Tag: Christopher Kelly

Pastore’s Managing Partner Leads Discussion with Congressman Jim Himes

Posted on by Kelly Somers

On September 23, the Connecticut Crypto Forum (the “Forum”) held an event at the University of Connecticut at Stamford. The Forum connects large and sophisticated capital pools with leading players and thinkers across the crypto, defi and Web 3.0 markets to strengthen investor knowledge, understanding and skill. Pastore LLC is proudly a Founder and Sponsor of the Connecticut Crypto Forum. The Forum’s September 23 event was an invite-only session.

In the first half of the event, a panel of speakers discussed the current maturity of the crypto and blockchain markets.  The panel addressed the current challenges facing the evolving asset class and concluded that crypto/blockchain assets are still “metaphorically” in their teenage years. The asset class still is characterized by volatility. Moreover, the panelists noted the time of hyper valuation of projects in the industry is over. What follows now is a time of acquisitions. Many companies and projects will likely fail, but the ones with worthwhile technology that lack sufficient cashflows to continue operation will likely be consolidated within larger players and ultimately be poised to make the industry more efficient. However, the panelists agreed that the industry’s best days are ahead of it.

During the second half of the event, Pastore LLC’s Managing Partner, Christopher Kelly, led a discussion with Congressman Jim Himes, an emerging leader in the crypto/blockchain industry on Capitol Hill. Congressman Himes noted the significant attention that crypto and blockchain assets have received in Congress. He noted that he is working with other members of Congress on legislation concerning the industry.

When a member of the crowd asked what should businesses do considering the lack of legal and regulatory clarity surrounding crypto assets, Mr. Kelly gave a poignant response: Don’t be afraid, be transparent and work with counsel to navigate the murky regulatory waters. Pastore, as a thought leader in the field, is positioned to help businesses and individuals plan a path forward despite the uncertainty.

 

Pastore Sponsors Connecticut Crypto Forum

Posted on by Kelly Somers

The Connecticut Crypto Forum has recently been created to advance education and knowledge in this new asset class. The forum will connect large and sophisticated capital pools with leading players and thinkers across the crypto, delfi, and Web 3.0 market to strengthen investor knowledge, understanding, and skill. The mission of the forum is to build a diverse, sophisticated, Connecticut-based community interested in crypto from many angles.

On May 13, 2022, the Connecticut Crypto Forum will be conducting an invite-only session for those interested in the forum to partake in. Pastore LLC is proudly a founder and sponsor of the Connecticut Crypto Forum.

Learn more about Pastore’s Crypto practice

 

 

 

Pastore LLC, as Co-Counsel with Skadden, Effectuates $1 Billion Purchase

Posted on by Luke Daigle

Pastore LLC, as Co-Counsel with Skadden, Arps, Meagher & Flom LLP, is representing GPB Capital Holdings LLC in its $1+ billion sale of its automotive assets. Providing World Class Corporate Governance Advice, GPB and Skadden Arps tapped Pastore LLC to address a multitude of corporate governance issues to ensure that the dozens of GPB automotive entities were authorized to enter into the transaction. Working long nights and weekends, Pastore LLC was led by Managing Partner Christopher Kelly, a former Skadden Attorney, and a team of associates.

With Vinson & Elkins L.L.P as legal advisor to Group 1 Automotive, the transaction was signed the morning of September 13, 2021.  The signing encompasses the agreement of Group 1 Automotive to purchase substantially all the automotive assets of GPB. GPB’s automotive portfolio generated $1.8 billion in annual revenues in 2020 while retailing over 52,000 new and used vehicles. This acquisition by Group 1 Automotive will provide the acquirer with 30 additional dealership locations and three collision centers, coupled with GPB’s extensive portfolio of luxury and non-luxury vehicles.

Media coverage of this transaction has included Yahoo Finance, WSJ, PR Newswire and Seeking Alpha, among others.

Pastore Advises Clients on Accredited Investors

Posted on by Liam Mennitt

Recently, Pastore & Dailey advised clients on a unique issue related to accredited investors.  The client, an SEC registered investment advisor, asked Pastore & Dailey whether the death of an accredited investor had any legal implications for the funds it manages when the accredited investor bequeathed his investment to a non-accredited investor.  The simple answer is no.

Under the securities laws, the term “sale” is defined as to include every contract of sale or disposition of a security or interest in a security, for value. Additionally, the term “offer to sell”, “offer for sale”, or “offer” is defined to include every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value.  15 U.S.C. § 77b(a)(3).

Thus, an involuntary transfer by operation of law, such as a divestment of an investment upon death to beneficiaries will not be considered a “sale” or an “offer to sell.”  Therefore, the recipient is not required to be an accredited investor.

