For digitally savvy investors itching to know whether U.S. courts would treat crypto-tokens as securities subject to the regulatory requirements of the Securities Act of 1933, the wait is over—sort of. The first federal judge to decide the issue in the class-action context landed on the same side as the SEC did back in 2017, finding that the virtual tokens in the case could be characterized as securities. We discussed the SEC’s 2017 report in a previous article. See Margaret A. Dale and Mark D. Harris, The SEC Concludes that Digital Tokens May Be Securities, NYLJ, Aug. 8, 2017.
On June 25, 2018, Magistrate Judge Andrea M. Simonton of the Southern District of Florida issued this cutting-edge opinion in Rensel v. Centra Tech. Her Report and Recommendation (R&R) considered a motion for a temporary restraining order to safeguard the proceeds from an initial coin offering (ICO). The underlying shareholder class action alleged that Centra Tech, a Florida-based technology start-up company, and several of its founders and executives, had violated various provisions of the Securities Act. To reach her decision, Judge Simonton analyzed whether the tokens Centra Tech offered during the course of its ICO were securities for purposes of the Securities Act (despite the defendants conceding the point for purposes of the motion).
By way of background, the defendants in the case are Centra Tech and its founders and officers, Sohrab Sharma, Raymond Trapani, Robert Farkas and William Hegener. The complaint alleges that, in late 2017, Centra Tech and its executives told investors they were developing what promised to be a groundbreaking solution to a major problem for holders of virtual currency—the fact that most vendors do not accept it. Centra Tech claimed that it had created “the world’s first Debit Card that is designed for use with compatibility on 8+ major cryptocurrencies blockchain assets.” In essence, the card would allow virtual-currency holders to actually spend their money. According to Centra Tech, through their platform, users could easily convert their cryptocurrency to the kind most vendors accept—“fiat” currency, which is traditional legal tender, like U.S. dollars or euros.
To raise capital for this innovative debit card and related projects, Centra Tech conducted an ICO, from July through October 2017. Part of the ICO involved the company selling Centra Tokens, or CTRs, to the public. The company told would-be investors that in order to use the products it was developing, they would have to own CTRs. No registration statement was in effect at any time the company was selling the tokens.
The plaintiffs in Rensel filed suit in the Southern District of Florida in December 2017, bringing a putative class-action for violations of Sections 12(a)(1) and 15(a) of the Securities Act of 1933. In the introduction to the complaint, plaintiffs likened the Centra Tech ICO to an offer and sale of unregistered securities and stressed the important role of the Securities Act to protect investors, citing the “varied and innumerable ways in which investors can be, and are likely to be, manipulated and harmed” in its absence.
In April 2018, the SEC took a similar position, suing Sharma, Farkas and Trapani for securities fraud and violations of rules relating to registration statements under various provisions of the Securities and Exchange Acts, as well as for aiding and abetting Centra Tech in committing the same violations. Just one month later, in May 2018, the Department of Justice indicted Sharma, Trapani and Farkas. The government’s press release announced that it was charging the defendants with “securities and wire fraud in connection with a scheme to induce victims to invest millions of dollars’ worth of digital funds for the purchase of unregistered securities, in the form of digital currency tokens issued by Centra Tech, through material misrepresentations and omissions.”
Application of the ‘Howey’ Factors
Like the SEC in 2017, Judge Simonton applied the Howey test to determine whether CTRs could be characterized as “investment contracts,” which is one of the enumerated definitions of a security in the Securities Act. The Supreme Court in SEC v. W.J. Howey Co., 328 U.S. 293, 299 (1946), set forth a four-prong test for identifying an investment contract: (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived from the entrepreneurial or managerial efforts of others. Though expressing it as a three-prong test, Judge Simonton found all of the factors satisfied.
The purchase of CTRs constituted an “investment of money” because, the court concluded, that term includes any investment that could subject the investor to financial losses. Whether by fiat currency (in the form of U.S. dollars or euros, for example) or virtual currency (in the form of Bitcoin or Ether), people buying CTRs from Centra Tech in the hopes of profiting from the company’s success were subjecting themselves to potential losses. Simple enough.
The court next evaluated the “common enterprise” prong through the lens of Eleventh Circuit precedent, which defines such an enterprise as existing when (1) the investors’ profits are directly linked to the success or failure of the developer’s products, and (2) the investor lacks control over the success or failure of the investment. Because the value of the investments in Centra Tech rose or fell with the products, over which investors had no control, this prong was satisfied.
Having not directly addressed, but ostensibly assumed, that the investors had a reasonable expectation of profits, the court evaluated the last Howey factor, describing the test as whether “the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.” Given Centra Tech investors’ lack of control over the development of the company’s purportedly revolutionary products, investors were entirely dependent on Centra Tech’s managerial efforts for the success or failure of the enterprise.
With all Howey factors satisfied, the court recommended that the district judge find that “the offering of Centra Tokens was an investment contract under the Securities Act, such that the Defendants sold or offered to sell securities by virtue of the Centra Tech ICO.” Despite this finding, the court ultimately recommended denying the temporary restraining order on the basis that the plaintiffs’ harm was not irreparable because it could be remedied by a monetary award.
The precedential value of the Rensel decision is limited in three notable ways. First, because the decision is an R&R issued by a Magistrate Judge, it will be subject to de novo review by U.S. District Court Judge James Lawrence King. (As of August 1, 2018, both plaintiff and defendants had filed and briefed objections to the R&R.) Second, because the opinion was issued on a motion for a temporary restraining order, the judge evaluated the question using the “likelihood of success on the merits” standard, rather than by making an actual judgment on the merits. Third and finally, the defendants in the case had conceded, for purposes of the temporary restraining order, that the tokens constituted securities under the Securities Act.
As it stands, the question of whether crypto-tokens are securities subject to regulation under the Securities Act is far from settled. In light of Rensel’s limitations, coupled with the expanding popularity of virtual currency and related products, we expect to see courts across the country begin to weigh in more definitively. We’ll be watching.
Margaret A. Dale and Mark D. Harris are partners at Proskauer Rose. Lindsey O. Collins, an associate, assisted in the preparation of this article.