Question 1

How to Determine the &#8220;Right&#8221; Lawyer for Companies

Accepted Answer

Audit Committee/Board-led Independent Investigation Where a company’s audit committee wishes to conduct an investigation into potential violations (this may happen before any government investigation starts), they should probably not use a law firm that regularly does work for the company. There are a few, related reasons for this.      First, any such investigation should be independent in order to be credible. It’s not independent if the firm conducting the investigation has other ongoing work for the company or frequently does work for the company and expects to continue doing work for the company.      Second, it may represent an actual conflict of interest for the law firm if issues the company consulted with the firm on in earlier periods become (or should become) subjects of the investigation.      Third, after the investigation concludes, the audit committee or the company may wish to present the results of the investigation to government regulators such as the SEC or DOJ; if the law firm that conducted the investigation is found to have a prior or ongoing relationship with the company, the government may worry that the investigation “pulled punches” as to the issues it covered or the involvement of company officers or directors in a position to award legal work to the firm.      Fourth, the audit committee and the Board have duties to the shareholders to ensure that any members of company management that were involved in directing or allowing violations to take place are properly dealt with, which might be more difficult to ascertain if the lawyer or firm making recommendations about company managers has had extensive, friendly relationships with the individuals being evaluated.   Finally, and we’ve seen this principle violated in the past with not-so-great results, the law firm that represents the company in the government investigation should not be the same firm that conducted the investigation. This is because the law firm would be put in the position of urging the government to rely on the firm’s own work (the “independent” investigation that the same firm just completed) at a time when the firm is charged with defending the company’s interests. This puts the law firm in the position of vouching for the integrity of its own investigation at a time when the government knows that the firm’s actual job is to minimize liability and protect the company’s interests—which could (and probably should) cause the government to question the impartiality and reliability of the investigation the law firm (and company) wants the government to take seriously.     Company Representation When it comes to representing the company’s interests in an SEC or DOJ investigation, it may be entirely appropriate that the lawyer or law firm that has previously represented the company in other contexts also defend the company’s interests in what may be a protracted, years-long investigative process with potential litigation at the end.      Choosing a law firm that has done work for the company, is familiar with the business model, and has developed a solid rapport with the business executives and in-house counsel is often a very good idea and can cut down on the costs associated with bringing in lawyers who know nothing of the company or its industry. This must always be subject, however, to making sure that the law firm has the necessary expertise with the relevant agencies. It seldom makes sense to use the lawyer who regularly assists the company in its FDA labeling and advertising issues in an SEC enforcement investigation into whether the company’s financial statements were intentionally misstated. If the FDA lawyer doesn’t have colleagues at the firm with the SEC or DOJ backgrounds necessary to handle such an investigation, the company needs to find a new firm that does have such expertise; this is no time for on-the-job learning.     If a different law firm has completed an independent investigation, the law firm charged with the company’s defense will want to point to the findings and recommendations of the internal investigation and persuade the government that the company has figured out what went wrong, taken appropriate remedial action in reliance on the investigation conducted by an independent firm, and should therefore not be excessively penalized for problems that have already been exposed, investigated, and properly addressed.    Insurance—Directors & Officers (“D&O”) Insurance Most companies of any size will have considered purchasing a D&O insurance policy and most corporate insurers will suggest such a policy as a prudent investment. As discussed further below, most corporate by-laws require the company to indemnify and advance to its directors and officers legal costs incurred in a lawsuit or investigation related to their service as corporate board members or executives. A D&O policy is one way for the company to offset or mitigate its liability for the costs of defense of these individuals if and when a lawsuit is filed or an investigation commenced.     General Counsel and those responsible with dealing with the company’s risks should consider retaining counsel with expertise in coverage issues in evaluating D&O policies and should also make sure the insurance company has the necessary depth and experience in D&O coverage to adequately address the company’s needs. In our experience, this is not an area in which it pays to have taken out “bare bones” coverage.      The costs of defending against a securities class action lawsuit or a government investigation into potential securities fraud at the company escalate very quickly. Adequate coverage can save tens of millions of dollars in the long run.      As with most insurance, a company with a D&O policy must pay careful attention to its notice obligations under the policy. Insurance companies are very happy to take premiums in on the front end, but each and every excuse to delay payment or to invoke an exclusion can and will be exercised. Accordingly, at the first indication of a potential issue where D&O coverage may be needed (for example, a subpoena received from a government agency), the company must notify its insurance carrier in accordance with the policy’s requirements.      Employee Representation One fraught area can be the decision whether and when to secure separate counsel for individual company employees. Separate counsel is required when the company’s and the individual’s interests materially diverge and the firm representing the company cannot ethically represent the employee as well. Sometimes this is apparent right away and at other times this only becomes apparent later during the course of an investigation. In either event, the lawyer that ends up representing an employee (or, sometimes, a group of employees) must be as qualified and well-versed in the relevant legal issues and have experience with investigations of the same type, or there could be serious missteps, to the detriment of both the individual employee and the company. No one is well-served if the lawyer taking on the representation is not qualified to do it.

