August 9, 2018Michael Hollingsworth Named to FLOCK Specialty Finance Advisory Council
July 31, 2018
The cryptocurrency industry made some significant news this past week as the SEC again denied a bitcoin-linked ETF application from the Winklevoss twins and the DOJ got a guilty plea from Jon Montroll, the founder of two defunct cryptocurrency investment sites. Here is a summary of those stories and other interesting enforcement-related news from the past week.
Founder of Cryptocurrency Investment Sites Pleads Guilty. On Monday, July 23, 2018, the U.S. Attorney for the Southern District of New York Geoffrey Berman announced the guilty plea of Jon Montroll, the person behind two now defunct cryptocurrency investment sites. Montroll pleaded guilty to one count of securities fraud and one count of obstruction of justice and faces a maximum sentence of 20 years in prison for each charge.
Montroll ran two online bitcoin services – WeExchange Australia, Pty. Ltd. (“WeExchange”) and BitFunder.com (“BitFunder”). WeExchange was a bitcoin depository and currency exchange service and BitFunder facilitated the purchase and trading of virtual shares of business entities that listed their virtual shares on the BitFunder platform. The DOJ alleged that Montroll converted a portion of WeExchange users’ bitcoins for his own personal use for expenses, such as travel and groceries. Montroll also promoted the sale of a security called Ukyo.Loan and promised to pay investors daily interest and the ability to redeem their shares at any time.
In 2013 hackers withdrew 6,000 bitcoins from WeExchange and as a result, the DOJ alleged BitFunder and WeExchange lacked the bitcoins necessary to cover what Montroll owed to users and that he failed to disclose the hack to users. Instead, the DOJ alleged that Montroll continued to sell Ukyo.Loan to customers, raising approximately 978 bitcoins after the hack, and at least on one occasion falsely represented to customers that BitFunder was commercially successful.
The SEC originally began the investigation into Montroll and BitFunder. Montroll provided the SEC with a falsified screenshot purportedly documenting the number of bitcoins available to BitFunder users in the WeExchange wallet shortly after the hack. Montroll also provided false and misleading answers to questions from the SEC during the investigation.
The SEC charged Montroll back in February with operating an unregistered securities exchange, defrauding users of that exchange, and making false and misleading statements in connection with an unregistered offering of securities. The investigation was conducted by, among others, Valerie Szczepanik, who as we reported back in June, was named the SEC’s new Crypto Czar. On the same day in February, in a parallel case, the U.S. Attorney’s Office filed its complaint against Montroll in the Southern District of New York.
Report from Stanford Law and Cornerstone Highlights Rise of Crypto Class Actions. On Wednesday, July 25, 2018, the Stanford Law School Securities Class Action Clearinghouse and Cornerstone Research released a midyear assessment report on securities class action filings and noted that the rise of class actions related to initial coin offerings (ICOs) or tied to cryptocurrencies continued with seven filings in the first half of the year. The report noted there were five class actions tied to ICOs or cryptocurrencies filed in late 2017. Six of the seven class actions filed this year are still active. As we previously reported back in May, one of those class actions is against Paragon Coin, a cryptocurrency startup focused on the legalization of marijuana. The other active class actions are against Ripple Labs, Bitconnect, Latium Network, DRIP, and Cloud With Me.
The report notes that federal class action securities filings continued at near record levels in the first half of 2018 with plaintiffs having filed more than 750 federal securities class actions since midyear 2016. We expect this trend to continue as regulators and law enforcement officials like the SEC and DOJ continue to target fraudulent crypto companies and those that are not complying with the federal securities laws.
SEC Rejects Bitcoin-Linked ETF Application by the Winklevosses. On Thursday, July 26, 2018, the SEC rejected a request to list a bitcoin-related exchange traded fund (“ETF”) run by Tyler and Cameron Winklevoss.
Back in June 2016, Bats BZX Exchange, Inc. (“BZX”) had filed a proposed rule change with the Commission seeking to list and trade shares of the Winklevoss Bitcoin Trust. The Commission disapproved the rule change in March 2017 and the Winklevosses filed a petition seeking review of the disapproval. The Commission granted the petition for review and sought public comments in support or opposition to the March 2017 decision, which culminated in the July 26 Disapproval Order.