Special Rule for Family Offices

Pastore & Dailey also advised the client on the legal implications of this unique circumstance when the accredited investor is a family office.

An accredited investor now includes any family office as defined in Rule 202(a)(11)(G)-1 under the Investment Advisers Act of 1940 (“Advisers Act”): (i) with assets under management in excess of $5,000,000, (ii) that is not formed for the specific purpose of acquiring the securities offered, and (iii) whose prospective investment is directed by a person who has such knowledge and experience in financial and business matters that such family office is capable of evaluating the merits and risks of the prospective investment.  17 C.F.R. § 230.51(a)(12).

The accredited investor definition was also expanded to include a family client, as defined in Rule 202(a)(11)(G)-1 under the Advisers Act.  A family client as defined in Rule 202(a)(11)(G)-1 is: (i) Any family member; (ii) Any former family member; or (vi) Any estate of a family member, former family member or key employee.  17 C.F.R. § 275.202(a)(11)(G)-1(d)(4).

In the Adoption Release, the SEC explained that it is not excluding from the accredited investor definition a beneficiary that temporarily qualifies as a family client under the family office rule.  Thus, a beneficiary who receives the stocks from the decedent will be considered a family client for purposes of the accredited investor definition for exactly one year.  SEC Release No. 33-10824, August 26, 2020.

There are limitations to this rule.  Although a beneficiary would not be required to unwind any of the securities received in an involuntary transfer, the beneficiary would not be considered an accredited investor in connection with the purchase of additional securities, unless the beneficiary qualified as an accredited investor on another basis.[1]

In conclusion, the requirement that an offering or sale of restricted securities be made to an accredited investor applies at the “time of sale of the securities to that person.” Thus, an involuntary transfer such as a divestment of shares to a beneficiary upon death of the accredited investor should not pose a problem for a testator and their funds.

Summary

As the requirement that an offering or sale of restricted securities be made to an accredited investor applies at the “time of sale of the securities to that person,” a involuntary transfer, such as a divestment of shares to a beneficiary upon death of the accredited investor should not pose a problem for an RIA and its funds.

__________________________________________________________________________________________

[1] SEC Expands the “Accredited Investor” and “QIB” Definitions and the Permitted Scope of “Testing the Waters.” Proskauer. September 9, 2020. https://www.proskauer.com/alert/sec-expands-the-accredited-investor-and-qib-definitions-and-the-permitted-scope-of-testing-the-waters#_ftnref3

SPACs Have Grown Up

Posted on by Liam Mennitt

In 2010, only $500 million of the IPO market was generated through special-purpose acquisition company (“SPAC”). SPACs have evolved from being an ignored strategy in reaching the public markets to becoming an attractive method to take a company public, pursue merger opportunities, and to create liquidity for existing shareholders.

As of October 16, 2020, there have been 143 SPAC IPO transactions in 2020. According to Dealogic, SPAC IPOs have raised $53 billion this year. SPACs have raised more money in 2020 than in the last ten years combined. Melissa Karsh & Crystal Tse, SPACs Have Raised More in 2020 Than the Last 10 Years Combined, Bloomberg (Sept. 24, 2020), https://www.bloomberg.com/news/articles/2020-09-24/spacs-have-raised-more-in-2020-than-the-last-10-years-combined.

Historically, Pastore & Dailey LLC has worked on SPAC offerings, litigation, and regulatory proceedings. SPACs have become popular in comparison to a traditional IPO because SPACs are cost-efficient and less time-consuming, and they face fewer amounts of due diligence and disclosure requirements than a traditional IPO. In the past, SPACs were generally used by small companies, but now small, mid-size, and large companies are using SPACs to become a public company and raise capital. While historically SPACs had a connotation of a back door method of taking a less than pristine company public, this is no longer the case.

A SPAC is a publicly traded company that raises capital with the intention of using that capital to acquire a private company. Through the acquisition, the SPAC takes the private company public. Many well-known companies have entered the public markets through a SPAC IPO, such as: DraftKings; Virgin Galactic; Nikola; and Opendoor, a real estate technology company.

Until a SPAC acquires a private company, the SPAC is just a company that holds cash. The cash is generally held in an escrow account until the SPAC acquires a private company. SPACs typically have a deadline of two years to acquire a private company. Andrew Ross Sorkin et al., SPACs Are Just Getting Started, N.Y. Times (Sept. 16, 2020), https://www.nytimes.com/2020/08/25/business/dealbook/spac-ipo-boom.html. If the SPAC does not acquire a private company in the two-year deadline, the SPAC is required to return the cash to its shareholders.

