Last week, a senior official of the Securities and Exchange Commission said that Bitcoin and Ether are not securities and that there might be circumstances when a utility token is also not a security. The same official and the Canadian Securities Administrators each provided lists of specific considerations to help evaluate the nature of a digital token. Separately, CME Group brought a host of disciplinary actions, including one against a Commodity Futures Trading Commission-registered introducing broker for its handling of block trades, and it also modified a summary access denial order issued a few weeks ago against a foreign broker. As a result, the following matters are covered in this week’s edition of Bridging the Week: 

• Anything but Sleep Inducing: SEC Corporate Finance Director Says Ether Not a Security and Canada Issues Guidance on Utility Tokens (includes My View and Legal Weeds);
• Introducing Broker Fined by NYMEX for Not Reporting Block Trade Times Accurately (includes Compliance Weeds); and more.

Video Version:

Briefly:

Anything But Sleep Inducing: SEC Corporate Finance Director Says Ether Not a Security and Canada Issues Guidance on Utility Tokens

Last week, William Hinman, the Director of the Division of Corporate Finance of the Securities and Exchange Commission, said that the cryptoasset Ether is not a security. It may have once been a security, but not today. As a result, transactions involving Ether are not securities transactions. 

Moreover, in a speech before the Yahoo Finance All Markets Summit in San Francisco, Mr. Hinman additionally indicated that he could envision that certain utility tokens might also not be securities. He said that such a conclusion might be appropriate “where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created.”

Typically, the term “utility token” references a digital token that has express functionality authorizing a holder to access or purchase assets based on a specific blockchain technology.

According to Mr. Hinman, when promoters raise money to build networks on which digital assets will operate and investors purchase such tokens with the expectation of selling their tokens in the secondary market, an investment contract likely exists – which is a type of security under applicable law – requiring registration for the digital token to be issued and sold to the public, or a valid exemption. In these cases, investors are passive, marketing is not ordinarily targeted solely to token users, and the likelihood of success of the underlying system is uncertain. In such cases, said Mr. Hinman, “[t]he purchaser usually has no choice but to rely on the efforts of the promoter to build the network and make the enterprise a success.” These characteristics, intimated Mr. Hinman, satisfy the tests of the Supreme Court’s 1946 SEC v. Howey decision, and make the cryptoasset a security.

According to the Supreme Court, an investment contract constitutes (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived solely from the entrepreneurial or managerial efforts of others.(Click here for a discussion of the Howey tests in the article “SEC Declines to Prosecute Issuer of Digital Tokens That It Deems Securities Not Issued in Accordance with US Securities Laws” in the July 26, 2017 edition of Between Bridges. Click here to access the Howey decision.)

However, a token that might have been a security at one point in time may cease being a security over time, said Mr. Hinman. This could happen when “the network on which the token or coin is to function is sufficiently decentralized – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts.” According to Mr. Hinman this is what happened to Ether which initially was distributed through fundraising and now has a “decentralized structure.”

In evaluating whether a digital token is likely a security, Mr. Hinman set forth 13 considerations, including:

• Is there a single person or small group that is behind the sale of the digital asset and who play a “significant role” in the development and maintenance of the token and its potential increase in worth?
• Does this person or group have a stake or other interest in the digital token and are they incentivized to cause an increase in value of the digital asset? Do purchasers anticipate such an effort and increase in value?
• Do the customer protection provisions of applicable law make sense, including disclosure obligations of a person or entity that plays a key role in the system?
• Do persons or entities other than the promoters exercise governance rights?
• Is token creation tied to the needs of users or for speculation?
• Is the token marketed and distributed to the general public?
• Is the system underlying the token fully functioning or in the early stages of development?

The Canadian Securities Administrators also issued guidance regarding when digital tokens are subject to securities laws and not utility tokens. CSA’s analysis generally followed Mr. Hinman’s analytic approach. According to CSA, “[i]n analyzing whether an offering of tokens involves an investment contract, businesses and professional advisors should assess not only the technical characteristics of the token itself, but the economic realities of the offering as a whole, with a focus on substance over form.”