Question 2

So you&#8217;ve received a subpoena or civil investigative demand

Accepted Answer

Now that the government has served a subpoena on you, what does it mean and what should you or your company do in response? We'll speak in the context of an SEC subpoena, but any subpoena issued by the government--whether by the SEC, DOJ, CFTC, or some other agency--will have similar considerations and parallel processes Before a Subpoena is Issued Often (although by no means always) the first indication of the existence of an SEC investigation is a telephone call from SEC staff to the company's legal department. It is not unusual for the SEC to initially obtain information from a company voluntarily, before the staff has fully developed its focus. If the investigation continues, the staff will almost invariably issue a subpoena to ensure that documents and data (whether already obtained or still to be provided) relevant to the investigation are safeguarded and available. How do I know that what I received is an SEC subpoena? When the SEC sends a subpoena, it will usually comprise a relatively thick packet of material at least 12 pages in length. The components include: a two- to three-page cover letter; a single page which is the actual “subpoena,” in that it informs the recipient of the date, time, and location at which they are required to produce documents and/or appear and testify; an often lengthy list of definitions, instructions, and document requests attached to the subpoena; a few pages on how and in what format to produce electronically stored data; and Form 1662, which is an SEC document that explains the ways in which the SEC routinely uses the information provided. What can the subpoena tell me? To an experienced SEC enforcement attorney, the subpoena will provide insights into what issues the SEC is investigating, the nature of the violations the SEC suspects have taken place, the persons likely to have knowledge of the issues the SEC is interested in, and more. What is a subpoena anyway? A legal document, called a writ, which is created to command you to be present (or described documents to be produced) at the location it lists on the date and at the time it states. A court or one of many governmental agencies, either a federal agency or a state agency, can complete and send you a subpoena. An “administrative subpoena” is a subpoena that an administrative agency (federal or state), not a court, creates. SEC subpoenas are administrative subpoenas. What happens if I ignore a subpoena sent by the SEC? You may ultimately be subjected to a penalty. The word “subpoena” literally means “under” (sub) “penalty” (poena). This is never a recommended response. However, if you do ignore an SEC subpoena the SEC will have to undertake what is called a “subpoena enforcement action,” in which it immediately files a lawsuit in U.S. District Court with jurisdiction over you or your company, and requests the federal court to order compliance with the subpoena. Ignoring the federal court order can result in a contempt finding, which could land you, or the person responsible for blocking compliance with the court’s order, in jail and subject to monetary sanctions. The statutory authority for doing this can be found in Section 21(c) of the Exchange Act, 15 U.S.C. § 78u(c). What should I do if get a subpoena from the SEC? There are two things that you should not do: (1) ignore the subpoena (see above) or (2) destroy or delete any documents or data that the subpoena seeks to be produced. You should consider retaining counsel to assist you in negotiating the parameters of the subpoena with the SEC staff and begin the process of organizing a defense strategy. If the subpoena is directed to your company, you need to immediately put employees who may have responsive documents or data on notice not to destroy any such information. You should immediately notify your IT department to suspend the regular deletion of electronic data until you can isolate responsive documents; also, they should take steps to ensure that individual custodians of relevant data cannot delete responsive data.

