Bridging the Week by Gary DeWaal: November 12 - 16 and November 19, 2018 (New Employee Orientation; Whistleblowing; ICOs and SEC Path Forward)

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Published Date: November 18, 2018

The Commodity Futures Trading Commission’s Division of Enforcement issued its annual report last week; it said the purpose of its enforcement program was to engender a “true culture of compliance.” The Division suggested the measure of success for such culture would be evidenced by a company's chief executive officer threatening new employees during orientation that the company itself would advise law enforcement authorities if they ever violated the company’s internal control requirements. Not exactly the warmest and fuzziest welcome aboard message! Separately, the SEC fined two companies for engaging in initial coin offerings without registration. The SEC also obligated the companies – and they agreed – to pay back initial investors, upon request, the amount of their ICO purchases as well as to file registration statements for their digital tokens. In contemporaneously issued guidance, the SEC said these settlements offered a path forward for other companies previously involved in ICOs. As a result, the following matters are covered in this week’s edition of Bridging the Week:

Because of the United States Thanksgiving holiday, the next regularly scheduled edition of Bridging the Week will be December 3.

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The Division said this would be accomplished when, standing before new hires, the chief executive officer warned that if they violated internal control requirements, not only would they have problems with internal company departments, including compliance, but with the CFTC “and perhaps the DOJ and the FBI.” Why? Because, warned the CEO, “the company is committed to identifying any misconduct and to reporting it out to the relevant authorities.”

In its annual report, the Division noted four of its priorities: preserving market integrity, protecting customers, promoting individual accountability, and augmenting cooperation with other regulators and criminal authorities. To accomplish these objectives, the Division said it began or continued a number of “key” initiatives during FY 2018: evolving its program of cooperation and self-reporting; enhancing data analytics (most notably by moving the Market Surveillance Unit from the Division of Swap Dealer and Intermediary Oversight to the Division); and creating specialized task forces to address spoofing and manipulative trading, virtual currency, insider trading and protection of confidential information, and obligations to file suspicious activity reports and maintain know-your-customer programs for anti-money laundering purposes. 

Consistent with its objectives, the Division observed that it filed 83 new actions in FY 2018, including 30 involving retail fraud, 26 pertaining to manipulative conduct, false reporting and spoofing, and 11 where illegal off-exchange contracts or failure to register was alleged. The Division indicated that more than two-thirds of its enforcement actions named one or more individual, including primary wrongdoers and aiders and abettors. Named individuals included supervisors, desk heads, chief executive officers and a chairman of the board.

Overall the CFTC’s enforcement activities resulted in fines of almost US $900 million in FY 2018, of which almost 95 percent were collected.

The Securities and Exchange Commission’s Division of Enforcement recently released its FY 2018 annual report. The SEC’s DOE noted that, during its 2018 fiscal year, it brought 821 enforcement actions (including 490 so-called stand-alone cases) and obtained over US $3.9 billion in fines and disgorgement pertaining to all types of underlying offenses. (Click here for details in the article “SEC Notes Many Open ICO Investigations in Annual Overview of Enforcement Activities” in the November 4, 2018 edition of Bridging the Week.)

My View: Although it may not rise to the level of John Grisham’s current best seller The Reckoning, the CFTC’s Division of Enforcement’s FY 2018 annual report is compelling reading. It is very concise, well drafted and punchy, and it clearly expounds the objectives of the Division’s enforcement program (whether one agrees with all of them or not) juxtaposed against its FY 2018 accomplishments.

That being said, the most compelling statistic in the Division’s annual report is that the number of whistleblower awards granted by the CFTC in FY 2018 (5) exceeded all whistleblower awards ever previously granted by the Commission (4). Moreover, the amount of awards – in excess of US $75 million – was many times in excess of the aggregate of the dollar value of all whistleblower awards previously given by the CFTC.

The CFTC’s experience in increasingly relying on potentially paid-for tips to formulate investigations is consistent with the experience of the SEC as reflected in an SEC report to Congress last week. According to the SEC, in FY 2018, the agency awarded over US $168 million to 13 persons, compared to US $329 million to 59 individuals overall since the SEC’s whistleblower program began authorizing rewards in 2012. The SEC said it received 5,200 whistleblower tips last fiscal year. (Click here to access a copy of the SEC’s 2018 Whistleblower Program Annual Report to Congress.)

Earlier this year, the United States Supreme Court in Digital Realty Trust, Inc. v. Somers held that employees reporting potential securities law violations by their employers must expressly report such incidents to the SEC in order to benefit from a key anti-retaliation protection under the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. Solely reporting securities law violations to the employer is not enough. (This key benefit is the right of a whistleblower claiming retaliation to sue an employer directly in a federal court at any time within six years. Click here for details on the Supreme Court’s decision in the article “Supreme Court Narrows Key Whistleblowing Protection” in the February 25, 2018 edition of Bridging the Week.)

