The Extraterritorial Reach of the SEC
As a lead statutory securities regulator, the SEC yields tremendous authority, policy influence, power, and enforcement in which the agency’s ferocity should never be underestimated. The SEC has been known to exercise its extra-territorial reach far outside its borders as far as Australia in the case of SEC v. National Australian Bank, for example. Unlike other, smaller securities regulators (e.g., Ontario Securities Commission (OSC) in Canada), the SEC has a $1.6B USD budget (compared to $100M USD for the OSC, where over 80 percent of all capital market activity is in Canada). Such a budget allows the SEC to investigate, enforce, and prosecute securities breaches both at home and around the world — the long arm of US securities laws. The SEC can and will prosecute non-resident companies that breach US securities laws. However, the SEC only has jurisdiction over breaches of its own rules under the Securities Act (1933) and Securities & Exchange Act (1934).
If a non-resident, foreign company breaches US securities laws, it doesn’t necessarily escape US securities regulatory scrutiny; US securities laws are the most stringent in the world and carry the greatest fines, penalties, reputational damage, and prison sentences for breaches. This is no different than in the digital currency space where many security tokens are often being sold and marketed as unregistered utility tokens, often violating US securities laws.
SEC Howey as a Litmus Test
The well-referenced and established SEC Howey test is used to determine whether a token issued is either a security token or a utility token. For example, the best example of a true functional utility token is Canadian Tire fiat currency distributed by Canadian Tire Corp, a reporting issuer on the TSX (Toronto Stock Exchange). This currency nullifies each of the four prongs of the Howey test. In practice, however, very few utility tokens have satisfied this litmus test.
We’re also seeing a coordinated approach among securities regulators to fend bad actors in the digital currency space. In 2018, for example, there was a regulatory sweep between the OSC and SEC in cracking down on several ICOs that were considered shady and suspect. This coordination should give comfort to token investors and purchasers in Canada and the US, especially given how quickly both regulators reacted and investigated.
In fairness, although the SEC has taken a hardline approach to token issuers generally, actual enforcement has not nearly been as harsh as the regulatory environment would predict. We’ve seen the start of a few class-action lawsuits filed against Paragon Coin on behalf of the investor class, and SEC enforcement action against Tezos and Munchee, for example. The SEC’s enforcement case against Canadian-based Kik Interactive for various alleged material misrepresentations made to US investors in their $100M USD ICO, is an example of the expansive extraterritorial reach of the SEC and US securities laws. Similarly, the SEC’s recent enforcement action against the Telegram Group Inc. $1.7B ICO in January 2018 to build its blockchain platform while failing to register its ongoing digital currency offering with the agency as a security, is further evidence of the SEC extending its extraterritorial reach. The SEC alleges that Telegram and its subsidiary company, TON Issuer Inc., failed to provide investors with information concerning its business operations, financial condition, risk factors, and management, for which securities rules require. Of the 171 investors world-wide that participated in the Telegram ICO, just over 20% (or 39 purchasers) were sold to US investors, with most large investors residing outside the US. Between the SEC enforcement actions against both Kik Interactive and Telegram, this may create a chill in the market, thereby preventing companies from raising capital in the US through a digital currency offering. We should expect these actions, with the US being the largest and most powerful capital market globally.
Regulatory Arbitrage with STOs
Regulatory arbitrage is a practice whereby digital currency issuers capitalize on loopholes in regulatory systems to circumvent unfavorable regulation. Arbitrage opportunities may exist through a variety of tactics, including restructuring transactions, financial engineering and geographic relocation. The most STO-friendly jurisdictions are Singapore, Malta, Switzerland, Japan, and various Caribbean islands (e.g., Jamaica, Grand Cayman, Barbados, Gibraltar). These countries are digital-currency-friendly and receptive to STO marketing for the sale and distribution of tokens. We will continue to see more regulatory arbitrage, where STOs are marketed in jurisdictions that have the least path of regulatory resistance.
Regulatory arbitrage is likely to be more nuanced and multifaceted. For example, a token issuer has both digital currency securities regulation and tax regulation as major risks and concerns. It’s perfectly conceivable, for example, for an STO issuer to select Switzerland for its banking jurisdiction, Panama for taxes, Malta for its exchange (e.g., Binance, the largest digital currency exchange in the world processing $5.6B USD in digital currency transactions, formerly based in Hong Kong, recently moved its operations to Malta), and Isle of Man for its gaming. In effect, this creates a form of “virtual jurisdiction” that catapults regulatory arbitrage to new heights.
