In the fall of 2017, the United States Department of Justice (“DOJ”) and the Securities and Exchange Commission (“SEC”) each filed actions against Maksim Zaslavskiy for securities fraud in connection with two token offerings, through which he promised token purchasers profits from his companies’ investments in real estate and diamonds. Zaslavskiy’s motion to dismiss the criminal indictment is currently pending before Judge Dearie in the Eastern District of New York. The briefing submitted in connection with this motion reflects the DOJ and SEC’s coordinated approach in applying the securities laws to token sales, emphasizing a focus on “substance over form” and the importance of assessing the present state of a company’s technology in determining whether a token constitutes a security. The briefing also underscores both the DOJ’s and the SEC’s focus on holding companies accountable for fraudulent statements to investors, in whatever form such statements may come.
This case offers a prime example of the kinds of conduct that the regulators deem most troubling in the context of token sales: the complaints allege that Zaslavskiy made explicit promises to token purchasers that they would enjoy large profits from their investment, without undertaking any efforts to build a legitimate business or deliver on those promises. But even for blockchain companies that have been vigilant in adhering to the emerging regulatory guidance, the Zaslavskiy case still warrants attention and careful consideration. Not only does it shed light on how the DOJ and the SEC will apply the securities laws to token sales, but this case will also inform how the federal courts consider these issues in both the criminal and civil contexts going forward.
In advance of the oral argument scheduled for tomorrow, April 27, 2018, concerning Zaslavskiy’s motion to dismiss, this article provides an overview of the Zaslavskiy case and offers practical considerations that can be gleaned from the briefing on motion to dismiss.
Factual Allegations Underlying Parallel SEC and DOJ Actions
REcoin Group Foundation LLC (“REcoin”) was purportedly engaged in the business of investing in real estate and developing real estate-related smart contracts. Around July 2017, Maksim Zaslavskiy—the founder and CEO—conducted an initial coin offering (“ICO”) on behalf of REcoin. He described REcoin as a “new blockchain” virtual currency that was “backed by real estate investments in developed economies.” The whitepaper also touted REcoin as an “attractive investment opportunity [that] grows in value,” and projected return annual profits of 9 – 67%. In all, approximately 1,000 individuals purchased tokens during the REcoin ICO.
The SEC and the DOJ allege Zaslavskiy made several material misrepresentations concerning the REcoin ICO, including misleading investors concerning: (i) concrete steps undertaken to purchase real estate to “back” the tokens; (ii) efforts made to hire a team of “brokers, lawyers, and developers” that he represented would ensure the project’s success; (iii) the touted compliance with the securities laws; (iv) the proceeds raised from the ICO; and (v) the company’s intention to actually develop and released the described tokens.
Shortly after the SEC first contacted Zaslavskiy regarding REcoin, he announced a new venture, Diamond Reserve Club (“Diamond”), that was purportedly engaged in the business of investing in diamonds. Diamond announced the launch of an “Initial Membership Offering” (“IMO”), a tokenized membership generating event for the company. In a September 11, 2017 release on Reddit, Zaslavskiy claimed that the REcoin offering was being shut down due to Government interference (though he later admitted in his testimony before the SEC that he instead decided to shut down the REcoin ICO because it was “too risky” to invest in real estate), and offered REcoin token purchasers either a refund, or the ability to convert their REcoin tokens into Diamond tokens at a discount. The Diamond whitepaper proclaimed that Diamond coins were “hedged by physical diamonds which are stored in secure locations in the United States and are fully insured for their value.” Like REcoin, Zaslavskiy emailed investors regarding the forecasted “minimum growth of 10% to 15% per year” in Diamond and stating that “negotiations with different exchanges” were ongoing and Diamond coins were tradable “on external exchanges and make more profit.”
The SEC and the DOJ allege Zaslavskiy made several material misrepresentations concerning the IMO, including misleading investors concerning: (i) the amount raised in the REcoin ICO; (ii) the reason for the decision to shut down the REcoin ICO; (iii) concrete steps undertaken to procure diamonds to hedge the tokens; and (iv) the company’s intention to actually develop and released the described tokens.
Shortly after the launch of the Diamond “IMO,” on September 29, 2017, the SEC filed a complaint against Zaslavskiy alleging (i) that both the REcoin ICO and the Diamond IMO were unregistered offerings of securities; and (ii) that Zaslavskiy made a series of false and misleading statements in connection with both token sales. On November 21, 2017, Zaslavskiy was indicted for substantially the same conduct as alleged in the SEC Complaint. On January 31, 2018, the SEC action was stayed pending resolution of the DOJ’s action.
