Blockchain and digital currency companies, and those considering fundraising through an initial coin offering, face ever-increasing scrutiny from state and federal financial regulators. Below, Boston-based Goodwin partner Jack Falvey, who focuses his practice on government investigations and white collar criminal defense, discusses how he counsels clients who are operating in the blockchain and cryptocurrency space.
Enforcement and regulatory activity in the blockchain space have recently increased significantly; What kind of matters are clients coming to you with?
We have helped a number of companies respond to subpoenas from both the SEC and its Massachusetts counterpart – the Massachusetts Securities Division. Both regulators are very actively looking at companies that conducted ICOs without registering the tokens as securities, or otherwise seeking to comply with state or federal securities laws. The companies we’re working with have not specifically been looked at because of a concern about fraud, but simply because their offerings – many of which place before the more specific regulatory guidance that has evolved during 2017 and 2018 – were unregistered. Regulators have really stepped up their interest in identifying token issuers, taking a close look at the companies and the offerings, and deciding whether or not they were indeed offering securities, and are therefore in violation of the securities laws.
What sort of approaches are available to companies that find themselves in that situation?
We’ve been trying (with the federal SEC in particular) to be proactive and constructive in figuring out a solution. Both federal and state regulators have taken the view that in almost all instances tokens are securities. When you look at the legal test (referred to as “the Howey Test”), it’s very hard in most instances to convince the regulators otherwise. In many instances we’ve explored the approach of whether, without contesting whether the tokens were or were not securities, there’s a way to register the tokens going forward, and seek to satisfy the regulators that the issuer can provide appropriate remedies to initial investors. To your question, rescission is the threshold remedy that they think about on the federal side; and there are some complex issues about who is entitled to it and how it’s measured. Would it include overseas investors? Only the round of purchasers who participated directly in the offering? Would it include those who bought in the secondary market? Do the purchasers get dollars or the currency in which they paid? So there’s a lot to work through there. And beyond that, the SEC and its state counterparts may want some level of a financial penalty. We also think hard at the outset about jurisdiction: if the offering was conducted overseas, does the SEC have jurisdiction over it. That itself can be an involved question.
If you’re finding yourself in a rescission situation, what hurdles does that pose from a business standpoint? Can these companies withstand that process?
That’s the existential question in all this. It depends on how aggressive the SEC decides to be in what it requires – and whether it is prepared to find one or more practical approaches to resolution that can remedy the problem but give the issuer something it can agree to. It may be that some companies will be able to afford to provide a rescission offer – you make the offer and purchasers will either take you up on it or not. That may enable companies to provide a remedy and keep operating, because a very large number of the initial purchasers will have already sold, so there’s a limited class of purchasers who may want to take you up on the rescission. But that leaves some other complicated questions. For example, what about everybody else? If you announced a settlement with the SEC, it will be posted on the SEC website, and there’s a question of whether those not covered by the rescission will bring private suits that you have to contend with.
What are authorities most concerned about when it comes to ICOs?
First and foremost, regulators are concerned about fraud – ICO’s that involved deception and were designed to cheat purchasers. Fraud situations are the rarer instances, but there have been some prominent federal prosecutions of ICOs that were fraud through and through. They were companies that never had a technology and were just falsely describing how they were going to use funds. On the criminal side, that’s what the Department of Justice is looking at – where were digital coin offerings used as a means for accomplishing fraud. That of course, hits Mom and Pop investors and is appropriately a concern.
What has been established at this point as far as regulation around the blockchain space?
I think the regulators understand and believe that blockchain technology is potentially tremendously important and that they’re proceeding with that as a given. But they are also heavily presuming that most of these tokens would be securities in their view. We have seen some examples of what we think should be considered a pure utility token, in that it won’t trade outside of the platform and therefore doesn’t have the prospect of being bid up in price. But what regulators believe has really drawn purchasers into this field is that their tokens will start doing what Bitcoin and Ether did – and that purchasers are speculating and the offerors encourage that.
Can you give me a sense of when you become part of the process? Are you involved at the outset or after an investigation is underway?
The answer is yes, both. We are sometimes involved at the token-offering stage and have to consider whether there may be reason to proactively engage with the SEC or other financial regulators – particularly if we think we can persuade them that the token is a utility or if there is a registration exemption that will work. If we are in after the enforcement folks have reached out with a subpoena, we focus on Day One on a response strategy. No one wants to get into a protracted and expensive dialogue or fight with regulators or have a very high burn rate without a strategy, so we discuss that closely with the client from the get-go.
Where do you think things are headed five, 10 or 15 years down the road? What are some potential impacts of blockchain technology and cryptocurrencies?
From all we can see, blockchain will be a breakthrough technology that’s going to be at the core of transactions that all of us engage in. Over the longer term, it shouldn’t raise any unusual regulatory or legal issues. It’s really just in the near term that this raft of digital currency offerings that have gone out have raised regulatory and litigation issues that aren’t fully resolved yet. For the next few years, a whole lot of these ICOs will work their way through federal and state enforcement and in some cases litigation -- and I think the SEC is trying to figure out a comprehensive approach right now.