Unlike Mr. Hinman who solely proposed considerations to evaluate, CSA provided 14 fact patterns derived from actual episodes it has considered, and provided its conclusions as to whether the relevant digital token had characteristics of a security or not.

In one example where the number of tokens was limited and the expectation that access to new tokens in the future would also be limited, CSA concluded that “initial purchasers may have an expectation of profit as increased demand with limited or reduced supply should lead to an increase in price.” This would suggest the digital token is a security.

Contrariwise, CSA concluded that where digital tokens have a fixed value that does not “automatically” increase over time or change “based on non-commercial factors,” there is likely a lesser expectation of profit by a digital holder. This would seem to suggest the cryptoasset is more likely not a security.

In his presentation, Mr. Hinman also reconfirmed that Bitcoin is not a security.

My View: Mr. Hinman’s detailed analysis of digital tokens and recognition that the characteristics of a digital token (such as Ether) may change over time – likely resulting in a different legal categorization – were overdue but very much welcomed. Moreover, his and CSA’s articulation of specific considerations in evaluating tokens is very helpful. (Click here to access other possible considerations in the PowerPoint download to the webinar “Beyond Bitcoin” by Katten Muchin Rosenman LLP and hosted by FIA on May 17, 2018.) However, at the fringes, it still is unclear when market appreciation might be considered derived from a promoter’s hype as opposed to investor sentiment. It is still troubling to me that, applying the SEC's broad view of Howey, smart kids who purchased and held, as collectibles, Beanie Babies promoted by Ty Inc. years ago, and later eagerly resold the Beanies Babies on eBay for a profit, potentially could have been considered to have been transacting in securities.

Ripple will be the next challenging digital asset for the SEC to provide its views on. Because of its powerful central governance, ongoing offering, and restricted consensus protocol, the SEC could very well see it more like a security than not. However, like Ether, Ripple is going through an evolution to become more decentralized, and XRP – the Ripple digital token – is designed and operates more like a payment mechanism than anything else. The large number of XRP outstanding also makes it more likely that the digital token will not appreciate markedly, although the promoters’ decision last year to make available no more than one billion XRP tokens monthly may augment its appeal as a speculative play. This is a digital asset on the cusp, but it still appears more likely not a security to me.

The issue of whether Ripple is a security is front and center in a purported class action lawsuit filed in a California state court last month, as well as a more recent case filed on June 5. (Click here for background regarding the first legal action in the article, “Class Action Lawsuit Filed Against Ripple Labs for Unregistered Sales of Securities” in the May 6, 2018 edition of Bridging the Week. Click here for a copy of the complaint in the second action.)

Legal Weeds: There is no unanimity among countries as to when digital tokens may be securities. The government of Gibraltar, for example, issued a proposal for the regulation of digital token sales, secondary digital token market platforms, and investment services relating to non-security and non-virtual currency digital tokens during March 2018, that expressed a narrow view of what constitutes a security token. According to Gibraltar Finance, most digital tokens are not securities because they are not structured as such – meaning they afford no equity interest or right to distributions (e.g., of profits or in the event of a firm’s insolvency). They more often represent “the advance sale of products that entitle holders to access future networks or consume financial services” – and thus represent “commercial products,” or have the characteristics of virtual currencies. (Click here for further information regarding Gibraltar’s views in the article “Gibraltar Suggests Many ICO-Issued Digital Tokens Are Commercial Products, Not Securities” in the March 18, 2018 edition of Bridging the Week.)

This is very different from the view of the SEC which claims that the expectation of profit can be derived by the anticipation of capital appreciation through secondary trading of the relevant digital asset.