While SPACs are gaining a lot of momentum, they have historically had less success then traditional IPOs. From the start of 2015 through July 2020, 223 SPAC IPOs had been conducted; but 89 of the 223 SPACs have managed to take a company public. Ciara Linnane, 2020 Is the Year of the SPAC – Yet Traditional IPOs Offer Better Returns, Report Finds, MarketWatch (Sept. 16, 2020), https://www.marketwatch.com/story/2020-is-the-year-of-the-spac-yet-traditional-ipos-offer-better-returns-report-finds-2020-09-04. Just 26 of those 89 companies that went public through a SPAC acquisition generated positive returns, and the shares of those companies had an average loss of 18.8%.

This current year, however, has proved to be a different story. SPACs in 2020 have generated a rate of return of 35%, significantly higher than the S&P 500’s year-to-date return of approximately 6%. Many of the large banks are starting to work on SPACs, as Goldman Sachs, Morgan Stanley, Citigroup, Credit Suisse, and Deutsche Bank have all conducted underwriting for SPAC IPOs. Richard Henderson et al., The Spac Race: Wall St Banks Jostle to Get In On Hot New Trend, Financial Times (Aug. 11, 2020), https://www.ft.com/content/1681c57d-e64d-4f58-b099-8885e85a708e.

Over the past ten years, the IPO market has significantly diversified. Direct listings gained a lot of momentum, and now SPACs are adding another strategic option in the IPO market.

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.

Pastore & Dailey Advises Clients on the Complexities of Family Offices

Posted on by Liam Mennitt

Recently Pastore & Dailey advised clients on complex questions regarding family offices and the compensation of non-family member “key employees” of such offices. Pastore & Dailey referenced the Investment Advisers Act of 1940, Dodd-Frank, and other securities act provisions to help the clients maneuver the complex structure of a family office and how to properly compensate non-family member employees pursuant to these provisions so as to not lose the family office exemption.

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.

Pastore & Dailey Is Pleased to Welcome Allison “Alex” Frisbee and Christopher Kelly as Counsel to the Firm

Posted on by Liam Mennitt

Pastore & Dailey is pleased to welcome Allison “Alex” Frisbee and Christopher Kelly as Counsel to the Firm.

These additions build the Firm’s corporate investigations capabilities and further strengthened Pastore & Dailey’s  securities regulatory and corporate transactional practices.   Alex and Chris join an exceptionally talented and experienced group of attorneys in the securities and corporate practices, with experience at the SEC, NYSE, state attorney generals, AM Law 200 firms and  large wall street firms.

Alex Frisbee – At K&L Gates LLP in its Washington, DC office, Alex worked on corporate investigations, securities enforcement and white collar matters (including complex internal investigations), and represented clients before the SEC, FINRA and other regulatory bodies.  Prior to K&L Gates, Alex worked at the New York Stock Exchange in its Division of Enforcement (subsequently part of FINRA) and in the NYSE’s Office of General Counsel.  Alex has vast experience in securities regulatory matters working both as an investigator and attorney at the NYSE.   At KL Gates, she has drafted Wells Submissions, white papers, letters and other advocacy pieces to regulators on behalf of public and private companies, broker-dealers, investment companies, investment advisers, corporate officers, directors, and individuals. Alex is a graduate of Washington and Lee University School of Law and Davidson College.

Christopher Kelly – Chris has practiced corporate, securities, transactional, fund and banking law for over 30 years at the most sophisticated levels.  He has worked on a wide variety of complex transactions aggregating in value over $10 billion.  He has handled multi-billion-dollar mergers & acquisitions, asset deals, stock purchase and sale transactions, and public and private stock and debt offerings.  His securities offerings have included common stock, preferred stock, trust preferred, mortgage-backed securities, other asset-backed securities, medium-term notes and debentures.   Chris has extensive experience with fund formation (on-shore and off-shore), compliance and regulatory matters for hedge funds, private equity funds, banks, and other financial institutions, including compliance programs, compliance training, compliance testing, compliance manuals, AML/KYC, surveillance, valuations, business continuity plans, advertising and sales and trading.  He has served as general counsel and chief compliance officer of investment advisers and of a broker-dealer. Chris began his practice in New York with Skadden, Arps, Slate, Meagher & Flom.  He then served as a Partner at Silver, Freedman & Taff, a leading corporate/securities boutique representing banks and other financial institutions, before joining Proskauer Rose LLP as a Partner in its New York office.  He left Proskauer to pursue various entrepreneurial opportunities, and to now serve as Of Counsel to Pastore & Dailey LLC.  Chris is a graduate of the University of Virginia School of Law and graduated with High Honors from the University of Virginia prior to attending law school there.

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/