Question 3

The SEC&#8217;s Cryptocurrency Suppression Program

Accepted Answer

Introduction In 2017, the U.S. Securities and Exchange Commission (“SEC”) established an agency-wide program dedicated to shutting down the cryptocurrency industry: what we call the cryptocurrency-suppression program (“Suppression Program”).1   The SEC’s rhetorical objective is to protect investors. We think that the real objective is to prevent disintermediation. Banks are intermediaries between savers and borrowers: they receive funds from depositors and relend those funds to borrowers for profit.2   Disintermediation is the removal of the middleman standing between savers and borrowers—the banks—and it occurs when depositors and savers move their money to alternative financial products, such as money market funds.3  For the purpose of this article, we define cryptocurrencies—including virtual currency, digital tokens, or digital coins—as private digital money or (“PDM”).4  PDM threatens bank products, such as checking and savings accounts, banks’ inventories of lendable funds, and consequently, banks’ profits. The Federal Reserve and national banks of the United States have a strong incentive to prevent the proliferation of private currencies that compete with non-private currencies, fiat money, like the United States dollar (USD). Regardless of what institutions actually profit from the Suppression Program, the SEC’s crusade against PDM stands on a foundation of sand and deserves to be knocked down. A Dubious Legal Foundation The SEC’s treatment of cryptocurrencies begins—according to the Agency—with the Securities Act of 1933 (“Securities Act”). The Securities Act requires every business enterprise that offers and sells units of its “securities” to the public to register those units or have an exemption from registration. Congress created the SEC in 1934 and granted it jurisdiction over securities transactions, including distributions of securities, and the exchanges over which securities are traded. The SEC can only address transactions that involve transfers of one or more units of a security, whether it is a specific, standard security, such as a stock or a bond, or a generic, non-standard security, called an “investment contract.” If a unit of a financial product to be transferred is not a “security” (a non-security, the SEC has no authority and cannot lawfully use its powers to intrude in the transfer.5   The SEC has used elegant sophistry to move PDM from the non-security bucket into the non-standard security bucket in order to implement its Suppression Program. Statutory Definition of “Security” Congress defined “security” by listing examples in its two original statutes, the Securities Act and the Securities Exchange Act of 1934 (“Exchange Act”) (collectively, “Acts”).6  Most of these terms are well-understood, like “stock” and “bond,” but each list includes the term “investment contract,” which is a catch-all term for a non-standard security.7  Although one might think an “investment contract” referenced a particular type of security in existence before 1933, this is not the case. In blue-sky securities laws that states enacted prior to 1933, the term was used, as used in the federal securities laws, as a category to include non-standard securities.8  Items that are listed as a “security” in the Securities Act and/or Exchange Act are, of course, securities. Items that are not listed require analysis. The question of whether an item may be a security, albeit non-standard, or is simply not a security depends on the judicial definition or set of conditions—the test—applied to the item. “Investment Contract” as a Non-Standard Security A definition uses words with known meaning to give meaning to an unknown term. In the Acts, a “security” is, for the most part, defined as any item in a list of understood items—an extensional definition.9   But the term “investment contract,” an exception to the known types of security, requires definition. One way to do this is to identify and abstract the common necessary conditions for the known examples of “security” and create an intensional definition of “investment contract,” namely, a definition that lists the necessary conditions to be satisfied to be considered an investment contract that is a security under the Acts. Over the years, the U.S. Supreme Court has created a definition and list of conditions an item must satisfy to constitute a non-standard security called an investment contract. Although the Supreme Court originally rejected the rule of ejusdem generis10  to constrict the meaning of investment contract,11  in SEC v. W.J. Howey,12 however, the Supreme Court implicitly accepted that the unknown, general item is “of the same kind” as the known items but not limited to those items. Using this principle, the Court effectively extracted properties that the other items shared and converted them into conditions and made use of those conditions to create an intensional definition of “investment contract.” Requirement to Register Units of Security for Public Sale The Securities Act, which is the first federal securities statute and preceded the creation of the SEC, requires the enterprise that offers any security for sale to the public to register the units with the SEC. The type of offering may provide the issuer of the units with an exemption from the registration requirement.13  Although a security is a social construct and units of the same class and series of securities, like money, are fungible insofar as they are interchangeable, so long as records are made and maintained, each has its own origin, existence, history of transfers, and sequence of owners, and this is especially important under the Securities Act for any security offered in an initial public offering (“IPO”), follow-on-offering, or secondary offering and any transaction exempt from registration. “Registration” under the Securities Act14  is both a process and an outcome of that process concerning specific units of a security. As a process, the SEC has sets of rules that address the required form and content of a registration statement, the Form S-1, and its filing through the SEC’s Division of Corporation Finance (“Corporation Finance”).15  For an IPO, the business enterprise seeking to register units must have three and, if an emerging growth company, two years of audited comprehensive income and cash flow statements. The process takes about six months. Corporation Finance reviews “selected registration filings,” which include Securities Act filings and “may examine a company’s registration statement to determine whether it complies with our disclosure requirements.”16  Although the “SEC does not evaluate the merits of offerings” or “determine if the securities offered are ‘good’ investments,”17  it may hold up