Extraterritorial Regulation of Cryptocurrency and Initial Coin Offerings

        Over the past few years, U.S. regulatory agencies have significantly increased their exertion of authority to regulate virtual currencies as well as their enforcement efforts over cryptocurrency transactions. This is not surprising given the potential for and actual abuse of the cryptocurrency markets, as well as the volatility of such markets. Cryptocurrency values have experienced significant volatility over the past year, the prime example being Bitcoin, which saw its highest value ever of $20,089 on Dec. 17, 2017, suffering a steady loss of value to its current value of $3,696.06 as of Dec. 18, 2018.

       Despite such volatility, there has been as steady increase in the amount of new cryptocurrencies and Initial Coin Offerings (ICOs) or Token Offerings over the past year. According to Coindesk.com, there has been exponential growth in the amount of ICOs over the past three years, increasing from 43 ICOs in 2016 to 343 in 2017 and about 650 in 2018, and the funds raised have jumped from $256 million in 2016 to $5.5 billion in 2017 and $16.7 billion in 2018.[1]

       This article examines the development of regulatory authority over cryptocurrency transactions and ICOs by the U.S. Commodity Futures Trading Commission (CFTC) and the U.S. Securities and Exchange Commission (SEC), as well as the extraterritorial reach of their regulatory powers (in particular the SEC in light of recent case law).

Jurisdiction of U.S. Regulators

       The need for regulation is borne out of the increase of unregulated virtual currency transactions and ICOs, particularly given the confidential nature of virtual currency transactions through the use of distributed ledger technology and the potential for the illegal uses of cryptocurrency and ICOs (money laundering, fraud, pump-and-dump schemes, etc.).

       In a Sept. 17, 2015, press release by the CFTC, the CFTC announced it had determined that virtual currencies are a commodity covered by the Commodity Exchange Act (CEA).[2] On July 25, 2017, the SEC issued an investigative report signaling to the public that it considered U.S. Federal securities law to be applicable to virtual organizations or capital-raising entities making use of technology to offer and sell “tokens” or “coins” to raise capital (ICOs).[3] The CFTC and the SEC have received the support of the courts over the past year, with recent rulings finding that cryptocurrencies are commodities and that ICOs can be considered securities.

       In March 2018, Judge Jack Weinstein of the U.S. District Court (E.D.N.Y.) ruled that the CFTC can regulate cryptocurrencies as commodities.[4] At page 24 of the ruling, Judge Weinstein held:

Virtual currencies can be regulated by CFTC as a commodity. Virtual currencies are “goods” exchanged in a market for a uniform quality and value. Mitchell Prentis, “Digital Metal: Regulating Bitcoin As A Commodity,” 66 Case W. Res. L. Rev. 609, 626 (2015). They fall well within the common definition of “commodity” as well as the CEA’s definition of “commodities” as “all other goods and articles ... in which contracts for future delivery are presently or in the future dealt in.” Title 7 U.S.C. § 1(a)(9).

       In United States of America v. Maksim Zaslavskiy,[5] Judge Raymond J. Dearie found that investments in two virtual currency schemes and ICOs of REcoin Group Foundation LLC and DRC World Inc. constituted securities. After analyzing the securities legislation and the Howie test[6], Judge Dearie concluded that the investments in REcoin and DRC were “investment contracts,” and thus “securities,” as:

1. individuals invested money (and other forms of payment) in order to participate in schemes and did so in exchange for investments in what they were told were investment-backed virtual tokens or coins;
2. the REcoin and DRC investment strategies depended on the pooling of investor assets to purchase real estate and diamonds, and the profits would be distributed to investors pro rata based on the proportionate share of “tokens” or “coins” granted to investors in exchange for their investment (a common enterprise); and
3. the investors could reasonably have expected to receive significant profits derived primarily from the efforts of Zaslavskiy and his team.

       Although there is currently no single government agency that regulates cryptocurrency, the SEC and CFTC continue to work together to regulate the markets. SEC Chair Jay Clayton and CFTC Chair Christopher Giancarlo published an op-ed in the Wall Street Journal on Jan. 24, 2018, announcing their coordinated efforts, along with other federal and state regulators, to maintain transparency and integrity in the cryptocurrency marketplace.

Extraterritoriality Application

       Given the borderless nature of cryptocurrencies and ICOs, regulatory enforcement agencies such as the SEC are faced with the ever-increasing challenge of regulating the extraterritorial offering of securities. The landmark decision in Morrison v. National Australian Bank Ltd. sets out the “bedrock principle” that U.S. legislation is meant only to apply within the territorial jurisdiction of the U.S. absent congressional authority otherwise.[7]

       Recent case law has shown the ability of the SEC to regulate extraterritorial coin offerings without infringing upon the “bedrock principle” set out in Morrison, which is entirely dependent on an appropriate factual matrix. The class action case of In re Tezos Securities Litigation[8] demonstrates the SEC’s broach reach to regulate coin offerings made outside of the U.S. This case involved an unregistered ICO that commenced on July 1, 2017, and raised the market equivalent of approximately $232 million in Bitcoin and Ethereum[9] by is close on July 14, 2017. Rather than focusing on the contractual situs, the court in Tezos focused on the actual situs of the ICO transactions, posing the following question: Where does an unregistered security, purchased on the internet, and recorded “on the blockchain,” actually take place?

       The contractual terms of the offering stipulated that the legal site of all ICO transactions is Alderney,[10]the applicable law is Swiss law, and the jurisdiction of any dispute would be exclusive jurisdiction of the courts of Zug, Switzerland. Despite this, the U.S. District Court for the Northern District of California determined that the actual situs of the ICO was the U.S. and that the application of the Exchange Act did not offend the “bedrock principle” of Morrison.

       In arriving at this determination, the court found that while no single factor was dispositive of the analysis, the factual nexus supported the inference that the securities were purchased in the U.S. because:

1. the investor participated in the ICO in the United States;
2. the token offeror used an interactive website to market the offering that was:
   
   1. hosted on a server in Arizona; and
2. run by an individual in California;
3. the investor learned about and participated in the ICO based on marketing that targeted almost exclusively U.S. citizens; and
4. the investor contributed Ethereum to invest in the ICO, which became irrevocable only after it was validated by a network of global “nodes,” which were more densely located in the U.S. than any other country.

       The major takeaway from the Tezos decision is that despite contractual terms that might stipulate otherwise, the courts will look at the realities of the transaction to determine whether or not extraterritorial coin offerings fall within the regulatory reach of U.S. governmental agencies such as the SEC.