In February 2018, the Swiss Financial Market Supervisory Authority (FINMA) provided its insight into the nature of different types of digital tokens – which it termed “payment tokens (e.g., virtual currencies),” “utility tokens” and “asset tokens (e.g., securities tokens).” FINMA defined utility tokens as tokens “intended to provide access digitally to an application or service by means of a blockchain-based infrastructure.” The regulator indicated it would not consider utility tokens as securities if the tokens’ “sole purpose” was to confer digital access rights at the time of issue. However, if a utility token could additionally or only have an investment purpose at the time of issue, it would be treated as an asset token too. (Click here for further background in the article “SEC Sues Bitcoin-Denominated Trading Platform for Operating an Unlicensed Securities Exchange; Principal Criminally Charge” in the February 25, 2018 edition of Bridging the Week.)

Introducing Broker Fined by NYMEX for Not Reporting Block Trade Times Accurately

A second futures exchange has fined EOX Holdings, LLC, within a few months of its first citation in connection with its handling of block trades and for failing to supervise its employees and agents related to such handling. According to a “Notice of Disciplinary Action” by the New York Mercantile Exchange, from March 1 through May 23, 2o17, EOX, a Commodity Futures Trading Commission-registered introducing broker, misreported the execution times of various block trades, and failed to have procedures to review block trades before and after they were submitted to the exchange for accuracy. Pursuant to an offer of settlement which was accepted by a NYMEX business conduct committee, EOX agreed to pay a fine of US $75,000 to resolve the exchange’s allegations. In December 2017, EOX agreed to pay a fine of US $442,500 to resolve charges brought by ICE Futures U.S. that, from August 2013 through July 2014, it may have also failed to adequately supervise two of its employees in connection with their execution of block trades and handling of nonpublic customer information. (Click here for details in the article “ICE Futures U.S. Charges Introducing Broker and Employees With Impermissibly Disclosing Customer Order Information and Executing Block Trades Contrary to Requirements” in the December 10, 2017 edition of Bridging the Week.)

Separately, the Chicago Mercantile Exchange modified its prior summary access denial order against Hana Financial Investment. The exchange had banned the South Korean-based brokerage firm from all trading on CME Group exchanges for 60 days except for liquidating orders because of its alleged incomplete cooperation with several investigations from May 2017 through the present. CME also claimed that the firm may have “improperly and inaccurately” netted positions among independently owned and controlled accounts within omnibus accounts at several CME Group clearing members, causing the clearing members to inaccurately report long and short positions and impacting open interest reporting. This episode appears to have prompted the Joint Audit Committee two weeks ago to issue guidance to all futures commission merchants regarding their handling of omnibus accounts. (Click here for information regarding the fallout from the Hana episode in the article “Futures Joint Audit Committee Advises on Margin Calculations and Payments for Omnibus Accounts” in the June 10, 2018 edition of Bridging the Week.)

Under the revised order, Hana may trade for its proprietary accounts.

Unrelatedly, JPMorgan Chase Bank, N.A. agreed to pay a fine of US $125,000 to NYMEX for violating position limits on three trade dates in May 2017. Apparently, a systems mapping issue caused the firm not to account for the violative positions in its monitoring system.

Additionally, Shingo Yamamoto, a trader for Fuji Futures Co. Ltd., was accused by NYMEX and the Commodity Exchange, Inc. of entering and cancelling orders on the Globex electronic trading system during the pre-opening period solely to assess depth of the order book. NYMEX charged Mr. Yamamoto with disruptive trading in connection with such transactions, and Fuji Futures with failure to supervise. To resolve these charges, Mr. Yamamoto agreed to pay a fine of US $25,000 combined to both exchanges and serve a 20-business-day all CME Group exchanges’ trading suspension, while Fuji Futures agreed to pay a penalty of US $45,000. Similarly, Peter Howard was suspended from accessing all CME Group exchanges for 50 business days for allegedly engaging in similar disruptive pre-opening activity on NYMEX on multiple occasions from October 2015 through February 2016, while Jared Kuehner agreed to pay a fine of US $40,000 and was denied access to all CME Group exchanges for 10 business days for purportedly engaging in disruptive trading during the pre-opening on various occasions from January through July 2016.

Alphabit Trading, LLC and Weihao Huang were fined US $25,000 by CME and Comex, respectively, for engaging in spoofing-type activity. Mr. Weihao was also suspended from CME Group all exchange trading for 20 business days.