The SEC looked at whether the proposal was consistent with Exchange Action Section 6(b)(5), which requires, in relevant part, that the rules of a national securities exchange be designed “to prevent fraudulent and manipulative acts and practices” and “to protect investors and the public interest.” BZX argued, among other things, that its proposal was consistent with Section 6(b)(5) on the grounds that the “geographically diverse and continuous nature of bitcoin trading makes it difficult and prohibitively costly to manipulate the price of bitcoin” and that “novel systems intrinsic to this new market provide unique additional protections that are unavailable in traditional commodity markets.” BZX asserted that the March 2017 disapproval order failed to appreciate that the proposal provides “traditional means of identifying and deterring fraud and manipulation” and overstated the extent to which surveillance and regulation of the underlying market has been present in prior commodity-trust exchange-traded product approval orders and the extent to which the Commission has relied on the existence of surveillance-sharing agreements between an exchange-traded product listing market and markets related to the underlying assets.
The SEC stated that it is not convinced that trading of bitcoin has adequate surveillance and that CBOE Global Markets Inc. (“CBOE”), which would have listed the bitcoin ETF, failed to show that the underlying market was “resistant to manipulation.” The SEC raised concerns about the reliability of trading and volume data for bitcoin and the ability of bitcoin exchanges to police trading. The SEC also stated that “where, as here, a listing exchange fails to establish that other means to prevent fraudulent and manipulative acts and practices will be sufficient, the listing exchange must enter into a surveillance-sharing agreement with a regulated market of significant size because ‘such agreements provide a necessary deterrent to manipulation because they facilitate the availability of information needed to fully investigate a manipulation if it were to occur.”
The SEC summed up their current position on bitcoin ETFs:
While the record before the Commission indicates that a substantial majority of bitcoin trading occurs on unregulated venues overseas that are relatively new and that, generally, appear to trade only digital assets, and while the record does not support a conclusion that bitcoin derivatives markets have attained significant size, the Commission notes that regulated bitcoin-related markets are in the early stages of their development. Over time, regulated bitcoin-related markets may continue to grow and develop. For example, existing or newly created bitcoin futures markets may achieve significant size, and an ETP listing exchange may be able to demonstrate in a proposed rule change that it will be able to address the risk of fraud and manipulation by sharing surveillance information with a regulated market of significant size related to bitcoin, as well as, where appropriate, with the spot markets underlying relevant bitcoin derivatives. Should these circumstances develop, or conditions otherwise change in a manner that affects the Exchange Act analysis, the Commission would then have the opportunity to consider whether a bitcoin ETP would be consistent with the requirements of the Exchange Act.
Commissioner Hester Peirce dissented from the Commission’s disapproval of the Winklevoss’ proposal and published a written dissent on the SEC’s website. Commissioner Peirce’s dissent states that she believes the proposed rule change satisfied the statutory standard and that BZX should be permitted to list and trade the ETF. She notes that “[m]ore institutional participation would ameliorate many of the Commission’s concerns about the bitcoin market that underlie its disapproval order. More generally, the Commission’s interpretation and application of the statutory standard sends a strong signal that innovation is unwelcome in our markets, a signal that may have effects far beyond the fate of bitcoin ETPs.” Commissioner Peirce argues the Commission erroneously read the requirements of Section 6(b)(5) in that the disapproval order focuses on the characteristics of the spot market for bitcoin, rather than the ability of BZX, pursuant to its own rules, to surveil trading of and to deter manipulation in the exchange traded production shares listed and traded on BZX. Commissioner Peirce noted that even if she accepted the majority’s approach and focuses on the underlying bitcoin markets, she would reach the same conclusion. She also stated that the disapproval order “suggests that approval for bitcoin ETPs will come only when bitcoin spot and derivatives markets have matured substantially, yet, at the same time, contributes to further delay in their maturation, as potential institutional investors may reasonably conclude that the Commission will continue to repress market forces for the foreseeable future.”
The vote to reject the ETF application was to 3 to 1, with there being one vacant seat as the result of previous Commissioner Michael Piwowar’s term ending on July 6, 2018.
As Bloomberg reports, some in the industry had assumed that the listing of bitcoin futures contracts on markets run by the Chicago Board Options Exchange (“CBOE”) and CME Group Inc. would resolve some of the regulators’ concerns. As we noted a few weeks ago, currently there are about 10 bitcoin-linked ETFs awaiting regulatory approval, including the application filed by CBOE Global Markets.
Nelson Mullins can help companies and investors navigate the evolving ICO, cryptocurrency, and blockchain regulatory and legal environment. The White Collar Defense and Government Investigations Group has extensive experience responding to regulator inquiries and other government investigations, as well as representing clients in related civil litigation, including class action lawsuits. The firm’s Blockchain and Digital Currency Group and Securities and Enforcement Practice are also available to advise ICO issuers, exchanges, investors, and institutional investors on how to comply with SEC and other governmental agency registration requirements and regulations.
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