All signs point to increased US regulation of Buy Now, Pay Later
The Buy Now, Pay Later market has experienced exponential growth as an innovative consumer offering.
For the first time, a US federal court has ruled that in appropriate circumstances cryptocurrencies can be subject to the provisions of US securities laws. In U.S. v. Zaslavskiy, No. 1:17-cr-00647, slip op., 2018 WL 4346339 (E.D.N.Y. Sept. 11, 2018), Judge Raymond Dearie of the Eastern District of New York upheld a criminal indictment for securities fraud involving the sales of cryptocurrency tokens in an Initial Coin Offering (ICO). Combined with another first-ever ruling earlier this year in Commodity Futures Trading Commission v. McDonnell, 287 F. Supp. 3d 213 (E.D.N.Y. 2018), that fraudulent ICOs can in proper circumstances be subject to enforcement proceedings under the antifraud provisions of the Commodities Exchange Act, the federal government has now established a significant beachhead in using federal financial regulatory tools to police activity in the cryptocurrency space.
In the beginning of the year, SEC chairman Jay Clayton prompted headlines when he asserted in a Wall Street Journal article that “some products that are labeled cryptocurrencies have characteristics that make them securities,” such that “[t]he offer, sale and trading of such products must be carried out in compliance with securities law.” Jay Clayton & Christopher Giancarlo, “Regulators are Looking at Cryptocurrency,” The Wall Street Journal, Jan. 24, 2018. But at that time Chairman Clayton’s assertion was untested in the courts. That test soon came in the Zaslavskiy criminal prosecution.
Zaslavskiy involved an alleged scheme to market investments in an ICO in which purchasers would obtain cryptocurrency “tokens” allegedly backed by sophisticated real estate investments run by lawyers, brokers and developers who would increase the tokens’ value. The government charged that, among other problems, there were in fact no real estate professionals involved, no real estate was ever purchased or even researched, token values thus would never increase and, indeed, no tokens were ever developed. The defendants later shifted their supposed offering to one allegedly backed by diamonds, where once again there were no experts, no diamonds purchased and no tokens, according to the government. Alleging that these ICOs involved “investment contracts” and thus “securities” under federal securities laws, the government indicted the defendant Zaslavskiy for securities fraud.
Zaslavskiy moved to dismiss the indictment. He argued that because a cryptocurrency is a digital representation of value that can be digitally traded and functions as a medium of exchange, it is therefore a currency, but the federal securities laws specifically provide that the term “security” as used in those statutes “shall not include currency,” 15 U.S.C. § 78c(a)(10), and thus the term “security” cannot extend to cryptocurrencies.
Zaslavskiy also argued that his cryptocurrency failed the “Howey test,” the US Supreme Court’s long-established test for determining whether certain transactions qualify as “investment contracts” and thus “securities,” based on the 1946 case SEC v. W.J. Howey Co., 328 U.S. 293 (1946), and its progeny, and that for this additional reason the defendants could not be prosecuted under US securities laws. Howey set forth a three-part test under which, in order to qualify as an “investment contract” and thus a “security,” there must be (1) an investment of money, (2) in a common enterprise and (3) with profits to be derived solely from the efforts of others. Howey, 328 U.S. at 298-301; see also SEC v. Edwards, 540 U.S. 389, 393 (2004). Zaslavskiy contended that none of Howey’s elements were met in his case: there was no investment of money, but rather an exchange of one medium of currency for another; that likewise there was no pooling of assets or pro-rata distribution of profits; and that the currency’s value was derived from a number of sources, not just the “managerial efforts of others.” Specifically, Zaslavskiy argued that the decentralized nature of a blockchain-based system makes all participants in the system contributors to the creation of value, including the token purchaser.
Lastly, Zaslavskiy argued that the government’s attempt to “regulate this new asset class using the framework conceived of in the 1930s is troubling,” and that using such laws in that context was unconstitutionally vague and would result in arbitrary enforcement and inconsistent criminal prosecutions.
In response, the government disputed each of these points. It argued that despite the use of the term “cryptocurrency,” what matters is not the name but its economic substance. The government argued that cryptocurrency is not a “currency” because it does not circulate as a medium of exchange, generally accepted as payment in a transaction, nor is it recognized as a standard of value.
