SEC Continues to Carve Out Regulatory Framework for Cryptocurrencies
Mary Donohue
Associate Editor
Loyola University Chicago School of Law, JD 2020
On September 11, 2018, the Securities and Exchange Commission (SEC) announced two enforcement actions relating to failures to register by market intermediaries in connection with digital asset activities. Despite earlier suggestions that the Commodity Futures Trading Commission (CFTC) might be the primary self-regulatory organization (SRO) regulating this market, the main takeaway from these cases is that market intermediaries dealing in digital assets may also have registration and customer protection liabilities, and the failure to observe them can result in serious penalties.
Enforcement Actions Reflect Commitment to Cooperation and Market Integrity
Both actions released early last month highlight the priority the SEC has placed on cooperation during investigations. Further the actions illustrate the SEC’s commitment to market integrity and protecting customers with digital asset markets.
The first enforcement action involved TokenLot, an unregistered broker-dealer, and its founders Lenny Kugel and Eli L. Lewitt. Kugel and Lewitt operated TokenLot from July 2017 to February 2018. TokenLot advertised and sold securities in the form of digital tokens to retail investors using their website platform. Through the online platform, dubbed an “ICO Superstore,” they received thousands of customer orders for digital tokens, processed investment funds, and handled more than 200 digital tokens in connection with external initial coin offerings (ICOs) and TokenLot’s secondary market activities. ICOs are a fundraising mechanism in which a new project sells their underlying crypto tokens in exchange for bitcoins and ether. ICO sales are similar to an Initial Public Offering (IPO) in which investors purchase shares of a company. In the SEC findings, the SEC emphasized that TokenLot continued to operate after the SEC had issued a Section 21(a) report concluding that tokens were securities and cautioning market participants that many ICO tokens might be considered securities, thus mandating registration with the SEC.
Both the SEC and the CFTC have enforcement division cooperation programs, where benefits are provided to individuals and companies who come forward and provide valuable information to SEC investors. Through an analytical framework, the SEC evaluates whether, how much, and in what manner to credit the cooperation by individuals and companies in its investigation and enforcement actions. TokenLot cooperated throughout the investigation by voluntarily shutting down purchase orders, selling digital tokens on behalf of ICO issuers, and winding down the TokenLot business; this lead the SEC to impose smaller penalties. As a result of their cooperation, TokenLot agreed to pay disgorgement of $471,000 and a prejudgment interest of $7,929 to the SEC for transfer to the general fund of the United States Treasury and were required to retain an independent third party to destroy their remaining inventory of digital assets. The SEC has suggested that cooperation efforts, as in this case, might alleviate damages and penalties in some cases. The second case dealing with Crypto Asset Management, LP (CAM) demonstrates the importance of complying with registration requirements of the Investment Company and Securities Act when trading cryptocurrencies.
The second enforcement action dealt with CAM, a managing member of a manager to Crypto Asset Fund, LLC. CAM had never been registered with the SEC, yet had approximately $37 million in assets under management. Timothy Enneking is the founder and sole principal of CAM and holds 99% of its interests. CAM was founded in March of 2017 for the purpose of investing in digital assets. This case marked the SEC’s first-ever finding of an investment company registration violation by a hedge fund. CAM falsely claimed in its offering material that the fund/offering was registered and regulated by the SEC, leading to a fine of $200,000 for several violations of the Securities Act, Advisers Act, and Investment Company Act.
Both of these cases reflect the reality that market intermediaries dealing in this digital space are still subject to the same registration and customer protection liabilities. The failure to observe the liabilities may lead to fines and cease and desist orders. In reflecting on the significance of the penalties with TokenLot, Steve Peikin, Co-Director of the SEC’s Enforcement Division explains, “TokenLot, Kugel, and Lewitt provided valuable information to Commission staff, stopped the conduct, and refunded money to investors.” The penalties and Mr. Peikin’s statement highlight the importance that the SEC has placed upon cooperation efforts in helping to alleviate some of the burden on the enforcement division in fact-finding, in addition to the possibility of lower fines. Additionally, the penalties that CAM was ordered to pay were largely due to a failure to register as an investment company or registering a security with the Commission. Paired with recent enforcement actions from the CFTC, companies interested in entering the cryptocurrency market will certainly have to consider these registration enforcement matters when beginning operations.
However, the SEC, has reflected a desire to work with broker-dealers and investors to ensure compliance with these acts and help avoid enforcement actions. Speaking to the cases, Stephanie Avakian, Co-Director of the SEC’s Enforcement Division said, “ [the SEC] continues to encourage those developing digital asset trading businesses to contact the SEC staff… for assistance in analyzing registration and other securities law requirements.” This statement suggests a willingness on the SEC’s end to work with investors and broker-dealers to ensure compliance and registration requirements are met.
Despite the CFTC’s determined jurisdiction in handling cases relating to digital assets, this string of enforcement actions and the SEC’s statements on them reflect the SEC’s commitment to ensuring market integrity and consumer protection.