequent decline in value was just as precipitous. Within a week of its peak, the value of UBI stock had fallen to $29.00 per share and further down to $22.00 per share before the close of the 2017 year. The freeze on trading allows the SEC an opportunity to investigate the causes of the sudden and drastic changes in the firm’s stock activity.

The SEC is tasked with closely monitoring the trading activity of publicly traded companies. Spikes in value and in the volume of trades within the market, like those seen here with UBI, raise red flags for the SEC to act upon. Pursuant to Section 12(k) of the Securities Exchange Act of 1934, the SEC may temporarily suspend the trading in particular securities pending an investigation.[6] In the case of UBI, the commission cited two distinct justifications for its suspension: concerns with (1) the accuracy of assertions dating back to September 2017 regarding the company’s business operations; and (2) the unusual and unexplained market activity in the company’s Class A common stock since November 2017.[7] It remains to be seen whether the cause of the fluctuation was caused by SEC violations or by a frenzy as the market responded to UBI’s pharmaceutical application of the Blockchain technology.

_____________________________________________________________________________________________________________

[1] U.S. Securities and Exchange Commission, Securities Exchange Act od 1934: Release No. 82452,  https://www.sec.gov/litigation/suspensions/2018/34-82452.pdf (last visited January 14, 2018, 3:05 PM).

[2] Matt Robinson, Crypto Stock That Surged 900% in 2017 is Hit With SEC Halt, Bloomberg (Jan. 8, 2018, 10:39 AM), https://www.bloomberg.com/news/articles/2018-01-08/crypto-stock-that-surged-900-percent-in-2017-gets-sec-suspension.

[3] Cory Johnson, How One Mysterious Startup is Riding the Bitcoin Wave, Bloomberg (Dec. 27, 2017, 12:17 PM), https://www.bloomberg.com/news/articles/2017-12-27/bedwetting-to-blockchain-how-one-startup-rode-the-bitcoin-craze.

[4] Id.

[5] UBI Blockchain Internet Ltd., Marketwatch, https://www.marketwatch.com/investing/stock/ubia/charts (last visited January 14, 2018, 3:07 PM).

[6] See supra note 1.

[7] See supra note 1.

SEC Issues Report on the Application of Federal Securities Laws to Crowdfunding Through Cryptocurrency

Posted on by Liam Mennitt

On July 25, 2017, the Securities and Exchange Commission issued a Report following their investigation of The DAO.  The DAO is an unincorporated organization that is just one example of a “Decentralized Autonomous Organization” –  a virtual organization embodied in computer code and executed on a distributed ledger or blockchain.

The DAO was formed in 2015 as unique form of crowdfunding whereby participants would vote on proposals and be entitled to rewards.  Between April and May of 2016, The DAO offered and sold approximately 1.15 billion DAO Tokens in exchange for approximately 12 million Ether.  Ether is a form of virtual currency.  These DAO Tokens gave the holder certain voting and ownership rights.

Token holders could vote on predetermined proposals deciding where The DAO invested its money, with each token holder’s vote weighted according to how many DAO Tokens he or she held.  On June 17th, 2016, an unknown individual or group attacked The DAO and appropriated approximately 1/3 of the total funds.  Although the funds were eventually recovered by The DAO, the SEC began investigating the attack and The DAO.  Ultimately, the SEC determined that an Enforcement Action was not necessary, however it issued a report laying out how the Securities Act and the Securities Exchange Act applies to The DAO and similar entities.

Section 5 of the Securities Act prohibits entities not registered with the SEC from engaging in the offer or sale of securities in interstate commerce.  Upon investigation of the circumstances surrounding The DAO, the SEC stated that The DAO qualifies as an “issuer” and thus must register as such with the SEC in order to sell DAO Tokens – which the SEC considers to be securities – in compliance with federal securities laws.  Given the SEC’s flexible interpretation and application of the Act, this Report is a caution to virtual entities that the federal securities laws are applicable and that the SEC intends to pursue enforcement of these laws in the field of virtual currencies and securities.