January 04, 2019 Top Story

Cryptocurrency Covered Under Securities Laws, Federal Court Rules

Transactions constituted investment contracts subject to securities law

By Martha L. Kohlstrand

For the first time, a federal district court has ruled that cryptocurrencies may be covered by U.S. securities laws.

In United States v. Zaslavskiy, the U.S. District Court for the Eastern District of New York held that an initial coin offering (ICO) may be subject to the securities laws, a decision that could have far-reaching implications for litigators, ABA Section of Litigation leaders say.

Brooklyn Businessman Argues Cryptocurrencies, Not Securities

In 2017, a Brooklyn entrepreneur founded two companies: one, which supposedly engaged in real estate investment and real estate–related “smart contracts,” and another, which purportedly invested in diamonds. To fund his companies, the entrepreneur induced investors to purchase cryptocurrency “tokens” or “coins” using credit cards, virtual currency, and online transfers. He claimed that the companies would soon launch ICOs, promising investors that one was backed by real estate and the other was “hedged by physical diamonds stored in secure locations in the United States and fully insured for their value.” But the companies were not what they seemed. Contrary to the entrepreneur’s representations, the companies never invested in real estate or diamonds and neither company developed any tokens or coins.

The entrepreneur was indicted under the U.S. securities laws but filed a motion to dismiss, arguing that the ICOs in question were not securities but currencies instead. The grand jury alleged in the indictment that the touted investments were “investment contracts, and therefore ‘securities’ as defined by Section 2(a)(1) of the Securities Act and Section 3(a)(10) of the Exchange Act.”

Court Applies Howey Test to Determine Investments Could Be Securities

The court relied on a U.S. Supreme Court case, Securities Exchange Commissions (SEC) v. W.J. Howey Co., to determine that the U.S. securities laws applied. In Howey, the Court held that the offer of a land sales and service contract was subject to the securities laws and laid out a test to determine whether an instrument is an “investment contract” and, therefore, subject to these laws. According to Howey, an investment contract is a “contract, transaction, or scheme whereby a person (1) invests his money (2) in a common enterprise and (3) is led to expect profits solely from the efforts of the promoter or third party.”

The district court concluded the first Howey prong was met because individuals invested money and other forms of payment in the companies believing they were purchasing investment-backed virtual tokens or coins. The court rejected the entrepreneur’s argument that the investments were not an investment of money because they were merely an exchange of one form of currency for another, and currencies are by definition not securities. Instead, the court determined that investors were not actually purchasing currency, but were giving up money or assets in exchange for “memberships” in either venture. Simply labeling the investment schemes as “virtual currency” or “cryptocurrency” did not transform a security into a currency.

As to the second prong, a reasonable jury could conclude that both companies were “common enterprises.” There was commonality between the investors of the two companies because each individual’s fortunes were tied to the fortunes of the other investors due to the pooling of their assets. Furthermore, the companies’ profits were promised to investors proportionately to their investments in the schemes.

Finally, the investors were led to believe that profits would come from the efforts of the entrepreneur and his co-conspirators, not from any effort of the investors. The real estate–backed tokens were described as “an attractive investment opportunity” which “grows in value” and has “some of the highest potential returns.” The diamond investors were told that the company would grow between 10 and 15 percent per year. There was no indication that the investors were to have any control over the management of the enterprises, nor would they have been capable of participating in or directing their investments. Since the indictment met all three requirements of the Howey test, the court denied the entrepreneur’s motion to dismiss.

The court further rejected the entrepreneur’s argument that the securities laws were unconstitutionally vague as applied to cryptocurrencies, pointing out that case law has made it clear that the securities laws are meant to be interpreted flexibly in order to serve their intended purpose of protecting investors.

Practical Impacts of Zaslavskiy

Zaslavskiy is the first federal district court decision that agrees with SEC guidance that cryptocurrencies are investments,” observes Alexander “Sandy” R. Bilus, Philadelphia, PA, cochair of the Section of Litigation’s Privacy & Data Security Committee. “The securities laws were in place decades before this type of investment scheme was thought up,” he adds, “but the laws can still apply.” Lynda J. Grant, New York, NY, cochair of the Cryptocurrency and Blockchain Subcommittee of the Section’s Securities Litigation Committee, agrees. “The decision is in line with recent statements made by SEC Chairman Jay Clayton,” she notes. “But until now, we’ve never had a federal court say that cryptocurrency can be a security.”

“This decision will help plaintiffs’ attorneys in ICO cases,” Grant opines. “The defendant’s brief made an argument that many ICOs look like securities but are actually utility coins that people can use. But the court disagreed.” “This decision will carry a lot of weight,” says Bilus. “It will provide guidance to attorneys and companies regarding ICOs.” However, “many of the lawyers and judges involved do not really understand the technology of cryptocurrencies,” Grant observes. “So we will continue to see this area of the law change and shift.”


Martha L. Kohlstrand is a contributing editor for Litigation News.

Hashtags: #cryptocurrency, #cryptocurrencies, #ICOs, #SEC, #securitieslaws

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