the registration process and choose not to issue a statement that the registration is effective. If the company sells the securities anyway, it invites scrutiny and potential adverse action from the SEC’s Division of Enforcement. Cryptocurrencies and Fraud The SEC has no authority over common law fraud18  and, although it “charges” violators with violations, it has no criminal authority. Congress circumscribed the SEC’s jurisdiction to address the specific intricacies of the securities industry. The fact that some cryptocurrency activity has been fraudulent is an insufficient basis for the SEC’s unilateral and unlawful extension of its jurisdiction.19  The anti-fraud provisions of the federal securities laws are intended to address fraudulent activity that involves securities; the U.S. Department of Justice (“DOJ”) and the United States Attorney’s Office in each federal district have the statutory tools20  to deter and redress fraudulent schemes and activities that use or involve cryptocurrencies. Both the SEC and DOJ are subject to the same commerce-clause limitations for federal involvement.21 Evidence that the SEC’s Program Is A Suppression Program The SEC’S Administrative Operations The SEC has been using the Division of Enforcement (“Enforcement”) and Corporation Finance to administer the cryptocurrency Suppression Program. The divisions’ levels of activity and visibility differ: since 2017, Enforcement has loudly and visibly brought legal actions to prevent the “unlawful” proliferation of cryptocurrencies, and Corporation Finance, which administers the registration process and declares an offering effective,22  has quietly and invisibly prevented cryptocurrency companies from registering their cryptocurrencies.23 Enforcement’s Role in the Suppression Program Enforcement’s role has been to shut down ongoing sales of cryptocurrencies through injunctions and cease-and-desist orders and to extract sales proceeds from cryptocurrency producers through the judicial and administrative legal remedies of disgorgement and civil money penalties. The Enforcement role began in the latter half of 2017 and has two key components: (1) a manifesto Enforcement published on July 25, 2017, named the “Report of Investigation: The DAO,”24  and (2) a special unit of Enforcement, which the SEC announced on September 25, 2017, called the Cyber Unit, which is tasked with investigating and bringing legal actions involving the internet, hacking, and other online misconduct. Enforcement’s DAO Report The DAO Report: (1) discussed the issuance of the DAO cryptocurrency, finding each DAO token to be a “security”; (2) announced that cryptocurrencies deemed to be securities are subject to the registration and anti-fraud provisions of the Securities Act and anti-fraud provisions of the Exchange Act; (3) warned that it would investigate and bring enforcement actions against sellers of cryptocurrencies deemed to be securities which did not comply with registration requirements or engaged in fraud; and (4) provided its analysis of why a token of cryptocurrency falls within the non-standard type of “security” called an “investment contract.” In enforcement actions25  against sellers of cryptocurrency, the SEC has claimed that units of PDM—as standalone money26  or even non-money27 —is a “security.” This claim is necessary because the SEC’s regulatory and enforcement jurisdiction is limited only to transactions involving the transfer of a security. The SEC announced and defended this position in its July 25, 2017 DAO Report, but the report used several sleights of hand “to fit” PDM into the non-standard security catch-all term, “investment contract.” The result is what one might call a “stretched security,” that is, neither a standard nor non-standard security under the federal securities laws.28 First, the DAO Report’s factual scenario concerned PDM that was a composite of two products, one with a non-currency function and the other with a currency-only function. The non-currency function was certainly a security, but the currency-only function was not. The SEC attributed the non-currency’s function as a security to PDM, subtracted and ignored the non-currency function, and concluded—in subsequent matters—that standalone PDM, too, was or could be a security. Second, the DAO Report’s analysis dispensed with a critical condition of the United States Supreme Court’s definition of “investment contract” in SEC v. W. J. Howey Co.:29 namely, that the parties to the investment contract (the seller and buyer of the security) must be financially connected through a “common enterprise.”30  Removing this condition stretched the definition of security to include an enterprise in which the buyer has little interest in the enterprise’s financial position and performance.31 Third, the DAO Report relied on the following implicit syllogism: Premise 1:       If a financial product is an investment, then it is a security; Premise 2:       A unit of PDM is an investment; and Conclusion:     Therefore, PDM is a security. The first premise—the conditional statement—is duplicitous because “investment” has a broad and narrow definition. An investment is ownership of an asset that may be sold for more than its purchase price, with the difference being a profit or return. The profit may come only from the secondary market’s interest in the asset, as is the case with collectibles.32  For instance, a numismatist may purchase historical banknote currency or United States currency, which are both limited in quantity, as an investment. Over time, these items may increase in value. The financial position and performance of the producer of the asset, if not defunct, is almost if not completely irrelevant. A security, however, is an investment in a common enterprise in which the holder receives a profit—return—in the form of interest or dividends directly from the issuer of the asset—the security—or from the market’s perception of the issuer’s likely increase in value as a capital asset.33 Enforcement’s Cyber Unit The Cyber Unit is focused on “cyber-related misconduct,” which explicitly includes “[v]iolations involving distributed ledger technology and initial coin offerings.”34  Although the objective of “enforcement” is to deter violations and encourage compliance, the SEC has not provided instructions or information on the conditions producers of cryptocurrencies must satisfy to registering their tokens for sale to the public.35 Corporation Finance’s Role Corporation Finance’s role has been to ensure that few, if any, PDM companies succeed in registering their cryptocurrency units for sale to the public. While supporting Enforcement’s requirement that producers of PDM register cryptocurrencies as securities, Corporation Finance has failed to specify how to proceed or what benefits