Zaslavskiy’s Motion to Dismiss the Indictment
On February 27, 2018, Zaslavskiy filed a motion to dismiss the indictment in the criminal case. The Court has been asked to consider: (i) whether the securities laws are appropriately applied to cryptocurrencies; (ii) whether Zaslavskiy’s token sales constitute “investment contracts” under the test articulated in SEC v. W.J. Howey Co., 328 U.S. 293 (1946); and (iii) whether the securities laws are void for vagueness as applied to cryptocurrencies and token sales.
The DOJ and the SEC each filed briefs in opposition to Zaslavskiy’s motion. The DOJ characterized Zaslavskiy’s brief as a failed attempt to recast REcoin and Diamond coins as “currencies” rather than securities, where both tokens constituted “prototypical investment contract[s].” The SEC agreed, characterizing Zaslavskiy’s offerings as “old-fashioned fraud dressed in a new-fashioned label.” On reply, Zaslavskiy characterized the DOJ and SEC’s briefing as inviting the court to grant the government “carte blanche to regulate industries whether it has the legal authority to do so or not.”
The briefing addresses three main issues:
1) Whether Cryptocurrencies Exist Outside the Securities Laws as a General Matter – Zaslavskiy argued that REcoin and Diamond coins are both “cryptocurrencies” and are thereby expressly excluded from the reach of the 1934 Act. Accordingly, he argued, the securities laws should therefore not apply to REcoin and Diamond. The SEC and the DOJ challenged Zaslavskiy’s urging of the court to issue a “broad ruling” that cryptocurrencies – as a class of assets – are statutorily exempt from the definition of securities under the Securities and Exchange Acts. The DOJ argued that there is no support for the defendant’s position that REcoin and Diamond tokens are currencies, arguing that REcoin and Diamond could not be so categorized because: (1) neither token had any value, since no token was ever developed; and (2) the tokens were marketed as an “attractive investment opportunity” that “grows in value,” rather than an aspiring substitute for cash, like Bitcoin. The SEC further argued that even if Zaslavskiy legitimately intended for the tokens to eventually be used as cryptocurrency, unsupported by the current state of the technology REcoin and Diamond coins were not actually cryptocurrency, even if so-named. On reply, Zaslavskiy contended that the DOJ “advances an expansive view of ‘money’ when it supports its prosecutorial prerogatives” by asking the court to apply a broad definition of money to its Howey analysis, but a restrictive definition to the statutory analysis of the currency exception.
Where the Eastern District of New York has recently found that regulators may exercise concurrent jurisdiction over cryptocurrencies until Congress provides further guidance, it is unlikely that the Court will rule in Zaslavskiy’s favor that the securities laws by definition do not apply to “cryptocurrencies.” But where the DOJ and SEC suggest a narrow definition of what digital assets may qualify as true “currencies,” and Zaslavskiy advocates for more expansive treatment, the Court could use this motion as an opportunity to provide additional guidance on the features of a particular digital asset that might qualify as a “currency” akin to Bitcoin.
2) Whether REcoin and Diamond Coins are Securities Under the Howey Test – Zaslavskiy argued on motion to dismiss that REcoin and Diamond coins were not investment contracts, because the token offerings do not satisfy the test set forth in SEC v. W.J. Howey Co., et al., 328 U.S. 293 (1946). Howey focuses specifically on the term “investment contract.” Courts often break the Howey test into four prongs to determine (1) whether an investment of money exists, (2) whether a common enterprise exists, (3) whether an expectation of profits exists, and (4) whether the expectation of profits is based solely from the efforts of others. Zaslavskiy argued that the first prong of Howey – “an investment of money” – is not met, because “[i]ndividuals who choose to buy REcoin or [Diamond] coins are simply exchanging one medium of currency for another, they are not ‘investing.’” Zaslavskiy also argued that the second prong – “a common enterprise” – is not established, because (i) there is no horizontal commonality because assets are not pooled; and (ii) there is no vertical commonality with Zaslavskiy because his profits were independent from any rise or fall in value of the tokens. Finally, Zaslavskiy argued that the profits in REcoin or Diamond coins are not “derived solely from the effort of others” because the token holders contribute value to the ecosystem and would be controlled by market forces, rather than managerial efforts, thus defeating the last prong of Howey.
