The Securities and Exchange Commission, together with state regulators, regulates the purchase and sale of “securities”. Further, it regulates the platforms or “exchanges” on which securities are sold. If a cryptocurrency is considered to be a security, then it is subject to regulation by the SEC. Read more about the the nature of cryptocurrencies at the LawTrades Blog. A company issuing a cryptocurrency, such as a token or coin offering, would need to comply with the securities laws. A failure to comply will result in a lawsuit by SEC for violation of securities laws. Also, failure to comply with the securities laws, in many cases, will allow purchasers of the securities to sue the issuing company for a return of the purchase price. It could also lead to lawsuits for fraud under state or federal laws. To understand common areas of securities laws and lawsuits applicable to cryptocurrency, proceed with the following analysis.
Is Cryptocurrency a Security?
Most cryptocurrencies are not securities and not subject to securities laws. For example, Bitcoin and Ethereum are not securities. Some other cryptocurrencies, however, are securities.
Section 2(a)(1) of the Securities Exchange Act of 1933 (“1933 Act”) provides a definition for what is a security. The long list does not include modern digital assets. The catch-all type of security is known as an “investment contract”. The question then becomes whether a cryptocurrency is considered an investment contract, and thus a security, under the securities laws. In determining whether a cryptocurrency is an investment contract, ask this question (known as “Howey Test”):
1) Is there an investment of money,
2) into a common enterprise,
3) with the expectation of profits,
4) derived solely from the efforts of others?
The central issue is whether the expectation to earn a profit from holding bitcoin is “derived solely from the efforts of others”. Because the Bitcoin and Ethereum systems are decentralized, not printed and backed by a government or corporation, they are not considered securities. It is also possible that a digital currency is centralized, but are structured more like a consumer item than a security, particularly if the asset is purchased for personal use and not intended as an investment.
An initial coin offering, on the other hand, meets all of the elements of the Howey test. It is an issuance backed by an issuing business entity. As such, coins or tokens issued in an ICO are considered securities, and their sale or exchange will be subject to securities laws.
What is required of securities giving rise to lawsuits?
The 1933 Act requires that any security, prior to being offered for sale to the public, be registered as a public offering or the issuer perfect a “private placement”. A private placement is a non-public offering exemption from registration. In both situations, a company issuing a security must provide adequate disclosure to the purchasers of the security to allow them to make an informed decision about the purchase.
Registered Public Offering
Registering to undertake an Initial Public Offering (IPO) requires the company to file Form S-1 with the SEC. This is a very long and difficult process. It can take hundreds of hours and require extensive assistance from legal and other professional services. Failure to complete the form appropriately will inevitably lead to an investor lawsuit. The company offering the security for sale must also create a prospectus containing important information about the offering and the security. It must provide the prospectus to anyone subsequently offered the opportunity to purchase the security. Lastly, there are extensive, ongoing obligations to report company information to the SEC.
Non-public offering (private placement) exemption
Most startup companies cannot afford to comply with the securities registration process. As such, if they seek to sell their securities to private investors in what is known as a “Private Placement”. A private placement is exempt from registration with the SEC. There are several statutory and rule-based exemptions that lay out the requirements for the private placement. Each exemption has specific rules, such as the amount of money that can be raised, the number of investors allowed, the knowledge or wealth of the investors, how soon the securities can be sold by investors after purchase, and whether the company can openly advertise (or “generally solicit”) to investors. The most commonly used exemption is under Rule 506 of Regulation D. Other, less common exemptions include: Section 3(a)(11), Section 4(a)(2), Section 4(a)(5) Section 4(a)(6), Regulation A, Rule 504, Rule 505.
These exemptions require the issuing company to create a disclosure document known as a “private placement memorandum”. The issuer must provide this document to any prospective purchasers of the securities prior to sale. Also, within a specified period of selling the securities, the companies must file Form D, a notice of exemption document, with the SEC. Failing to file Form D is not fatal to the sale, but it can result in a future bar from selling securities under a registration exemption.
What type of Securities Lawsuits affect Cryptocurrencies
These rules will frequently give rise to securities lawsuits against the company issuing the cryptocurrency or virtual currency.
If a company fails to register with the SEC or perfect an exemption from registration, the SEC will likely initiate a lawsuit pursuant to Section 4 of the 1933 Act to halt any future sale of the securities. It can also lead to massive fines or damages against the company.
Failure to comply with any of the applicable rules in a private placement will forfeit the exemption and subject the startup to potential lawsuits by investors.
If any information in the prospectus or private placement memorandum are erroneous and “material” (a manner of saying important to the investment decision), the private investors may sue for a return of their invested capital.
Companies who knowingly provide erroneous information to the SEC or to investors would also be subject to criminal actions as well as civil lawsuits.