To better align its rules with Digital Realty, to increase efficiencies in the claims process, and to potentially reduce very large awards where total monetary sanctions are at least US $100 million, the SEC proposed amendments to its whistleblower program in July 2018. Over 100 distinct comments were received in response. (Click here for background in the article “Whistleblower Receives US $30 Million Payment From CFTC – Largest Award to Date; SEC Proposed Updates to Its Whistleblower Rules” in the July 15, 2018 edition of Bridging the Week.)

The challenge for companies is to encourage employees to report potential compliance issues internally and not be seduced by the lure of a big potential monetary reward for reporting problems to a government agency. Unfortunately, current whistleblowing incentives, while helpful for the government to receive tips, impede a strong compliance culture by discouraging employees from working with management to collectively root out wrongdoing. Notwithstanding, management must promote an environment where employees are encouraged if not mandated to report problems – despite the potentially rich inducements dangled by government whistleblower regimes. They must accomplish this while not in any manner discouraging (let alone penalizing) employees from whistleblowing to the government, however.

In its enforcement action against CarrierEQ Inc. d/b/a AirFox, the SEC alleged that the company issued digital tokens on the Ethereum blockchain – termed “AirTokens” – to raise funds to develop a “new, international business and ecosystem” that would permit holders to transfer AirTokens to each other, engage in peer-to-peer lending, and to buy and sell goods and services, as well as take advantage of existing company functionality. Prior to the ICO, AirFox was principally a bricks and mortar company that sold technology that allowed customers of certain prepaid mobile telecommunications operations to earn free or discounted airtime or data for viewing advertisements on their smartphones.

In its enforcement proceeding against Paragon Coin, Inc., the SEC claimed that the company initiated an ICO to raise funds to bring blockchain technology to the cannabis industry and promote the legalization of cannabis. Digital tokens issued in connection with the ICO were named “Paragon Coins” or “PRG.”

Both companies promoted their ICOs as an opportunity to profit through appreciation in the price of their tokens, said the SEC. Neither AirFox’s nor Paragon’s blockchain-based business models were up and running at the time of their ICOs, which were marketed, noted the SEC, to the general public. Each company said they would take steps to list their tokens on secondary markets.

AirFox raised approximately US $15 million and Paragon, approximately US $12 million in value through their ICOs.

In accepting settlements from the respondents, the SEC noted that each company’s digital tokens were investment contracts, and thus securities under applicable law. This is because purchase of the digital tokens represented an investment in a common enterprise with a reasonable expectation of profits through the entrepreneurial or managerial efforts of others. The offer of these securities to the general public required registration, said the SEC.

To resolve these actions, each respondent agreed to pay a fine of US $250,000, file a registration statement with the SEC, and pay back, upon request, any initial purchaser of a digital token from the issuer. This pay back undertaking does not appear to apply to any secondary market purchaser of a digital token.

Contemporaneously with publication of its two settlement orders, the SEC issued a “Statement of Digital Asset Securities Issuance and Trading” by the Divisions of Corporation Finance, Investment Management and Trading and Markets that reviewed recent SEC enforcement actions against initial offerors and brokers of cryptosecurities, investment vehicles investing in cryptosecurities, and secondary market facilities for the trading of cryptosecurities. Among other things, the Divisions indicated that the AirFox and Paragon settlements provided a “path to compliance” for prior issuers of unregistered or not lawfully exempt cryptosecurities. (Click here to access the Division’s guidance.)

In other legal developments involving cryptoassets:

Legal Weeds:In July 2017, the SEC published a Report of Investigation that concluded that digital tokens issued by an entity for the purpose of raising funds for projects – even if using distributed ledger or blockchain technology – may be securities under federal law. If so, such securities must be registered with the Commission or eligible for an exemption from registration requirements. Moreover, the SEC concluded that any person offering trading facilities like an exchange for digital tokens that are securities must be registered as a national securities exchange or be exempt from such registration requirement. 

The SEC’s Report followed an investigation by the SEC’s Division of Enforcement which concluded that digital tokens offered and sold during April and May 2016 by DAO, an unincorporated virtual organization created by UG, a German corporation, were securities subject to the SEC’s registration requirements. (Click here for background on the SEC’s DAO report in the article “SEC Declines to Prosecute Issuer of Digital Tokens That It Deems Securities Not Issued in Accordance with US Securities Laws” in the July 26, 2017 edition of Between Bridges.)

A few months later, the SEC filed and simultaneously resolved an enforcement proceeding against Munchee Inc., for conducting an initial digital coin offering of MUN digital tokens that constituted the unregistered offer or sale of securities. Munchee agreed to cease and desist from its violations to settle this matter. It was not required to pay any fine. The company voluntary returned all funds it had received from token purchasers – US $60,000.