Rather, the government contended, the defendant’s cryptocurrency is a “security” that passes the three-part Howey test. The investors (1) paid money, (2) to participate in a common enterprise the basis of which was that investors’ assets would be pooled to invest in real estate and diamonds, and that (3) there would be shared profits derived from the managerial efforts of the defendant and his co-conspirators and the supposed expertise of the teams they would assemble, with the investors’ role reasonably expected to be primarily passive and not deriving solely from the operation of a blockchain “ecosystem.”
The government also rejected Zaslavskiy’s vagueness argument. It pointed out that case law developed under the securities statutes, such as Howey, clearly define, explain and outline the definition of securities and investment contracts, and therefore these statutes provided sufficient notice that the defendant’s conduct constituted securities fraud. It noted that the SEC has issued reports announcing its position that cryptocurrencies can be regulated as “securities.” Moreover, it said that functional tests like the Howey test that had been developed under the securities laws are designed to enable those laws to adapt to govern new types of financial products as they arise.
The SEC filed a brief in support of the government’s position and echoing most of its arguments, which also discussed the importance of treating cryptocurrencies as “securities.” The SEC noted that billions of dollars in capital have been raised in recent years through ICOs and contended that a majority of ICO fundraising is unlawfully conducted through unregistered and fraudulent offerings of securities. For this reason, the SEC argued, it is important that such offerings be regulated by the securities laws.
Zaslavskiy in reply countered the government’s argument that cryptocurrencies do not circulate as a medium of exchange by citing the recent McDonnell decision where the court expressly noted that “[v]irtual currencies are generally defined as ‘digital assets used as a medium of exchange,’ ” and stressed that in this case that is precisely how those cryptocurrencies were marketed.
In his September 11 ruling, Judge Dearie upheld the indictment, based on the Howey test for identifying when an arrangement constitutes an “investment contract” falling within the statutory definition of a “security” under the federal securities laws. Under the Howey test, the Court looked at whether the “elements of a profit-seeking business venture” were sufficiently alleged in the indictment, such that, if proven at trial, a reasonable jury could conclude that “investors provide[d] the capital and share[d] in the earnings and profits; [and] the promoters manage[d], control[led] and operate[d] the enterprise.” The Court noted that while “ultimately the fact-finder will be required to conduct an independent Howey analysis based on the evidence presented at trial,” nonetheless “the Indictment alleges sufficient facts that, if proven at trial, could lead a reasonable jury to find that REcoin [the defendant’s initial cryptocurrency plan] and Diamond [his later cryptocurrency plan] constituted ‘investment contracts’ ” subject to federal securities laws.
The Court’s decision went through the three elements of the Howey test. “First, a reasonable jury could conclude that that, if proven at trial, the facts alleged in the Indictment demonstrate that individuals invested money (and other forms of payment) in order to participate in Zaslavskiy’s schemes,” since “[t]hey did so in exchange for investments in what they were told were investment-backed virtual tokens or coins.” Further, Zaslavskiy’s investors were alleged to be “able to invest in REcoin [and Diamond] through [their] websites using their credit cards, virtual currency or online funds transfer services.”
The Court next concluded that “the Indictment alleges facts that, if proven at trial, would allow a reasonable jury to find that both REcoin and Diamond constituted a ‘common enterprise.’ ” Noting that so-called “horizontal commonality” — where “each individual investor’s fortunes” are tied “to the fortunes of other investors by the pooling of assets, usually combined with the pro-rata distribution of profits” — is sufficient to establish a common enterprise, the Court held that “[i]f proven at trial, the facts alleged in the Indictment would lead a reasonable jury to conclude that the horizontal commonality requirement is satisfied.” The Court noted that “it can readily be inferred from the facts alleged that the REcoin and Diamond investment strategies depended upon the pooling of investor assets to purchase real estate and diamonds.” The Court also stated that “[i]t can also be inferred that investors’ fortunes were necessarily tied together through the pooling of their investments.” Further, the Court stated that “the Indictment makes clear that REcoin and Diamond profits would be distributed to investors pro-rata — given that investors were promised ‘tokens’ or ‘coins’ in exchange for, and proportionate to, their investment interests in the schemes.”
Lastly, the Court concluded that “the facts alleged, if proven, would enable a jury to conclude that investors were led to expect profits in REcoin and Diamond to be derived solely from the managerial efforts of Zaslavskiy and his co-conspirators, not any efforts of the investors themselves.” The Court noted that “REcoin and Diamond investors undoubtedly expected to receive profits on their investments,” given that the “REcoin ‘token’ was described to investors as ‘an attractive investment opportunity’ which ‘grows in value,’ and as having ‘some of the highest potential returns.’ ” Likewise, Diamond investors “were told that Diamond was expected to grow by 10 to 15 percent per year.”