In response, casting Howey as a “flexible” and “highly fact-specific” test, the DOJ emphasized that a case-by-case approach is especially appropriate when analyzing a “relatively new, hybrid vehicle” such as cryptocurrency. The DOJ argued that the first prong of Howey is satisfied here, where the token purchasers paid consideration in exchange for a financial interest in REcoin and Diamond. The SEC agreed, emphasizing that any “exchange of value,” including “exchanging one medium of currency for another,” is enough to satisfy this first prong.
The DOJ argued that the second prong of Howey is also satisfied because there is horizontal commonality where all of the assets from token purchasers were pooled together to support the purported investments and profits were to be apportioned on a per token basis, thus satisfying pro-rata distribution. The SEC agreed, emphasizing that the “fortunes of each investor depended on the profitability of the venture as a whole.” Both agencies also argued that strict vertical commonality was established, because Zaslavskiy’s commissions were ultimately tied to the performance of the investment and the token holders’ ability to exploit the token’s value.
The regard to an expectation of profits, both agencies pointed to various statements in the promotional materials that supported the token purchasers’ expectation of high returns derived from the efforts of Zaslavskiy and his management team. The DOJ rejected out-of-hand the defendant’s argument that the token purchasers – rather than management – were essential to the success of the “blockchain ecosystem” as having “no basis in reality.” The SEC agreed, arguing that even if the investors’ efforts help to make the enterprise profitable, those efforts do not negate a promoter’s significant managerial efforts in satisfaction of Howey. On reply, Zaslavskiy did not dispute that some of the value in the REcoin and DRC projects were to be derived from his managerial efforts, but argued that the decentralized cryptocurrency network necessarily “distributes the responsibilities for profits across all of its participants” and is “fundamentally at odds with [] prong three of the Howey test.”
In sum, Zaslavskiy seems to face an uphill battle in defeating the Howey factors on motion to dismiss, given the allegations that: (1) individuals purchased tokens with fiat and cryptocurrency; (2) the investors assets were pooled to support the supposed investments in diamonds and real estate; and (3) they were promised considerable returns on their investment, based on the expertise of a team of professionals in making wise investment decisions. Even still, the DOJ’s and the SEC’s detailed application of the Howey factors in their opposition briefs provides a useful lens through which anyone engaged in a token sale can assess how the regulatory authorities might view their particular token under Howey. In addition, Zaslavskiy’s argument that a decentralized blockchain platform necessarily spreads responsibility among all of its users – rather than solely on the efforts of management – is an interesting one. While this is perhaps not the best test for such a theory (as it is alleged that the platform was not developed and the success of the venture would depend on the management team’s investment decisions), the underlying premise of this argument raises the potential shortcomings of assessing new technology based upon old guidelines and tests. That is, can a court properly assess the relative contributions of users on a platform utilizing distributed ledger technology using a test developed in the 1940’s to assess interests in a citrus grove? These arguments are likely to come up in the context of other regulatory actions in this space, the Court could use this motion as an opportunity to opine on whether – and to what extent – the decentralized nature of blockchain platforms should impact the Howey analysis.
3) Whether The Securities Laws as Applied to Cryptocurrencies Are Void for Vagueness – Finally, in his motion, Zaslavskiy characterized the DOJ’s attempt to regulate cryptocurrencies using securities laws as “troubling,” arguing that there is “no meaningful guidance for would-be developers to know whether their work runs afoul of criminal securities laws.” Zaslavskiy also argued that using the Howey test to determine the lawfulness of a given ICO creates an “ad hoc” or “case by case” determination of criminal liability, which runs afoul with Due Process.
In response, the DOJ and SEC emphasized that the definition of an investment contract is “time-tested and flexible.” The DOJ argued that the securities laws “comfortably survive … a repackaged facial attack,” and that Zaslavskiy’s conduct “comfortably fit within” the definition of an investment contract under Howey, as developed through a “rich body of case law.” The DOJ argued that the underlying statutes give a person of ordinary intelligence a reasonable opportunity to know what is prohibited. The DOJ also pointed to evidence that Zaslavskiy himself understood the potential implications of the securities laws, including evidence of: (1) representations that REcoin was in “full compliance” with such laws on his token sales; and (2) Zaslavskiy “switched strategies” to an “IMO” shortly after the SEC’s initial outreach. The SEC agreed with the DOJ’s position, addressing this argument only in a footnote. On reply, Zaslavskiy characterized the current cryptocurrency landscape as a “regulatory maze marked by conflicting statements, ambiguity and enforcement actions contrary to law” with, for example, the CFTC defining cryptocurrencies as commodities but FinCEN defining cryptocurrency as something akin to money. Furthermore, Zaslavskiy argued that, notwithstanding the SEC’s promulgated statements regarding ICOs, its guidance is inadequate to provide notice in large part because it declined to engage in its formal rulemaking process.