However, there are limits to regulatory arbitrage as utility tokens are often viewed as security tokens by US, Canadian and many other leading securities regulators around the world. The state of Wyoming, for example, is viewed as the most crypto-friendly state in the US. Caitlin Long is the former chair and president of Symbiont, a developer of blockchain products for capital markets, and most recently led the Wyoming Blockchain Coalition – which passed a slate of blockchain and cryptocurrency-friendly legislation in the state in 2018. Long spent 22 years in traditional finance at Morgan Stanley and Credit Suisse and echoes this sentiment:
“Utility tokens trade, clear, settle and custody on blockchains, and the trading, clearing, settlement and custody infrastructure of Wall Street is not set up to integrate with blockchains. So, if every utility token is always a security, that effectively means that you can’t trade a utility token.”
Cryptocurrency, otherwise referred to as “digital currency”, is based on cryptography, an advanced and arcane branch of mathematics that is powered by blockchain technology. Long’s comment is supported by the SEC’s position that 99-percent of all utility tokens are considered securities and should be regulated accordingly. This imposes a higher regulatory burden on issuers to comply with STOs.
Implications of Regulatory Arbitrage for Digital Currency Issuers
Regulatory arbitrage has been exploited in the digital currency space as issuers seek to raise capital in jurisdictions that have the least amount of regulatory resistance and scrutiny. Jurisdictions such as Malta, Singapore, Switzerland, Cayman Islands, and Estonia, have developed hospitable environments to digital currency issuers. The absence of formal digital currency legislation in these countries is being developed, while still in its infancy stages. The following are a series of implications that may result from regulatory arbitrage in impacting corporate governance outcomes:
- By issuers shopping for loopholes in certain jurisdictions that have either lax securities or other weak regulatory enforcement mechanisms for utility tokens (or non-registered securities with a local securities regulator), directors of issuers are cautioned to conduct enhanced due diligence on the principles and management of the issuer before assuming such roles. The director role and potential fiduciary liability from getting involved with questionable or suspicious characters who have nefarious business objectives can cause irreparable reputational risk to directors.
- The choice of jurisdiction where the issuer is domiciled is likely to impact the decision to issue either a utility token (non-registered with any securities regulatory authority) or a security token (which requires registration with a local securities regulator), or hybrid of both. The sale, distribution, and solicitation of a utility token in a jurisdiction such as the US, for example, is likely to carry significant enforcement fines, penalties, litigation risk, and potential criminal breaches under federal statutes. This has significant financial and reputational risk exposures for directors.
- The jurisdiction of choice of where the issuer is domiciled is also likely to influence the countries in which investors are solicited to buy and sell the token during the distribution of the offering. This can include both an STO Offering or an IEO on a given digital asset exchange. Although the issuer may be domiciled in the US, distribute its token in Estonia to non-US investors through an IEO, it still may be captured under US SEC rules and regulations due its domicile status. Directors of issuers must have competent and expert counsel in understanding the various forms of digital currency structures and their regulatory implications.
- Depending on where the issuer is domiciled and conducting business, will determine the scope and type of regulatory licenses required. For example, a digital asset exchange registered in Malta, domiciled in Canada, looking to attract US customers or investors on its platform, may have to secure an ATS (Alternative Trading System) license and file registration statements with the SEC if it wishes to trade as an STO. Similarly, if the digital currency platform involves the movement or transfer of fiat and/or digital currency, it may be required to register as an MSB (Money Service Business) with the local AML regulator. This has separate and distinct regulatory compliance implications for directors.
- The principle of issuing a digital currency in a borderless world implies that capital is perfectly mobile across borders. The transmission of capital across borders is not without costs and regulatory burden as issuers need to ensure compliance with local securities rules and regulations of where their token is sold, issued, and distributed. Directors need to ensure the extent of regulatory capture and how regulatory arbitrage costs can be effectively mitigated.
- Aaron Stanley, Forbes, “Security Token Blues: Key Secondary Market Trading, Custody Questions Still Linger”, April 30, 2018, internet article