Monday, March 19, 2018

BigLaw: "Latham & Watkins Discusses SEC Charges Against BitFunder and the State of Digital Asset Trading"

Seriously big.
I think they are still the top-grossing law firm in the world.

From Columbia Law School's CLS Blue Sky blog, March 19:
The SEC continues to send messages to the nascent cryptocurrency market. The agency has recently brought enforcement actions and issued a public statement that illustrate the agency’s views on how the federal securities laws apply to crypto or digital asset trading platforms. In the latest enforcement action,[1] the SEC in U.S. District Court, Southern District of New York alleging that a bitcoin trading platform functioned as an unregistered exchange, facilitated unregistered offerings and trading of securities, and defrauded investors by failing to disclose a cyberattack on the platform. The SEC’s Divisions of Enforcement and Trading and Markets also issued a joint public statement on digital asset trading platforms.[2] These latest developments provide insight into the SEC’s views on key issues participants in the digital or crypto asset market face, especially those participants currently operating or seeking to operate a crypto asset trading platform or exchange.

The SEC’s Enforcement Action

On February 21, the SEC filed an action against BitFunder and its founder in federal district court alleging violations of the federal securities laws. The SEC’s key allegations are as follows:
  • BitFunder is an unincorporated entity founded by its operator, Jon E. Montroll, in October 2012 and operated out of Montroll’s home in Texas. BitFunder was an online bitcoin fund raiser and trading platform, on which users could create, offer, buy, and sell shares in various virtual currency-related enterprises (referred to as “Assets” and “Asset Shares” on the BitFunder website), using bitcoin as the form of payment.
  • BitFunder required users to register with an Australian virtual currency exchange, WeExchange, and deposit bitcoins into a single digital wallet maintained by WeExchange in order to trade on BitFunder. Users’ bitcoins were commingled in the wallet and Montroll had control over WeExchange and the wallet maintained by WeExchange.
  • Users on BitFunder’s platform could buy and sell Asset Shares in initial and follow-on offerings by listing Asset Shares on the platform. Users also could buy and sell Asset Shares in secondary market trading. In exchange for the trading services it offered, BitFunder charged a transaction-based fee whenever a user sold Asset Shares. Montroll manually calculated how much BitFunder was owed in accrued transaction fees and withdrew those fees from the WeExchange wallet from time to time.
  • Separately, in July 2013, Montroll individually offered and sold certain securities, called Ukyo Notes or Ukyo Loans, on BitFunder’s platform as one of the platform’s listed Assets and represented that he would use the proceeds from the offering for private investment purposes, including Bitcoin related activities and “offline business opportunities,” and promised to pay investors certain daily interest.
  • Shortly after the beginning of the Ukyo Notes offering in July 2013, BitFunder’s platform suffered a cyberattack over the course of five weeks, which resulted in the theft of approximately two-thirds of the bitcoins in the wallet maintained with WeExchange, which had a value of approximately US$775,000 at the time of the theft. As early as the first week of the cyberattack, and during the offering of the Ukyo Notes, Montroll knew of the cyberattack and the bitcoin theft. Yet, Montroll did not restore the wallet to its previous bitcoin balance prior to the theft or inform BitFunder users of the theft. He also did not disclose the cyberattack to Ukyo Notes investors.
  • After the cyber theft of bitcoins, Montroll continued to operate BitFunder and solicit new users and accept their bitcoin deposits, earn transaction fees, and raise funds from Ukyo Notes investors. When BitFunder users had problems withdrawing their bitcoins because of the bitcoin deficit caused by the theft, Montroll claimed that the delays arose from technical issues with BitFunder’s platforms. Montroll also withdrew bitcoins from the WeExchange Wallet and converted them to fiat currency to pay personal expenses. The bitcoin deficit ultimately caused Montroll to shut down BitFunder by November 2013.
The SEC’s charges fall into four categories:
  • Unregistered Exchange: The SEC alleges that BitFunder violated the exchange registration requirement in Section 5 of Securities Exchange Act of 1934 (Exchange Act) for acting as a securities exchange and effecting transactions in securities without being registered as a national securities exchange or exempted from such registration.
  • Securities Fraud: The SEC alleges that, BitFunder and Montroll violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and Section 17(a) of the Securities Act of 1933 (Securities Act) (with respect to Montroll only), for misrepresenting the use of money raised from the offering of the Ukyo Notes, failing to disclose the cyberattack and the resulting bitcoin theft to Ukyo Notes purchasers and continuing to operate and solicit and accept bitcoin deposits from new users, and defrauding purchasers of the Ukyo Notes and users of BitFunder.
  • Unregistered Securities Offering: The SEC alleges that Montroll violated Section 5 of the Securities Act by offering and selling unregistered securities (Ukyo Notes) without filing a registration statement with the SEC.
  • Control Person Liability: The SEC charged Montroll as a “control person” liable under Section 20(a) of the Exchange Act, alleging that he controlled BitFunder and was a “culpable participant” in BitFunder’s failure to register as a securities exchange.

Public Statement of Divisions of Enforcement and Trading and Markets on Online Trading Platforms
On March 7, 2018, the SEC Divisions of Enforcement and Trading and Markets (Staff) issued a joint public statement on digital asset trading platforms. The Staff pronounced that many of these platforms may be required to register with the SEC as a national securities exchange or be exempt from registration. The Staff alerted investors that the SEC did not review the standards for picking digital assets for trading or the trading protocols used by the trading platforms and that these standards or protocols should not be equated to, or assumed to meet, the standards of an SEC-registered national securities exchange. In addition, although many online digital asset trading platforms appear to perform exchange-like functions, investors using these platforms should not believe that the pricing and execution data offered by the online digital asset trading platforms would have the same integrity as that provided by national securities exchanges.

What the Latest Developments Mean to Crypto Market Participants...

Previously from CLS' Blue Sky blog: 
"Perpetual Dual-Class Stock: The Case Against Corporate Royalty"
The author is a commissioner on the SEC and a recovering academic.
(enough footnotes to make Matt Levine envious)  
Finance:Taking Modigliani-Miller To Court 60 Years On
Columbia Law School: "Risks of Classifying Employees as Independent Contractors"
Governance: The Growing Concentration of ETF (and mutual fund) Voting Power
Something that doesn't come up in casual conversation but may be important. ...