“Guidance by Enforcement”: How the SEC Is Slowly Shaping ICO Regulation

On November 27, 2018, a California judge turned back the SEC’s request for an injunction against token company BlockVest, a company the U.S. Securities and Exchange Commission (SEC) is pursuing for allegedly conducting an unregistered securities offering. The judge, however, ruled that BlockVest’s token distribution, which was conducted via airdrop, was given freely and received without expectation for returns, so it didn’t constitute an investment contract.

While the judge’s ruling is not a law-binding verdict, it was still a victory for BlockVest and the wider ICO industry, something that’s been a rarity for the SEC’s mounting list of token sale targets.

Among other regulatory developments, 2018 has been one extended game of cat and mouse between the U.S. Securities and Exchange Commission and any number of initial coin offerings (ICO) that have sprung up in the investing exuberance of 2017’s bull market. And the SEC has been catching its fair share of mice.

Back in last year’s unprecedented boom, which saw the crypto market’s assets increase threefold, many ICOs attempted to evade the SEC’s scrutiny by self-labeling their products as utility tokens. If they could prove their tokens were built to serve a function rather than exist as an investment vehicle, then they could avoid a securities classification and continue their sale without registering with the SEC.

The SEC, though, didn’t buy the distinction.

So far this year, the SEC has come out hard against a handful of ICOs, broker dealers, funds and even an exchange, slapping them with fines for acting as unregistered entities. As though a symbolic culmination of its enforcement actions this year, the SEC’s most recent and damning charge was leveraged against EtherDelta, one of the space’s most popular decentralized exchanges that houses many Ethereum tokens whose ICOs the SEC views as securities offerings.

A New Phase of Enforcement

In correspondence with Bitcoin Magazine, Jake Chervinsky, an associate at Kobre & Kim law firm, explained that he believes the SEC established a baseline of enforcement in 2018, one that sets a precedent for how the agency views the burgeoning ecosystem of token offerings.  

“I think ‘phase one’ saw the SEC establish its fundamental views on the legality of common issues in the crypto industry by prosecuting a small number of companies and individuals from various industry segments, including ICO issuers, exchanges, broker-dealers, and token funds. The SEC’s goal was to put everyone on notice that their conduct may be illegal — for example, it’s clear that the SEC views all ICOs conducted in the United States as unregistered securities issuances in violation of the 1933 Act.”

Chervinsky originally posited his theory on the SEC’s enforcement phases in a Twitter thread this November. In the thread, he suggested that 2019 will see phase two; in our conversation, he explained that the SEC is operating under the unspoken expectation that token projects will have to work with the agency to operate legally, as 2018’s enforcement examples have done all the talking for them.

“In ‘phase two,’ the SEC expects everyone in the industry to come forward voluntarily and work with the SEC to make sure they’re in compliance with the securities laws. As SEC Chairman Jay Clayton said to crypto companies during Consensus: Invest 2018: ‘Get your act together!’”  

For those that fail to acquiesce, Chervinsky anticipates that they could be made examples of still.

“The SEC will likely prosecute companies that refuse to comply voluntarily. In the end, the SEC’s goal will be to bring the entire industry into compliance with the securities laws, even if that means dozens or hundreds of different companies.”

Basically, the SEC’s rationale is that token companies have no excuse not to register with the agency. They should operate under the assumption that they’ll be treated like a security, unless they can prove otherwise. But the onus is on the company to show why they don’t fit the mold, and simply calling their offering a utility token doesn’t cut it.

Moreover, these token companies have a library of enforcements and charges to consult when in doubt over their securities status. Chervinsky calls this “guidance by enforcement,” an old dog’s trick that the SEC has used in the past. For this new industry, Chervinsky believes that the SEC went after the easiest targets to set firm examples at the outset.

“They chose the ones that they did simply because they were the easiest for the SEC to resolve quickly and efficiently, and the factual allegations in these public cases made for useful guidance for the rest of the industry.”

These examples set a loose standard for token projects going into 2019 “for other crypto industry stakeholders to negotiate their own settlements,” Chervinsky holds. But he cautioned that “these orders are not binding precedent.”

Indeed, in his Twitter thread, Chervinsky elaborates that, for the SEC, the more nebulous the guidance the better. If the SEC plays it loose, then they get to set the rules on their own terms and exercise enforcement at their discretion. Most of these cases, he explains, are settled privately, and the SEC would rather avoid open litigation, as a few court rulings could lead to legal precedents that would lock the SEC’s jurisdiction in rigid, codified confines.