The Court further pointed out that the “Indictment  makes clear that the investors could have reasonably expected their profits to be derived primarily from the managerial efforts of Zaslavskiy and his team,” given that “Zaslavskiy’s marketing materials and communications advertised that he (and other skilled professionals) would use their expertise to develop the ventures, invest proceeds in real estate and diamonds, and generate profits.” Even though “Zaslavskiy suggested that Diamond investors could ‘trade Diamond coins on an external exchange and make more profit,’ there [wa]s no indication that investors were to have any control over the management of REcoin or Diamond. Nor is there any indication that investors would have been capable of participating in directing their investments.” While “market forces might contribute to the value of the schemes’ underlying assets,” the Court held that this did not “change the fact that, according to the Indictment, Zaslavskiy and his co-conspirators induced investors to participate based on promises of ‘the soundest’ investment strategies.’ ” The Court thus held that “the Indictment, if proven, would permit a reasonable jury to conclude that Zaslavskiy promoted investment contracts (i.e. securities), through the REcoin and Diamond schemes,” as specified under the Howey test.
The Court also pronounced itself unpersuaded by Zaslavskiy’s argument that the virtual currencies were “ ‘currencies,’ and therefore, by definition, not ‘securities.’ ” The Court found that this argument “ignores the fact that, per the Indictment, no diamonds or real estate, or any coins, tokens, or currency of any imaginable sort, ever existed — despite promises made to investors to the contrary,” and that it also “overlooks the fact that simply labeling an investment opportunity as ‘virtual currency’ or ‘cryptocurrency’ does not transform an investment contract — a security — into a currency.” Thus, because the allegations in the Indictment could allow a reasonable jury to find that the investment opportunities satisfied the Howey test, the Court concluded that “the Indictment is facially sufficient” and “because the ultimate characterization of the investment scheme at issue depends on facts that must be developed at trial, [the Court] need not resolve this issue at this time.”
The Court lastly rejected the defendant’s argument that the antifraud provisions of the federal securities laws were unconstitutionally vague to the extent that the government attempted to apply them to virtual currency. The statute’s express coverage of investment contracts, along with the Howey test and the language of Rule 10b-5, “made it reasonably clear at the relevant time that [the charged] conduct was criminal,” noting that “courts are clear that the securities laws are meant to be flexibly interpreted to effectuate [their] remedial purpose” and that the Howey test caselaw “for over 70 years [has] provided clear guidance to courts and litigants as to the definition of ‘investment contract’ under the securities laws.” The conduct charged against Zaslavskiy, said the Court, “falls within the core of the statute’s prohibition,” and its enforcement in this case is “not the result of the unfettered latitude that law enforcement officers and factfinders might have in other, hypothetical applications of the statute.”
Zaslavskiy is important for establishing that under proper facts and circumstances the federal securities laws can apply to activity in the cryptocurrency space. However, it does not purport to conclude that all cryptocurrencies in all circumstances should be regarded as “securities” for the purposes of the federal securities laws. Rather, the decision addressed only the specific factual allegations in the particular indictment at hand, and stressed that ultimately it would be up to the trier of fact at trial to determine whether the alleged facts were proven so as to warrant a conviction under the securities laws.
Zaslavskiy likewise did not purport to establish the SEC as the exclusive federal regulator in cryptocurrency matters. In this respect, it is similar to the ruling under the commodities laws in McDonnell earlier this year, which upheld the use of CFTC enforcement powers as to a virtual currency scheme while also noting that possible regulatory roles for the SEC, the Department of Justice, the Treasury Department’s Financial Enforcement Network (FinCEN), the IRS and others, in circumstances “when virtual currencies function differently than derivative commodities.” While at some point in the future such issues about the scope of regulatory authority for different bodies may be clarified or more comprehensively addressed by new cryptocurrency legislation or regulations, for now the existing securities and commodities laws remain relevant in analyzing cryptocurrency ventures, particularly in regard to how they attract investors. As noted by the Zaslavskiy court, “[w]hether and when the SEC chooses to engage in formal rulemaking regarding the regulation of digital assets is of no moment here.” What matters for now is that cryptocurrency ventures can indeed qualify as investment contracts that must comply with existing federal securities laws, and that in such circumstances their promoters can face criminal or civil repercussions if their ventures run afoul of them.
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