Compliance Weeds: CME Group and ICE Futures U.S. have made clear that entering and cancelling orders during the pre-opening period to assess market depth or manipulate the indicative opening price constitutes prohibited disruptive trading under CME Group Rule 575A (click here to access) and IFUS Rule 402(l) (click here to access), respectively. According to CME Group, a specific example of such prohibited activity is as follows:

During the pre-opening period on CME Globex, a market participant enters an order priced through the IOP (a bid higher than the existing best bid or an offer lower than the existing best offer) for the purpose of identifying hidden liquidity (e.g., resting stop and iceberg orders). The market participant then cancels that initial order and enters a new order based on the information obtained.

(Click here for additional background in the relevant CME Group MRAN (Q/A 20) and here for the relevant IFUS FAQS (Q/A 15).)

More Briefly:

• CFTC Soon to Report That Recent Big Futures Price Movements Not Tied to High-Frequency Trading: J. Christopher Giancarlo, Chairman of the Commodity Futures Trading Commission, indicated that the Market Intelligence Branch of the Commission’s Division of Market Oversight would soon be issuing a report concluding that the largest price movements in 16 different futures contracts from 2012 through 2017 appeared attributable to longer-time increased market volatility and by the direct revelation of information and news events and not by the activities of proprietary trading groups or high-frequency traders. Moreover, the study will provide quantitative evidence that, despite perception, “there is no clear indication of a wide-spread increase in the frequency or intensity of sharp price movements in recent years.” Mr. Giancarlo made his observations in a speech before the Women in Derivatives Forum in Washington, DC.
   
• Broker-Dealer Agrees to Pay Back Customers US $10.5 Million and Remit Fine of US $5.2 Million for Not Supervising Salespersons Who Purportedly Misled Customers Regarding Mortgage-Backed Securities Prices: Merrill Lynch, Pierce, Fenner & Smith Inc. agreed to pay a fine in excess of US $5.2 million and reimburse customers in excess of US $10.5 million to resolve charges brought by the Securities and Exchange Commission that it failed to supervise its traders and salespersons in connection with their sales of residential mortgage-backed securities to clients. According to the SEC, Merrill Lynch’s alleged violations, which occurred from June 2009 through December 2012, were attributable to having policies and procedures to monitor communications for false and misleading statements but not implementing them specifically to monitor for RMBS transactions, and having policies and procedures dealing with excessive markups, but not meaningfully reviewing RMBS transactions to check for them. The SEC charged that, during the relevant time, Merrill Lynch made false and misleading statements regarding RMBS transactions to customers and/or charged customers excessive, undisclosed markups.
   
• Not Deterred by Adverse California Ruling, CFTC Files Anti-Fraud Lawsuits Against Two Alleged Leveraged Metals Dealers in Florida: The Commodity Futures Trading Commission brought two separate enforcement actions in Florida federal courts against purported precious metals dealers, charging they misappropriated retail customer funds and committed fraud. One action named Mark Olsen Mining Company and Betty Lee Grimes, while the other named Omega Knight 2, LLC, Aviv Michael, its owner and president, and Erez Hen. The CFTC brought these actions relying on its view of the prohibition against manipulative or deceptive device or contrivance provision of law enacted under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Click here to access 7 U.S.C. §9(1)), as well as its traditional anti-fraud authority in connection with futures contracts (click here to access 7 U.S.C §6b(a)(2)(A-C)). The CFTC charged that these transactions were just like futures contracts (and thus its traditional anti-fraud authority applied) because they were offered on a leveraged basis and no delivery was made within 28 days (click here to access 7 U.S.C. §2(c)(2)(D)(iii)). The CFTC’s view of its Dodd-Frank authority was recently rejected by a California federal court. (Click here for background on this decision in the article “California Federal Court Dismissal of CFTC Monex Enforcement Action Upsets Stable Legal Theories” in the May 6, 2018 edition of Bridging the Week.)