As Enforcement Ramps Up, Guidance Plays Catch Up

Still, Chervinsky expects “that the SEC will provide additional guidance as time goes on, likely through FinHub and ‘crypto czar’ Valerie Szczepanik” — though he’s also certain that the SEC shouldn’t have to hold the guiding torch of regulation alone. The U.S.’s legislature, he says, needs to do its own part to effect the proper legislative changes that would allow regulations, and by proxy, the entities they regulate, to operate more organically within a more mature system.

“I think Congress can — and eventually will need to — do more to clarify how the federal securities laws apply to digital assets. The foundation of the securities laws dates back to the 1930s, long before anyone could have imagined the concept of a digital asset issued via the internet through the use of blockchain technology. This old legal framework simply wasn’t designed for the digital age, and as a result, it doesn’t provide the regulatory clarity that the crypto industry needs to move forward.”

So far, there have been very few benchmarks for moving regulation forward: the Howey Test, a metric to measure whether or not an asset is a security as defined by the Securities Act of 1933; the DAO Report, a report released by the SEC after the DAO hack in 2016; prior enforcement actions; and, most recently, the SEC’s Statement on Digital Asset Securities Issuance and Trading (something that Chervinsky said “reads like a comprehensive primer on the types of securities violations that the SEC wants to resolve in the industry”).

Much like the outdated Securities Act, Chervinsky finds that these various references for guidance are not robust enough to substantiate actual regulation and satisfy the industry’s need for clarity. And even though he thinks Congress should be bringing more to the table than it has already, the SEC should also be doing more to help the industry.

“The SEC can and should do a lot more than regulate by enforcement. The SEC could issue informal guidance explaining its position on the many outstanding questions facing the crypto industry, such as when a token transforms from a security to a non-security, or how a company can conduct an ICO outside U.S. borders without implicating the SEC’s jurisdiction. The SEC could also pursue official rulemaking to formalize its positions on digital assets. This would result in enforceable rules — like Regulation D for private placements or Regulation S for offshore securities issuances — that the crypto industry could rely on moving forward.”

He added:

“… Similarly the securities laws are unclear as to whether the SEC has jurisdiction over cryptocurrency exchanges and initial coin offerings located physically outside U.S. borders. Given that the SEC doesn’t appear likely to provide any additional clarity on these issues, the burden may fall to Congress to step in and take action.”

Heading Into a New Year, the Industry Has More Questions Than Answers

Other legal experts agree with Chervinsky that the SEC, in a way, has left investors hanging with its sluggish regulatory action that is punctuated with hard-hitting regulatory charges. Some have even said that the new Statement on Digital Asset Securities Issuance and Trading lays a minefield for the digital asset industry and those launching companies to curate it.

Less a minefield and more a labyrinth, Chervinsky believes that some of the SEC’s other guidance, like the clarification that ether, while sold as a security, has decentralized to the point of not being one, could construct a maze of confusion over what counts as fully decentralized — and how a token company is supposed to get there in the first place.

Chervinsky notes that “in July, the SEC suggested that a digital asset could start life as a security and then evolve into a non-security once it becomes ‘sufficiently decentralized,’ but the law doesn’t contemplate such a transformation.”

Even so, with its prosecution of ICOs, broker dealers, funds and now an exchange in EtherDelta, Chervinsky believes that the SEC has “made an example of at least one target in each of the key segments of the crypto industry.”

The only piece missing, he believes, are the traders — those who engage in “acts of market manipulation, including pump and dump schemes, wash trading, spoofing, and outright fraud.” He believes the SEC hasn’t gone after these actors because of insufficient market data but that they’ll be in the agency’s crosshairs soon enough. (If you read this and your heart skipped a beat, don’t worry; he’s talking about traders who actively commit market manipulation and fraud, not everyday, Dick and Jane traders).

With all the pieces in place, Chervinsky expects 2019 to be somewhat of an open season for the SEC for those who decide to shirk their regulatory responsibilities. But that doesn’t mean that every shot will be a killshot. With each successive enforcement, more questions will be opened and more avenues of interpretation traversed.

In Chervinsky’s opinion, resolution on these fronts will be a slow, painful march marked by a combination of legal battles and molasses-paced legislative drafting.

“The crypto industry won’t have a firm standard for what conduct is allowed and what’s illegal until Congress passes new legislation or the SEC’s theories are tested in court.”

Some of these standards are in the making, as the recent court action in California surrounding BlockVest suggests. As for the rest, the industry will have to hunker down and withstand the brunt of what’s become a slow, blow-after-blow exchange with an evolving regulatory landscape. But, so long as it can take note of where the bruising has set in, these blows should become less damaging (and less frequent) over time.