While SEC went to great lengths to outline the guidance that the Commission has provided on cryptocurrencies and token sales over the past nine months, many blockchain companies would likely agree with Zaslavskiy’s general position that the application of the securities laws to ICOs has felt like a moving target. While unlikely to be dispositive on this motion to dismiss, Zaslavskiy’s arguments on this point underscore the need for further clarity – and more explicit parameters– as blockchain companies seek to structure complaint token sales in the current regulatory environment. The Court could use this motion as an opportunity to opine on a means by which the SEC and DOJ could assist in providing the community with such clarity.
Practical Implications
The briefing on motion to dismiss in the Zaslavskiy case sheds light on several emerging trends in the securities regulation of token sales:
Coordinated Effort and Approach: The Zaslavskiy briefing demonstrates that the DOJ and SEC are coordinated in their approach to the investigation and pursuit of securities law violations in the context of token sales, and that the agencies will follow a case-by-case approach when assessing potential civil and criminal liability. The motion to dismiss briefing in Zaslavskiy illuminates how the DOJ and the SEC will employ the Howey factors, in particular: (1) the “investment of money” prong of Howey will be assessed broadly to include any “exchange of value,” which could potentially extend beyond traditional exchanges of one form of currency for another; and (2) that touting the expertise of a management team in a company’s market materials will be considered evidence of an expectation that profits will arise largely from those “managerial efforts,” regardless of whether some incremental value is arguably provided by the token purchasers themselves.
Focus on Substance over Form: Consistent with the guidance in the DAO Investigative Report and SEC Chairman Clayton’s recent public statements, both the SEC and the DOJ will continue to look at substance over form when assessing potential violations of the securities laws. It is therefore less important whether a company calls its token sale an “initial coin offering,” a “token generation event,” or an “initial membership offering,” and more important that the company conducts its token sale – and its underlying business – in accordance with the current regulatory guidance. The regulators will look at what a company is actually doing, rather than what its whitepaper says it is doing.
We Are On Notice: The SEC’s opposition brief offers a comprehensive overview of the recent guidance on the application of the securities laws to token sales – from the DAO Investigative Report, the Munchee cease and desist order, and the SEC’s recent press releases. While this area of the law is constantly evolving, it is clear that the SEC will seek to hold companies and individuals accountable for their adherence to the guidance that is publicly-available at the time that they choose to act. As such, blockchain companies – and those who assist in token sales – must make it a priority to stay informed as additional guidance becomes available. What is more, consistent with SEC Chairman Clayton’s recent comments, those advising companies in connection with token sales must seek to address and respond to the regulatory guidance head-on, rather than looking for ways to circumvent the strictures of the securities laws.
Jurisdictional Debates Remain: While there is still considerable uncertainty as to which regulatory agency might exercise jurisdiction over a particular token, the SEC and the DOJ have made clear that simply labeling a token a “cryptocurrency” will not eliminate the application of the securities laws. Indeed, rather than focusing on the aspirational, long-term goals for a particular token – including its potential to eventually serve as an alternative currency – the DOJ and the SEC will instead assess the token’s present functionality in determining whether the securities laws should apply.
Misrepresentations Can Take Many Forms: The DOJ and SEC complaints against Zaslavskiy emphasize that both agencies are monitoring all forms of electronic communication for potential misstatements in violation of the securities laws, including (i) whitepapers; (ii) formal and informal communications made via online social media platforms; and (iii) email communications between company representatives and token purchasers. Companies must therefore be vigilant in monitoring all forms of communication with token purchasers and the general public to ensure that any statements attributable to the company are accurate and not misleading. Companies should also educate their employees about the risk of liability for misstatements in any public forum, including the regulators’ particular focus on statements that could be understood as: (1) statements about the investment potential of tokens; (2) overstatements of actual or projected token sales; (3) statements about token functionality or platform features that do not yet exist; (4) statements touting the availability of tokens for exchange on the second market; (5) statements misrepresenting the credentials, experience, or membership of the project team; and (6) statements ensuring compliance of a particular token sale to the federal securities laws.
Conclusion
The Zaslavskiy case provides helpful direction as to how the DOJ and the SEC are currently approaching the application of the securities laws – and the Howey test in particular – to token sales. In this evolving regulatory environment, it is essential for companies issuing tokens to stay apprised of emerging regulatory guidance in all forms, as the regulators will hold companies accountable for their adherence to these developing standards. In the event that the DOJ or the SEC contracts you directly, please direct them immediately to legal counsel.