Munchee claimed in its promotional efforts that MUN tokens would rise in value as a result of the firm’s managerial efforts, and that MUN tokens would be traded on secondary markets. Holders of MUN tokens would not receive any income or dividends from Munchee. Although Munchee described utility benefits of possessing MUNs in promotional materials and other marketing efforts, (e.g., the more MUNs a person held, the more MUNs it would receive for writing restaurant reviews), the SEC said that principal benefit of holding MUNs was the potential for appreciation of their value through Munchee’s entrepreneurial efforts. 

According to the SEC, “[d]etermining whether a transaction involves a security does not turn on labeling – such as characterizing an ICO as involving a ‘utility token’ – but instead requires an assessment of ‘the economic realities underlying a transaction’.” (Click here for background regarding the SEC’s Munchee Order in the article “Non-Registered Cryptocurrency Based on Munchee Food App Fails to Satisfy SEC’s Appetite for Non-Security” in the December 17, 2017 edition of Bridging the Week.)

In its decision denying Mr. Zaslavskiy’s motion to dismiss, the federal district court in Brooklyn upheld that, based on facts and circumstances, cryptoassets issued as part of ICOs could be securities under federal law.

Last week’s enforcement actions against CarrierEQ and Paragon Coin make clear that the SEC views cryptoassets (1) issued in ICOs or pre-ICO offerings (2) to fund non-developed projects (3) marketed as an opportunity to gain profits through secondary market trading if the project was successful (4) relying on the managerial or entrepreneurial efforts of the projects’ promoters, as securities that, if sold to the general public, must be registered under applicable law. 

An entity that previously engaged in an ICO of a cryptoasset that the SEC is likely to regard as a security without registration or a valid exemption must now consider self-reporting its ICO to the SEC, formally qualifying its cryptosecurities, offering to buy back previously issued digital tokens, and potentially paying a fine. 

My View: Last week, Christine LaGarde, the former Minister of Economic Affairs for France and currently the Managing Director and Chairwoman of the International Monetary Fund, said that central banks should consider “the possibility to issue digital currency” in a speech before the Singapore Fintech Festival. She articulated three benefits of digital currencies: their ability to reach persons in remote parts of the world not routinely serviced by banks; security and consumer protection; and privacy. Although she noted three principal risks in central bank-supported digital currencies – risks to financial integrity, financial stability and innovation – the potential for digital currencies to result in payments that would be “immediate, safe, cheap and potentially semi-anonymous” justify their consideration. 

When a world regulatory icon like Ms. LeGarde so openly embraces the potential for state bank-issued virtual currencies, it is clear that digital ledger technology and cryptoassets are not going away anytime soon.

My View2: NY DFS’s approval of NYDIG to engage in services involving XRP is not the first time the agency has equated XRP as a virtual currency. (Click here, e.g., for NY DFS’s approval order for Coinbase Custody Trust Company LLC.) This may be useful precedent for persons who trade XRP as a virtual currency and not as a cryptosecurity. Whether XRP is a virtual currency or security has been the subject of recent debates. (Click here for background in the My View commentary to the article “Anything but Sleep Inducing: SEC Corporate Finance Director Says Ether Not a Security and Canada Issues Guidance on Utility Tokens” in the June 17, 2018 edition of Bridging the Week.)

More Briefly:

Separately, Enhui Ban and Lili Hao were each banned from ever trading on any CME Group market for not participating in a COMEX staff investigation or answering charges brought against them.

For further information

CFTC Chairman Urges World Adoption of Market Capitalism:

CFTC Enforcement Division Lauds Success of FY 2018 Accomplishments; Says Goal Is to Foster “True Culture of Compliance”:

CFTC, SEC and State of Utah Sue Coin Shop for Running Purported Ponzi Scheme Based on Silver:

COMEX Sanctions Nonmember for Wash Trades; Two Others Penalized for Not Participating in an Exchange Investigation:

Defendant Pleads Guilty to Securities Fraud in Connection with Two Initial Coin Offerings:

Defendants in Criminal Action Argue Spoofing Not Wire Fraud:

Michigan Disallows Campaign Donations Made in Cryptocurrencies

NY DFS Grants Another Virtual Currency and Money Transmitter License:

SEC Assesses Penalties for Non-Fraudulent Initial Coin Offerings and Requires Registration; Issues Advisory on Issuance and Trading of Cryptosecurities:

The information in this article is for informational purposes only and is derived from sources believed to be reliable as of November 17, 2018. No representation or warranty is made regarding the accuracy of any statement or information in this article. Also, the information in this article is not intended as a substitute for legal counsel, and is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. The impact of the law for any particular situation depends on a variety of factors; therefore, readers of this article should not act upon any information in the article without seeking professional legal counsel. Katten Muchin Rosenman LLP may represent one or more entities mentioned in this article. Quotations attributable to speeches are from published remarks and may not reflect statements actually made. Views of the author may not necessarily reflect views of Katten Muchin or any of its partners or other employees.

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Gary DeWaal

Gary DeWaal is currently Special Counsel with Katten Muchin Rosenman LLP in its New York office focusing on financial services regulatory matters. He provides advisory services and assists with investigations and litigation.

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