This past week saw important developments in the cryptocurrency space with two new regulatory actions, and a significant and much-anticipated decision in a criminal securities fraud action relating to an initial coin offering.

Specifically, in In the Matter of TokenLot, LLC, et al., Admin. Proc. No. 3-18739 (Sept. 11, 2018) and In the Matter of Crypto Asset Management, LP and Timothy Enneking, Admin. Proc. No. 3-18740 (Sept. 11, 2018), the SEC announced settlements with two digital securities companies it alleges were operating as unregistered broker-dealers.  In United States v. Zaslavskiy, No. 17-CR-0647, ECF No. 37 (E.D.N.Y. Sept. 11, 2018), Judge Raymond J. Dearie denied defendant’s motion to dismiss the Indictment, and agreed with the DOJ that the initial coin offerings (“ICO”) conducted by defendant’s companies could constitute investment contracts within the purview of federal securities law.

U.S. v. Zaslavskiy

In U.S. v. Zaslavskiy, the Government charged Maksim Zaslavskiy with conspiracy to commit securities fraud and two counts of securities fraud.  The charges relate to two ICOs conducted by Zaslavskiy’s companies, REcoin and Diamond.  According to the Indictment, REcoin and Diamond offered investors the chance to purchase “blockchain virtual currency” or “cryptocurrency” that was backed by real estate investments or diamond investments, respectively.  The Government alleged that, in reality, REcoin and Diamond issued no digital assets, tokens, or coins, and did not actually invest in any real estate or diamonds.  As described by Judge Dearie:  “Stripped of the 21st century jargon … the challenged Indictment charges a straightforward scam, replete with the common characteristics of many financial frauds.”

In his motion to dismiss, Zaslavskiy challenged (1) whether federal securities law applied to “cryptocurrencies,” (2) whether the specific offerings of REcoin and Diamond were securities offerings, and (3) whether the application of federal securities laws to cryptocurrencies renders the securities laws void for vagueness.  The Court dismissed all of these challenges.

First, the Court refused to apply a broad exemption under federal securities laws for all so-called cryptocurrencies and digital coins and tokens.  While “currencies” are excluded from federal securities law under the Exchange Act and the Securities Act, the Court found that merely referring to a product or an asset as a “cryptocurrency” was clearly not sufficient to exclude it from any and all federal securities regulations.  Instead, the Court focused on the “content of the instruments in question, the purposes intended to be served, and the factual setting as a whole.”  Order at 8 (quoting Marine Bank v. Weaver, 455 U.S. 551, 560 n.11 (1982)).  Notably, the Court did not address the broader issue of whether true cryptocurrencies, such as Bitcoin, would be exempt from federal securities laws.

Second, turning to the specific facts in Zaslavskiy’s case, the Court held that the tokens, coins, and cryptocurrencies offered by REcoin and Diamond could constitute securities in terms of their content, purposes, and the “factual setting as a whole,” reasoning that they are similar to the investment contracts that the Supreme Court held in SEC v. Howey, 328 U.S. 293 (1946), to fall within the purview of federal securities law.  According to Howey, a financial transaction is an “investment contract” if “a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or third party.”  In this case, investors paid to invest in REcoin and Diamond’s ICOs and were promised high returns from pooling their investments in diamonds and real estate, which were to be selected and managed by Zaslavksiy and “an experienced team of brokers, lawyers, and developers.”  Order at 3.  The Court found that a reasonable fact-finder could determine that these were indeed investment contracts, and therefore denied this aspect of defendant’s motion.

Finally, the Court held that the application of federal securities laws to cryptocurrencies does not render those laws unconstitutionally vague.  Void for vagueness challenges involve a “two-part test:  [a court] must first determine whether the statute gives the person of ordinary intelligence a reasonable opportunity to know what is prohibited and then consider whether the law provides explicit standards for those who apply it.”  Farrell v. Burke. 449 F.3d 470, 486, 495 (2d Cir. 2006) (internal quotation marks and citations omitted).  In rejecting the defense argument, the Court cited well-settled precedent in which courts emphasize that federal securities laws are meant to be interpreted flexibly, and extensive case law post-Howey regarding the definition of “investment contract.”  As Judge Dearie stated, the conduct charged “falls within the core of the statute’s prohibition,” and found Zaslavskiy’s void for vagueness arguments “plainly insufficient to bypass regulatory and criminal enforcement of the securities laws.”  Order at 21.

SEC Enforcement Actions: In the Matter of TokenLot, LLC, et al. and In the Matter of Crypto Asset Management, LP and Timothy Enneking

First, in In the Matter of TokenLot, LLC et al., the SEC charged TokenLot LLC and its principals, Lenny Kugel and Eli L. Lewitt, with operating as unregistered broker-dealers.  TokenLot operated a website which marketed and sold digital tokens to investors in connection with ICOs and secondary market trading, even though TokenLot, Kugel, and Lewitt were not registered as broker-dealers.  The SEC’s Order assumes that TokenLot’s activities in marketing and selling ICOs and facilitating secondary trading of digital tokens falls within the purview of federal securities laws.  The tokens, also known as coins, offered by TokenLot and other similar platforms are issued by virtual organizations that are executed on a distributed ledger or blockchain and are used by the companies to fund development of the digital product.  Holders of tokens or coins can then use them in the digital product or sell them for profit.

TokenLot and its owners settled the charges against them without admitting or denying the SEC’s findings, and agreed to pay $568,929 in combined disgorgement, prejudgment interest, and penalties.

Second, in In the Matter of Crypto Asset Management, LP and Timothy Enneking, the SEC alleged that Crypto Asset Management, LP (“CAM”) and its principal, Timothy Enneking, operated as an unregistered investment company and made material misstatements in violation of federal securities law.  According to the SEC’s order, CAM operated a pooled investment vehicle that invested in digital assets.  Although the SEC did not specify what type of digital assets were involved, it asserted that they constituted “investment securities” under the Investment Company Act and “securities” under the Securities Act.  Further, CAM allegedly marketed itself as the “first regulated crypto asset fund in the United States,” despite not having filed a registration statement with the SEC.

According to the SEC, CAM violated the Securities Act by making material misstatements to investors when offering and selling digital assets.  CAM and Enneking entered into the order without admitting or denying any of the findings and agreed to pay $200,000 in penalties.

The recent SEC enforcement actions underscore prosecutors’ and regulators’ increasing focus on the burgeoning cryptocurrency space, and Judge Dearie’s decision in Zaslavskiy is a significant victory for prosecutors in a widely anticipated decision.  Though clearly limited to its facts, the decision will certainly serve as a powerful precedent to the SEC and DOJ in future litigation regarding the application of securities law to the cryptocurrency space.