would flow from such registration. Corporation Finance’s Labyrinth On June 29, 2017, the SEC announced the expansion of its confidential treatment of draft registration statement processing procedures from emerging growth companies to all companies, including companies conducting IPOs.36  Beginning July 10, 2017, about two weeks before the DAO Report, the SEC would accept such drafts “From all issuers for nonpublic view.” This has benefits to the issuer, for sure, but it also makes registration statements exempt from FOIA. Cryptocurrency companies may face insuperable barriers in their quests to register units or tokens for public sale through Corporation Finance. Exemptions from registration have also—and not surprisingly—met with SEC hostility. The registration gate for the crypto-company37  seems closed.38 Corporation Finance’s Framework Corporation Finance has published no information on how to get through its cryptocurrency registration labyrinth. Instead, it has published a “Framework” that offers a byzantine analysis one might use to determine whether the SEC will deem a “digital product” to be a “security.”39  The Framework is another, different kind of maze that shows the reader that no matter what route one takes, a virtual currency or digital token will be deemed a “security.” Options for the Cryptocurrency Producer This gives the cryptocurrency company two options: enter the labyrinth and seek to register the units of cryptocurrency for sale, or sell cryptocurrency units without registration. If the company chooses the registration route, the cryptocurrency units will likely not be registered. If the company chooses to sell units without registration, Enforcement will shut down operations. These options—one of which is allegedly required and “legal” and one of which is “illegal”—ensure failure in either case and leave the crypto-company with no viable option. Hence, our view that the SEC is engaged in a Suppression Program designed to hinder the production of PDM in the United States. Conclusion The SEC’s present intrusion into transactions involving the transfers, including sales, of cryptocurrencies or digital assets is a suppression program that the SEC undertook without any public mandate.40 We have suggested who might wish to suppress cryptocurrencies—existing large U.S. banks and financial institutions, which have a vested interest in preventing the rise of disintermediation—which may help explain why the SEC’s cryptocurrency initiatives have resulted in suppression. We have introduced the key elements, both conceptual and operational, of the Suppression Program. In the following articles, we will explain why the conceptual basis for the program—namely, the use of the investment contract—is flawed and even reveals the SEC’s use of sleight of hand. This discussion will include: (1) a proposed standardized definition of “security” that applies to well-understood types (closed-end types) and the open-ended investment contract; (2) a review of the U.S. Supreme Court’s definition of and test for investment contract; (3) a demonstration that the Court’s definition of an investment contract fits nicely within the standardized definition; and (4) an analysis and critique of the SEC’s interpretation of the Supreme Court’s test for an investment contract, which stretched the meaning of security out of shape, and the SEC’s sleight of hand in applying that interpretation to cryptocurrencies. Because the SEC has expanded its own jurisdiction, the federal judiciary should not extend Chevron deference to the SEC’s definition of “security.”41 Finally, we raise several related arguments that address the non-fit of cryptocurrencies in the SEC’s disclosure program and the anomalous results that flow from the SEC’s strained analysis in this area. [1] This is the first of a series of articles on the SEC’s cryptocurrency suppression program. The articles progress from the first article, Part I, which introduces the suppression program, to Part II, which discusses the SEC’s history with cryptocurrencies and the agency’s evolution toward attempting to regulate them. Part III talks about digital collectibles and compares the digital token to the concept of a “security.” Part IV discusses the standardized definition of “security.” Part V discusses the Supreme Court’s “Howey test,” the fundamental description of what types of “investment contracts” may be regulated as securities. Part VI describes how the SEC has come to rewrite the definition of what constitutes an investment contract—and how this definition strays from the Howey opinion, specifically when it comes to cryptocurrencies. Part VII explains why the SEC’s views are not only contrary to controlling law but represent a failure to properly understand the nature of the non-standard security represented by an “investment contract.” Part VIII discusses the SEC’s investment contract test in light of arguments it has made in a number of recent cases brought against companies that had developed or planned to develop cryptocurrencies. Part IX discusses the anomalous results that flow from the SEC’s treatment of cryptocurrencies as securities and poses the question of why the SEC has embarked on its campaign to suppress such products. [2] See, e.g., Diego Zuluaga, Cato Institute, Speech: The Future of Financial Services: Disintermediation, Decentralization: A Familiar Tune for Credit Unions? (Oct. 12, 2018) (“Will financial technology — Big Data, machine learning, blockchains — render incumbent financial institutions — banks, fund managers, stock exchanges — obsolete?”), https://www.cato.org/publications/speeches/future-financial-services-disintermediation-decentralization-familiar-tune. [3] See, e.g., Fein, Melanie L., Comment Letter, Shooting the Messenger: The Fed and Money Market Funds, (Apr. 2, 2012) (comment letter filed in response to proposed SEC rulemaking after the 2008 financial crisis) (The SEC “is considering regulatory proposals that may threaten the future viability of money market funds (‘MMFs’).”), https://www.sec.gov/comments/4-619/4619-157.pdf. In the article’s abstract, Fein observes that “[i]ndustry members believe that the SEC is acting under pressure from the Federal Reserve Board” and that “[m]any in the industry surmise that the Fed’s ultimate goal is to eliminate MMFs [a $2.5 trillion market] as competitors of banks.” Id. [4] Private money is money that a private organization, not a central bank or government-authorized bank, produces and may be transferred by sale, gift, or use to purchase products, or traded or exchanged for other money, including government-produced (fiat) money. Given that a digit is a numeral, digital money is money that exists only as recorded numerals. Private enterprises, banks, central banks, or non-central banks can