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The search for cryptocurrency enlightenment is winding through Brooklyn, where a pair of federal judges with a combined 83 years on the bench could provide the clearest rules yet for entrepreneurs using digital coins.
Senior judges Raymond Dearie and Jack Weinstein of the U.S. District Court for the Eastern District of New York are presiding over the most significant cases to date in the emerging world of virtual currency. What they’ve already said and what they ultimately decide could give the crypto community a more authoritative guide to the laws that apply to it, helping clear up confusion that persists among its members.
Federal regulators are starting to lay out their thinking about whether digital assets are securities, commodities, a hybrid of the two, or something else entirely, while at least one member of Congress is working on a bill to provide more clarity.
It is judges, however, who likely will define the early legal contours of the crypto world, lawyers in the space told Bloomberg Law. The Securities and Exchange Commission, Commodity Futures Trading Commission, Justice Department, and aggrieved investors have already filed more than two dozen crypto-related cases in federal courts nationwide, according to Bloomberg Law’s ICO Developments Tracker. The tool focuses on initial coin offerings, which businesses use to raise money by selling digital tokens they create.
“Where we’ve gotten clarity” on other securities matters such as insider trading “has been in the courts,” Marjorie Peerce, co-managing partner of Ballard Spahr LLP’s New York office, told Bloomberg Law.
Dearie and Weinstein are looking to a 1946 Supreme Court decision for guidance about whether cryptocurrencies should be treated as securities.
Under the Supreme Court’s Howey test, to qualify as an investment contract a scheme must involve “an investment of money in a common enterprise with profits to come solely from the efforts of others.”
Courts are “in a new world here,” Dearie said in a May 8 preliminary proceeding in a criminal ICO securities fraud case. “Back in Howey days we were not talking digital currencies.”
Cryptocurrencies can have “characteristics of both currency and investment,” he added. A South Florida magistrate judge offered a glimpse at what resolving that characteristic uncertainty might look like in a June 25 temporary restraining order. To get the order, there had to be a likelihood of success on the merits; to be a likelihood of success on the merits, ICO coins have to be securities. Her Howey analysis—which the district judge hasn’t yet signed off on—found that an ICO meant to fund a cryptocurrency debit card was a securities offering.
“Investments of money” don’t have to involve actual cash, so coin purchasers made investments even if they used other virtual currencies to do so, she said. Because the purchasers had no control over the coins’ value, they were engaged in a common enterprise with the people behind the ICO. Finally, because the crypto debit card’s success was dependent on the efforts of the company making it, the purchasers expected to profit solely from the ICO company’s efforts.None of the federal court cases involving cryptocurrency and securities have been resolved yet. The litigation includes matters involving the SEC and the CFTC, which has asserted jurisdiction over Bitcoin and similar virtual currencies that the SEC doesn’t consider to be securities.
“Until Congress clarifies the matter,” the commissions have “concurrent authority, along with other state and federal administrative agencies, and civil and criminal courts, over dealings in virtual currency,” Weinstein affirmed in a March preliminary injunction order in one case.
Congress has yet to provide that clarification. But Rep. Warren Davidson (R-Ohio) has said he’s concerned a “disparate set of court opinions might not be as coherent as we would like or, frankly, the SEC would like, consumers would like, and in particular, investors would like,” so he’s working on a bill to provide coherence.
The fastest-moving cases in the courts right now—a criminal securities fraud case and a civil commodities fraud case—weren’t brought by the SEC or investors.
The Justice Department last fall charged Maksim Zaslavskiy with securities fraud after he allegedly sought investments in two ICOs, one purportedly backed by real estate and the other by diamonds. He raised more than $300,000, but REcoin Group Foundation LLC and Diamond Reserve Club didn’t actually own any real estate or diamonds, according to the October 2017 complaint to Dearie’s court.
Zaslavskiy in February moved to dismiss the charges against him on the grounds that cryptocurrencies weren’t securities, so even if he’d acted fraudulently, he couldn’t have committed securities fraud.
The DOJ and the SEC—which brought a civil fraud suit against Zaslavskiy in September 2017—didn’t see it that way. Because Zaslavskiy’s ICO sought investments in a common scheme and promised purchasers a return on their investment, each of his ICOs was “a prototypical investment contract” and falls within the definition of a security set out by the Howey test, the DOJ said. Dearie hasn’t ruled on Zaslavskiy’s motion to dismiss, and the case is set for a January 2019 trial.
Dearie, who is also presiding over the SEC’s civil suit against Zaslavskiy, has heard 11 securities cases since 2007, according to Bloomberg Law Litigation Analytics. Three of his securities decision have been appealed, and of those, two were affirmed. Overall, Dearie has been affirmed in 84.6 percent of cases.
Zaslavskiy’s alleged fraud “is not a hard case,” Peter Van Valkenburgh, the research director at Coin Center, told Bloomberg Law. Coin Center is a Washington-based research and advocacy nonprofit specializing in cryptocurrency and blockchain technology.
Zaslavskiy sold tokens to investors who “really relied on nothing but the seller’s good word for the token’s value,” Van Valkenburgh said.
“Those cases where you have real technology and real decentralization are hard cases,” Van Valkenburgh said. “So far I haven’t seen any of those cases brought. I’m not sure how they’d turn out.”
The CFTC brought a commodities fraud case against Patrick K. McDonnell, who has used the nickname “the Coyote of Wall Street,” in January. McDonnell allegedly solicited bitcoin and other cryptocurrencies from investors, promising to then invest those funds on their behalf, according to the CFTC’s complaint in the U.S. District Court for the Eastern District of New York. He’s said he actually just charged investors fees in exchange for cryptocurrency trading advice, although the CFTC contends he never dispensed the advice, either.
McDonnell, who, like Zaslavskiy, is representing himself, moved to dismiss the complaint. Weinstein denied the motion and instead granted a preliminary injunction in the CFTC’s favor, ruling for the first time that the agency has “concurrent authority” with other agencies to regulate cryptocurrencies.
The SEC has filed about a half-dozen ICO-related cases since September 2017, according to Bloomberg Law’s ICO Developments Tracker. The litigation followed a first-of-its-kind SEC investigative report on ICOs in July 2017. The report concluded that digital tokens issued as part of an ICO could be securities.
SEC Chairman Jay Clayton and other agency officials have since sent repeated warnings to firms launching and advising ICOs that the fundraising tools might involve the offering and selling of securities, requiring them to follow securities law. But most recently in June, William Hinman, director of the commission’s Division of Corporation Finance, provided some of the agency’s thinking on when a digital asset isn’t a security, saying cryptocurrency Ether isn’t subject to securities laws.
The agency has “discussed in detail” how federal laws define securities, Clayton said in written testimony prepared for a congressional hearing in June.
“We have been clear—we are not relaxing our requirements that apply to the offer, sale and trading of securities,” Clayton said.
As the SEC’s interest grew, so did that of the plaintiffs’ bar.
The recent wave of ICO class action litigation began in November 2017, according to Bloomberg Law’s ICO Developments Tracker. Investors filed more than a dozen securities class actions involving cryptocurrency in federal courts through the end of May. Many involve the same defendant. For the most part, the suits allege that the ICOs sold them unregistered securities in violation of federal law, and often acted fraudulently in doing so.
David Silver, a Florida-based partner at Silver Miller, a plaintiffs firm that was among the first to explore using securities laws to obtain relief for ICO investors, said the current spate of suits is part of “a testing phase, but eventually everything’s going to come around.”
To contact the editor responsible for this story: Seth Stern at email@example.com
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