For digital technology savvy investors who want to know if US courts treat cryptocurrencies as securities subject to the regulatory requirements of the 1933 Securities Act, the expectation is excessive. The first federal judge to decide the matter in the context of class action landed on the same side that the SEC had done in 2017, finding that virtual tokens in the case could be characterized as titles. We discussed the SEC 2017 report in a previous article. See Margaret A. Dale and Mark D. Harris, The SEC concludes that digital tokens may be titles, NYLJ, 8 August 2017.
On 25 June 2018, magistrate judge Andrea M. Simonton of the district Southern Florida has released this opinion to the vanguard in Rensel v Centra Tech. Your report and recommendation (R & R) considered a motion for a temporary restraining order to safeguard the proceeds from an initial supply of coins (ICO). The underlying shareholder share held that Centra Tech, a Florida-based technology start-up, and many of its founders and executives, had violated various provisions of the Securities Act. To reach its decision, Judge Simonton analyzed whether the Centra Tech tokens offered over the course of its ICO were securities for the purposes of the Securities Act (although the defendants conceded the point for purposes of motion).
By way of background, the defendants in the case are Centra Tech and its founders and officials, Sohrab Sharma, Raymond Trapani, Robert Farkas and William Hegener. The complaint claims that towards the end of 2017, Centra Tech and its executives told investors that they were developing what promised to be a revolutionary solution to a major problem for virtual currency holders – the fact that most vendors he does not accept it. Centra Tech claimed to have created "the world's first debit card designed to be used with compatibility on more than 8 major blockchain assets of cryptocurrencies". Basically, the card would allow holders of virtual currency to actually spend their money. According to Centra Tech, through their platform, users could easily convert their cryptocurrency into the most acceptable type from the "fiat" currency, which is traditional legal tender currency, such as US dollars or euros.
To raise capital for this innovative debit card and related projects, Centra Tech conducted an ICO, from July to October 2017. Part of ICO involved the company that sold the Centra token, or CTR, to the public. The company told potential investors that in order to use the products it was developing, they would have to own CTRs. No registration statement was in effect at any time the company sold the tokens.
The plaintiffs in Rensel filed suit in the southern Florida district in December 2017, bringing a collective putative action for violations of Sections 12 (a) (1) and 15 (a) of the Securities Act of 1933 In the introduction to the complaint, the plaintiffs compared the Centra Tech ICO to an offer and sale of unrecorded securities and emphasized the important role of the Securities Act to protect investors, citing "the various and countless ways in which investors can be, and are likely to be manipulated and damaged "in his absence.
In April 2018, the SEC took a similar position, citing Sharma, Farkas and Trapani for securities fraud and violations of the rules on registration declarations under various provisions of the Securities and Exchanges, as well as for the help and aiding of Centra Tech in committing the same violations. Only a month later, in May 2018, the Justice Department charged Sharma, Trapani and Farkas. The government press release announced that it was accusing the defendants of "fraud on securities and cables in connection with a plan to induce victims to invest millions of dollars of digital funds for the purchase of unregistered securities, under form of digital currency tokens issued by Centra Tech, through false declarations and omissions. "
Application of the" Howey "factors
Like the SEC in 2017, Judge Simonton applied the test Howey to determine whether CTRs could be characterized as "Investment Contracts", which is one of the enumerated definitions of a security in the Securities Act. The Supreme Court in SEC v. WJ Howey Co. 328 US 293, 299 (1946), submitted a four-pronged test for the identification of an investment contract: (1) a cash investment (2) in a & # 39; joint venture (3) with a reasonable expectation of profits (4) to be derived from the entrepreneurial or managerial efforts of others. Judging Simonton, while expressing it as a three-pronged test, all the factors are satisfied.
The purchase of CTR was a "money investment" because, the court concludes, this term includes any investment that could subject the investor to financial losses. If for fiat currency (for example US dollars or euro) or for virtual currency (in the form of Bitcoin or Ether), people who bought CTR from Centra Tech hoping to profit from the company's success were subject to potential losses . Simple enough.
The court then evaluated the "joint venture" pole through the lens of the former Eleventh Circuit, which defines that business as existing when (1) investors' profits are directly related to the success or failure of the developers produced, and ( 2) the investor does not have control over the success or failure of the investment. Because the value of investments in Centra Tech increased or decreased with products, on which investors had no control, this pole was satisfied.
Having not directly addressed, but apparently assumed, that investors had a reasonable expectation of profits, the court assessed the last factor Howey describing the test as if "the efforts made by those that are not the investor are undeniably significant, those essential management efforts that influence the failure or success of the business ". Given the lack of control of Centra Tech's investors on the development of the company's allegedly revolutionary products, investors were entirely dependent on Centra Tech's managerial efforts to succeed or fail.
With all the factors Howey satisfied, the court recommended to the district judge to find that "the offer of Centra tokens was an investment contract under the Securities Act, such as the Defendants sold or offers to sell securities under the Centra Tech ICO. "Despite this finding, the court finally recommended to deny the temporary restraining order based on the fact that the applicants' damage was not irreparable because it could be remedied by an award .
The previous value of the decision Rensel is limited in three notable ways. Firstly, since the decision is an R & R issued by a magistrate judge, it will be subject to a de novo review by US District Court Judge James Lawrence King. (As of August 1, 2018, both the plaintiff and the defendants had filed and objected to the R & D.) Second, because the opinion had been issued on a motion for a temporary restraining order, the judge assessed the question using the "probability of success on merit" standards, rather than making an effective judgment on merit. Thirdly, the defendants in the case admitted, for the purposes of the provisional restraining order, that the tokens were securities under the Securities Act.
At present, the question of whether crypto-tokens are securities subject to regulation under the Securities Act is far from being resolved. In light of the limitations of Rensel along with the growing popularity of virtual currency and related products, we expect to see the courts across the country begin to weigh more definitively. We will look at.
Margaret A. Dale and Mark D. Harris are partners of Proskauer Rose.