Last Friday, November 16, the U.S. Securities and Exchange Commission Division of Corporation Finance, Division of Investment Management, and Division of Trading and Markets issued a “Statement on Digital Asset Securities Issuance and Trading.” The purpose was to note that, while the SEC encourages technological innovation, market participants must still adhere to the Commission’s well-established and well-functioning federal securities law framework when dealing with technological innovations, regardless of whether the securities are issued in certificated form or using new technologies, such as blockchain. The SEC discussed four main areas.
1. Offers and Sales of Digital Asset Securities. The Commission highlighted that it had brought a number of actions involving offerings of digital asset securities, principally focused on two important questions. First, when is a digital asset a “security” for purposes of the federal securities laws? Second, if a digital asset is a security, what Commission registration requirements apply? It noted its most recent actions, against AirFox and Paragon in connection with their unregistered offerings of tokens. Both companies agreed to pay penalties but also undertook to register the tokens as securities under Section 12(g) of the Securities Exchange Act of 1934 (“Exchange Act “) and to file periodic reports with the Commission. These two matters demonstrate that there is a path to compliance with the federal securities laws going forward, even where issuers have conducted an illegal unregistered offering of digital asset securities.
2. Investment Vehicles Investing in Digital Asset Securities. The Investment Company Act of 1940 (“Investment Company Act”) establishes a registration and regulatory framework for pooled vehicles that invest in securities. This framework applies to a pooled investment vehicle, and its service providers, even when the securities in which it invests are digital asset securities. Investment vehicles that hold digital asset securities and those who advise others about investing in digital asset securities, including managers of investment vehicles, must be mindful of registration, regulatory and fiduciary obligations under the Investment Company Act and the Advisers Act.
3. Trading of Digital Asset Securities – Exchange Registration. A platform that offers trading in digital asset securities and operates as an “exchange” (as defined by the federal securities laws) must register with the Commission as a national securities exchange or be exempt from registration. This was underscored by the Commission’s recent enforcement action against the founder of EtherDelta, a platform facilitating trading digital assets securities. Any entity that provides a marketplace for bringing together buyers and sellers of securities, regardless of the applied technology, must determine whether its activities meet the definition of an exchange under the federal securities laws.
Exchange Act Rule 3b-16 provides a functional test to assess whether an entity meets the definition of an exchange under Section 3(a)(1) of the Exchange Act. The activity that actually occurs between the buyers and sellers—and not the kind of technology or the terminology used by the entity operating or promoting the system—determines whether the system operates as a marketplace and meets the criteria of an exchange under Rule 3b-16(a).
The exchange analysis includes an assessment of the totality of activities and technology used to bring together orders of multiple buyers and sellers for securities using “established non-discretionary methods” under which such orders interact. A system “brings together orders of buyer and sellers” if, for example, it displays, or otherwise represents, trading interest entered on a system to users or if the system receives users’ orders centrally for future processing and execution.
Entities using blockchain or distributed ledger technology for trading digital assets are advised to carefully review their activities on an ongoing basis to determine whether the digital assets they are trading are securities and whether their activities or services cause them to satisfy the definition of an exchange
4. Trading of Digital Asset Securities – Broker-Dealer Registration. An entity that facilitates the issuance of digital asset securities in ICOs and secondary trading in digital asset securities may also be acting as a “broker” or “dealer” that is required to register with the Commission and become a member of a self-regulatory organization, typically FINRA. Section 15(a) of the Exchange Act provides that, absent an exception or exemption, it is unlawful for any broker or dealer to induce or attempt to induce the purchase or sale, of any security unless such broker or dealer is registered in accordance with Section 15(b) of the Exchange Act. Section 3(a)(4) of the Exchange Act generally defines a “broker” to mean any person engaged in the business of effecting transactions in securities for the account of others. As with the “exchange” determination, a functional approach (taking into account the relevant facts and circumstances) is applied to assess whether an entity meets the definition of a broker or dealer, regardless of how an entity may characterize either itself or the particular activities or technology used to provide the services.