produce and issue money, with private digital money being that which wholly private enterprises produce and distribute. In the United States, the Federal Reserve Banks produce and distribute money, most of it digital, with some made tangible: the United States Treasury’s Bureau of Engraving and Printing, prints Federal Reserve Notes (currency), and the United States Mint, another Treasury bureau, mints United States coins. Coins and currency, however, constitute a small percentage of the monetary base (M0) or money supply (M1 or M2), amplified by fractional reserving of deposits. See, e.g., David Black, Who Needs Cryptocurrency FedCoin When We Already Have A National Digital Currency? Forbes (Mar. 1, 2020), https://www.forbes.com/sites/davidblack/ 2020/03/01/who-needs-cryptocurrency-fedcoin-when-we-already-have-a-national-digital-currency/#66da6c944951 (“almost 90% of US dollars have no physical existence – they are purely digital. But this isn’t just for the USA; worldwide, only 8% of currency exists as physical cash!”). [5] The legal term is ultra vires, which means beyond or outside the scope of one’s authority. [6] The Supreme Court has noted that “security” has the same meaning in each statute. United Housing Found., Inc. v. Forman, 421 U.S. 837, 847 n.12 (1975) (The definitions of “security” in the two acts are “virtually identical” and, for that case in particular, “the coverage of the two Acts may be considered the same.”) [7] The term “security” is defined in both the Securities Act and Exchange Act. In § 2(1) of the Securities Act, 15 U.S.C. § 77b(1), it is defined as: The term “security” means any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, or, in general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. (Emphasis added). In § 3(a)(10) of the Exchange Act, 15 U.S.C. § 78c(a)(10), “security” is defined in very similar terms: The term “security” means any note, stock, treasury stock, bond, debenture, certificate of interest or participation in any profit-sharing agreement or in any oil, gas, or other mineral royalty or lease, any collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit, for a security, or in general, any instrument commonly known as a “security”; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribe to or purchase, any of the foregoing; but shall not include currency or any note, draft, bill of exchange, or banker’s acceptance which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited. (Emphasis added). [8] Maura K. Monaghan, Note, An Uncommon State of Confusion: The Common Enterprise Element of Investment Contract Analysis, 63 Fordham L. Rev. 2135, 2144 (1995), https://ir.lawnet.fordham.edu/cgi/viewcontent.cgi?article=3173&context=flr. [9] An extensional definition lists objects or items that fall within the meaning of the defined term. See, e.g., https://www.ucfmapper.com/education/how-to-write-definitions/various-types-definitions/. [10] Ejusdem generis is a rule used to assign meaning to “general words [that] follow specific words in a statutory enumeration” and requires that “the general words [be] construed to embrace only objects similar in nature to those objects enumerated by the preceding specific words.” Circuit City Stores Inc., v. Adams, 532 U.S. 105 (2001); see also, N. & W. Ry. v. Train Dispatchers, 499 U.S. 117 (1991) (if “the whole context” calls for a different outcome, then ejusdem generis should not be employed). [11] SEC v. Joiner Corp., 320 U.S. 344, 350 (1943) (Court rejected defendants’ use of ejusdem generis rule “to constrict the more general terms to the specific terms which they follow.”) The Court noted that “[n]ovel, uncommon, or irregular devices, whatever they may appear to be, are also reached if it could be proved as a matter of fact that they were widely offered or dealt in under terms or courses of dealing which established their character in commerce as ‘investment contracts,’ or as ‘any interest commonly known as a ‘security.’” Id. at 351. [12] 328 U.S. 293 (1946). [13] For example, the intrastate offering is a transaction exemption based on the jurisdictional scope of federal law. Other transaction-based offerings include private offerings, determined by the number of offerees and buyers, and limited offerings, based on the total proceeds from sales. Also, exemptions based on the entity issuing the security include governmental sales of security at the federal, state, and municipal levels. See, generally, SEC, Exempt Offerings, https://www.sec.gov/smallbusiness/exemptofferings. [14] The SEC has other types of registration, for instance, registration of business enterprises like registered investment companies, business development companies, broker-dealers and individuals, such as registered investment advisers. Registration of specific units of a security under the Securities Act differs in purpose and meaning from registration of a class of security under the Exchange Act. [15] 17 C.F.R. § 239 sets forth the rules for registration and 17 C.F.R. § 239.11 requires, as default, use of Form S-1, at https://www.sec.gov/about/forms/sec870.pdf. Item 16, Exhibits and Financial Statement Schedules, has two subparts: (a) requires exhibits that Item 601 of Regulation S-K requires (17 C.F.R. § 229.601) (exhibits), and (b) requires financial statement schedules that Regulation S-X (17 C.F.R. Part 210) and Item 103 of Regulation S-K (17 C.F.R. § 229.103) require. Section 210.3-01(a) mandates filing, for the registrant and its subsidiaries, “consolidated, audited balance sheets as of the end of each of the two most recent fiscal years,” but “[i]f the registrant has been in existence for less than one fiscal year, there shall be filed an audited balance sheet as of a date within 135 days of the date of filing the registration statement.” The parallelism for a new company, however, does not extend to the income and cash flow statements. Under § 210.3-02(a), the company must file audited statements of consolidated income and cash flows for three years preceding the date of the most recent audited financial balance sheet. [16] “Registration under the Securities Act of 1933,” at https://www.investor.gov/introduction-investing/investing-basics/glossary/registration-under-securities-act-1933. [17] Id. [18] The SEC’s authority to investigate and take action in relation to securities fraud comes from its mandate to enforce the requirements of the Securities Act and Exchange Act, see 15 U.S.C. § 78u(a)(1), and more specifically to bring actions for violations of Section 17(a) of the Securities Act, 15 U.S.C. § 77q(a), and Rule 10b-5, 17 CFR § 240.10b-5, enacted pursuant to Section 10(b) of the Exchange Act, 15 U.S.C. § 78j(b). Both of these provisions taken together prohibit fraud in connection with the offer, purchase, or sale of any “security.” [19] The