The staff of the Divisions of Enforcement and Trading and Markets (collectively, Staff) of the U.S. Securities and Exchange Commission (SEC) on March 7, 2018 jointly issued a statement on digital asset trading platforms (Statement),1 which is addressed to investors as well as the market participants operating such platforms. The Statement reiterates that, if a platform “offers trading of digital assets that are securities” and “operates as ‘exchange,’ as defined by the federal securities laws,”2 the platform must register with the SEC as a national securities exchange or be exempt from registration. The Statement serves as both: (i) an informational guide for investors using online trading platforms; and (ii) a warning to operators of those platforms that the SEC is actively monitoring for potentially fraudulent or manipulative behavior in the market for security tokens, as the SEC has cautioned recently for initial coin offerings (ICOs).
The Statement is the latest in a series of recent actions by the SEC addressing issues relating to digital assets, such as SEC Chairman Clayton’s statement on December 11, 2017.3 However, this is the Division of Trading and Markets’ first formal guidance on the subject. The Statement follows a recent enforcement action in which the Division of Enforcement alleged, among other things, that online platform BitFunder and its founder had: offered trading in digital assets that qualified as securities; facilitated unregistered offerings of securities; defrauded investors by failing to disclose a cyberattack on the platform; and failed to either register a national securities exchange or obtain formal exemption from registration.4
The BitFunder enforcement action demonstrates the potential risks to investors using unregistered exchanges, as well as the potential liability that online trading platforms and their operators could face by operating outside of SEC review. Notably, in addition to bringing an action against the platform, the Division of Enforcement alleged that its founder, as a “control person” liable under Section 20(a) of the Securities Exchange Act of 1934 (Exchange Act), controlled BitFunder and was a “culpable participant” in BitFunder’s failure to register as a securities exchange. Under the Exchange Act, a person who directly or indirectly controls an entity liable under any provision of the Exchange Act, or the rules thereunder, may be liable jointly and severally with, and to the same extent as, the entity under such person’s control, unless the controlling person acted in good faith and did not directly or indirectly induce the controlled entity’s violation.5 Therefore, the individual operators of digital asset trading platforms should be aware of their potential personal liability, in addition to the entity’s liability, if the trading platform violates US securities laws.
Considerations for Investors
The Statement provides guidance to investors navigating online trading platforms for digital assets. The Staff urges investors to rely on platforms or entities registered with the SEC, such as national securities exchanges, alternative trading systems (ATSs) and broker-dealers, in order to gain the protections of federal securities laws and SEC oversight.
The Statement states that many platforms describe themselves as “exchanges” when they are neither regulated by the SEC nor meet the regulatory standards of a national securities exchange. The Statement cautions investors not to assume that an unregistered, non-exempt online trading platform will offer services equivalent to those provided by a platform subject to SEC review, irrespective of what a given platform may claim about its standards, its trading protocols or the exchange-like functions it purports to perform.
The Statement also provides a number of resources and considerations to aid investors in their decision-making with respect to online trading platforms offering digital assets. These resources include a series of due diligence questions that the Staff recommends investors pose to a platform provider before deciding to trade digital assets on such platform, as well as links to a number of SEC tools.
Considerations for Market Participants
In the Statement, the Staff also discusses considerations for market participants that operate or are considering operating online trading platforms for securities. The Staff states that there are two options for such market participants: to register the platform as a national securities exchange; or to operate under an exemption (e.g., the exemption available to broker-dealers that register as ATSs pursuant to SEC Regulation ATS).
The Staff describes several key regulatory requirements with which a registered national security exchange must comply. First, the exchange must have rules in place to prevent acts of fraud and market manipulation. Second, as national security exchanges are self-regulated, they must also have internal governance and self-regulatory procedures that will not only discipline members when needed, but also enforce compliance with federal securities laws and the exchange’s own rules. Finally, a national security exchange must file its rules with the SEC.
Alternatively, a platform that wants to use the ATS exemption must follow a separate suite of regulatory requirements, including registering with the SEC as a broker-dealer and becoming a member of the Financial Industry Regulatory Authority. Broker-dealer and ATS registration subjects trading platforms to a panoply of regulatory requirements governing all aspects of their business, finances and operations. The Staff cautions that some online platforms that may not meet the definition of an exchange nevertheless offer trading services for digital assets that are securities. Some of these include sites that offer digital wallets that allow a user to hold or transact in digital assets that are securities. These platforms, the Staff warns, could implicate a number of registration requirements under federal laws and regulations, including as transfer agent and clearing agencies as well as exchanges, ATSs and broker-dealers. The Staff further reminds market participants that a platform offering digital assets could be seen as participating in an unregistered offering of securities, if those digital assets are not registered or otherwise exempt from registration.
The SEC’s recent actions, including issuance of the Statement and the BitFunder enforcement action, make clear that the agency continues to apply the existing securities law framework to the digital asset market, and will use its enforcement power as it feels appropriate to enforce federal securities laws. Platform operators and market participants are on notice of the need to register with the SEC as an exchange or an ATS if any digital asset traded thereon may be considered a security.
It is important for operators on non-U.S. platforms to bear in mind that a platform’s location outside of the United States may not render the SEC’s positions described above inapplicable if the SEC has jurisdiction over the activities of the platform, including through the participation of U.S. persons in the platform. The SEC takes an expansive view of its jurisdiction in these areas, and, to the extent that a non-U.S. platform permits U.S. persons to transact, the SEC likely would require the platform to comply with the above requirements.
To assess whether registration as an exchange is necessary, operators of digital asset trading platforms should first determine whether any of the digital assets traded on their platforms are securities. SEC Chairman Clayton recently emphasized that whether a token is a security is a matter of substance, not form.6 Similarly, the Commodity Futures Trading Commission (CFTC) has separately brought enforcement actions against digital asset exchanges that were not properly registered with the CFTC.7 As the SEC, CFTC and other regulators continue to focus on digital assets and the ICO market, issuers of tokens and the platforms that seek to develop secondary markets for them should continue to observe SEC and other relevant regulatory requirements.
1) Securities and Exchange Commission, Divisions of Enforcement and Trading and Markets, Statement on Potentially Unlawful Online Platforms for Trading Digital Assets (Mar. 7, 2018).
2) Under Section 3(a) of the Exchange Act, an “exchange” is “any organization, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as that term is generally understood…” See also Exchange Act Rule 3b-16 (further defining an exchange as an “organization, association, or group of persons” that “(1) [b]rings together the orders for securities of multiple buyers and sellers; and (2) [u]ses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of a trade.”)
3) See, e.g., Statement on Cryptocurrencies and Initial Coin Offerings, Remarks of SEC Chairman Jay Clayton (Dec. 11, 2017).
4) See Securities and Exchange Commission against Jon E. Montroll and BitFunder, 1:18-cv-01582, filed February 21, 2018.
5) Section 20(a) of the Exchange Act, 15 U.S. C. § 78t.
6) See Statement on Cryptocurrencies and Initial Coin Offerings, Remarks of SEC Chairman Jay Clayton, supra note 3.
7) In the Matter of: BFXNA INC. d/b/a BITFINEX, Respondent, 2016 WL 3137612, CFTC No. 16-19 (2016).