question of whether the U.S. government should regulate cryptocurrencies through a legislative scheme is a separate topic not addressed in this or the successive articles in this series. [20] The federal criminal code is in Title 18 of the United States Code. Applicable statutes would include 18 U.S.C. § 1341 (Frauds and swindles) and 18 U.S.C. § 1343 (Fraud by wire, radio, or television). [21] The interstate commerce clause of the U.S. Constitution, at Article I, Section 8, Clause 3, grants Congress the power “[t]o regulate Commerce . . . among the several states . . . .” It is used to create federal civil and criminal laws that affect interstate transactions. [22] https://www.investor.gov/introduction-investing/investing-basics/glossary/registration-under-securities-act-1933. [23] The cost of registration is nominal. [24] SEC, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Exch. Act Rel. No. 81207 (July 25, 2017) (“DAO Report”), https://www.sec.gov/litigation/investreport/34-81207.pdf. [25] For convenience, we use the term enforcement action to refer to any SEC lawsuit, whether executed as a legal action in the appropriate United States district court or as an administrative proceeding before an SEC administrative law judge. Federal courts have jurisdiction over violations of the federal securities laws under 15 U.S.C. § 77v(a), 15 U.S.C. § 78aa, and 28 U.S.C. § 1331. [26] “Standalone PDM” is a financial product that functions only or will function only as private money; it has a currency-only function. We discuss its purported function as an investment below. [27] Non-monetary digital assets that are simply perceived as “investments.” This is discussed below in the context of the SEC’s complaint against Ripple Labs, Inc., which the Agency filed on December 22, 2020. [28] The Commodity Futures Trading Commission (CFTC) also considers some PDM to be a commodity. See, e.g., CFTC v. My Big Coin Pay, 334 F. Supp. 3d 492 (D. Mass. 2018). [29] 328 U.S. 293, 298-99 (1946) (“an investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise”). [30] Ignoring the common enterprise requirement (which it referenced in citing Howey and then failed to discuss further), the SEC instead focused on language from a later case: “The ‘touchstone’ of an investment contract ‘is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.’” DAO Report, at 11 (quoting United Housing Found., Inc. v. Forman, 421 U.S. 837, 852-53 (1975)). [31] Although the DAO Report placed great weight upon and discussed at great length the commitment to develop a trading platform for DAO tokens, a cryptocurrency enterprise’s promise to develop blockchain technology that comes with each unit of PDM is no different from a warranty that may come with any product: in each case, the promise creates a separate contract on which the consumer may sue on a breach-of-contract (or warranty) action. [32] Some collectibles are not fungible, which creates a market for that particular type of item within the larger market for such items—see, for example, non-fungible tokens (“NFTs”) and the markets for digital collectibles. Some collectibles can be fungible, however. [33] Scripophily is the hobby of collecting stock certificates of defunct companies. These certificates are no longer securities because their value is not linked to the issuer’s financial performance. They may be valuable, however, as collectibles in a secondary market. [34] SEC, Press Release, SEC Announces Enforcement Initiatives to Combat Cyber-Based Threats and Protect Retail Investors (Sept. 25, 2017), https://www.sec.gov/news/press-release/2017-176. [35] The SEC’s Division of Corporation Finance, which administers the filing of registration forms, has yet to offer any information on how to register units of cryptocurrency for public sale. [36] SEC, Division of Corporation Finance, Announcement, Draft Registration Statement Processing Procedures Expanded (June 29, 2017), https://www.sec.gov/corpfin/announcement/draft-registration-statement-processing-procedures-expanded#_ftn1. [37] We use crypto-company to refer to any company that produces and sells units or “tokens” of cryptocurrency. [38] A search of the SEC’s EDGAR (Electronic Data Gathering and Receipt) program, which contains all issuer files including registration statements, shows no filed registration statements on Form S-1 for crypto-currencies or digital tokens of domestic issuers, which is the form for first-time issuers, and only one registration statement on Form F-1, which is for foreigner issuers. The only companies with activities concerning cryptocurrencies that have succeeded in registration have registered common stock—not cryptocurrencies. They include, for instance, investment pools that hold crypto-currencies and sell equity interests to such pools. [39] SEC, Framework for “Investment Contract” Analysis of Digital Assets (Apr. 3, 2019) (“Framework”), https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets#_edn1. [40] Although under Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984), an agency’s construction of a statute that it regulates is entitled to deference, the Supreme Court has noted that, “in determining whether Congress has specifically addressed the question at issue, a reviewing court should not confine itself to examining a particular statutory provision in isolation. The meaning—or ambiguity—of certain words or phrases may only become evident when placed in context.” FDA v. Brown & Williamson Tobacco Co., 529 U.S. 120, 132-33 (2000) (finding that the FDA did not have jurisdiction to regulate tobacco because Congress had legislated tobacco safety in other statutes outside of the Food, Drug and Cosmetic Act which the FDA enforces). But cf. Credit Suisse Sec. (USA) LLC v. Billing, 551 U.S. 264, 277 (2007) (in finding that the SEC had jurisdiction to regulate underwriters in practices that otherwise might run afoul of the antitrust laws, the Supreme Court noted that “the SEC has continuously exercised its legal authority to regulate conduct of the general kind now at issue.”). [41] In Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 468 U.S. 837 (1984), the Supreme Court constructed a test to determine when a court should defer to an agency’s interpretation of provisions of the statutes it has been tasked with administering. The test is whether the statutory language is ambiguous and, if so, whether the agency’s interpretation is reasonable. A reviewing court accords different levels of deference to an agency interpretation of its own statute depending on the circumstances. United States v. Mead Corp., 533 U.S. 218, 228, 236-37 (2001). In Smith v. Berryhill, __U.S. ___, 139 S. Ct. 1765 (2019), the Supreme Court held that scope of judicial review is not a question that Congress would delegate to an agency.

Question 4

What about Non-Fungible Tokens (NFTs)?

Accepted Answer

A digital asset need not be a financial product generally or a cryptocurrency specifically1; it can be a digital collectible—a blockchain-tracked, non-duplicable digital item or image. Digital collectibles are becoming a popular product in an emerging industry; such a product may become a digital asset and also an investment if a secondary market demand for it develops and grows. One such item, the non-fungible token (“NFT”), is a digital collectible, a unique item that remains the only such “object” or token and the blockchain “effectively gives each NFT a unique and non-hackable certificate of authenticity.”2 This is simply a digitized form of the collectible sports card, such as a baseball or football card, with much better record-keeping and tracking. Perhaps not surprisingly, demand for NFTs is growing as it has been for cryptocurrencies: in fact, on February 28, 2021, CNBC reported on the NBA’s “Top Shot” blockchain-based trading card system, which has generated gross revenue of $230 million.     The emergence of NFTs and similar digital collectibles raises an important question: does or will the SEC equate a digital collectible to a “digital asset” as in the Ripple Complaint and treat NFTs, too, as “investment contracts?” If the answer is “yes,” then one must either distinguish a hard collectible, such as a baseball card made of cardstock, from the digitized version, or treat a baseball card as a security, too. If the answer is “no,” then an NFT and other digital collectibles must be distinguished from digital currency in a way that identifies the peculiarity of the currency. If the differences are insignificant, the question is why hard collectibles are not also securities under the federal securities laws? What makes a coin or paper valuable, whether in hard or digital form, is the same: market demand, both primary and secondary, for that type of “object” and the scarcity of that “object.” This is true for fiat currency as well. All items of value are social constructs, including digital tokens, securities, and money, whether private digital money or fiat currency issued by governments. Although not tangible, each “unit” has its own origin and history. Hard collectibles, digital collectibles, and digital currency or digital assets are all investments in the sense that—if a secondary market exists—one may, upon resale, be able to recover one’s purchase price and a profit as part of the total resale price. Also, these items are all usable in the same way as any asset is usable. They may be flipped for a quick gain, held to increase in value, used to secure loans, or traded for other assets of the same class or otherwise. Is a token’s identity irrelevant? The inability to detect or the indifference to the user of a particular token distinguishes the non-collector from the collector. But each token, non-digital or digital, is different in fact or in concept. Every metallic coin, even if “fungible” in the sense of having been created in a certain denomination and time period, is a unique product with its own history of production, transfers, use, and ownership. A share of stock is a legal construct: tracing the individual, unique, yet fungible units sold is essential to any legal action that asserts violations of the registration mandates of Sections 5(a) and 5(c) of the Securities Act. A collectible digital token usually has an accompanying image. With respect to securities, the image or concretization of the “object” cannot be material, as old stock certificates, each one unique, is giving way to digitized stock. On a preliminary analysis, one can conclude that tokens of digital collectibles are no different from tokens of digital currency.      [1] In its Complaint in SEC v. Ripple, the SEC asserted that “[t]he term ‘digital asset’ or ‘digital token’ generally refers to an asset issued and transferred using distributed ledger or blockchain technology, including assets sometimes referred to as ‘cryptocurrencies,’ ‘virtual currencies,’ digital ‘coins,’ and digital ‘tokens.’” Complaint, SEC v Ripple Labs, Inc., Case No. 1:20-cv-10832, ¶ 32 (SDNY Dec. 22, 2020) (“Ripple Complaint”). [2] Jabari Young, People have spent more than $230 million buying and trading digital collectibles of NBA highlights, CNBC (Feb. 28, 2021).

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