SEC selective ICO enforcement might not be so bad; stablecoins hit a wall called FinCEN

Two or three years ago everyone and their Great Aunt Mathilda wanted to do an ICO and was convinced that if they went to Zug and sold tokens they wouldn’t have to worry about securities laws. I’d have calls with people where they would say that they wanted to do a blockchain for wholesale fish distribution and would issue a token for it “and of course OF COURSE it’s not a security Steve, it has utility. Also, did I mention we’re in Zug?” Then would come the ask, that one get paid for designing or advising on the token by accepting tokens. The first time that happened I laughed out loud, and then I realized that for some reason they … weren’t joking.  (Eventually I just stopped taking the calls).

We’ve known for some time now that the SEC saw things differently and that, in fact, most of those ICOs were unregistered securities offering. While we have by no means seen the end of ICO enforcement actions by the SEC — give it a few more years for the dust to die down — everyone and their Great Aunt Mathilda is pretty familiar with the basic parameters of the ’33 and ’34 acts and even the dimmest ICO bro wannabe can rattle off the Howey Test without thinking too hard. It’s barely even news anymore when a project and its initiators get sued by or settle with the SEC.

Some have said that the SEC’s enforcement in the space hasn’t been even and there have been charges by some of so-called “selective enforcement.” This term has been used as a pejorative and to challenge the clarity and fairness of the rules governing ICOs under U.S. securities laws. Telegram has gone so far as to challenge the constitutionality of SEC enforcement activity, claiming that, as applied, the rules that they apply are not identifiable with “ascertainable certainty.” While I have my doubts that this is going to win the day for Telegram, I also don’t think the argument is going to fall entirely on deaf ears. There may be some sympathy on the bench for this argument (though I suspect the argument is a loser, legally, at the end of the day). And for Telegram, the argument is probably a loser for a really simply reason — the fact that you have cooperated with an SEC investigation (which is where Telegram’s efforts seem to have been focused, if one reads their affirmative defense portion of their answer closely) isn’t an exculpation or excuse.

But back to the generic “selective enforcement” objection — the notion that the laws aren’t fair or clear because X project paid nothing and Y project paid a kajillion dollars or got shut down. Set aside the fact that you don’t know what happened at the negotiation table, there’s another problem with the “but selective enforcement” argument. Unless you can show that the government is enforcing a law selectively for improper reasons — say, a law that you can show is only selectively and intentionally applied against people because of their race — the government has discretion to do precisely this. In fact, most laws are selectively enforced (think about speeding as an overly simplistic example).

A really interesting upcoming article in the Washington Journal of Law and Policy makes the case that regulation by selective enforcement in the ICO space is actually a good thing for the most part, though it comes with some risks. In “Regulation by Selective Enforcement: The SEC and Initial Coin Offerings”, James Park and Howard Park posit that

The SEC’s Regulation by Selective Enforcement strategy has been successful in establishing the agency’s authority over ICOs — and has done so with limited involvement of the courts. The SEC has moved decisively with these cases, considering their complexity and its reputation for taking years to resolve enforcement matters. At the same time, it has been thoughtful in applying the law to a new setting. The SEC’s various enforcement releases have effectively communicated basic parameters to the industry with respect to when ICO tokens are securities. As a result, the number of unregistered ICOs available to U.S. investors has quickly declined.

On the other hand, a danger of Regulation by Selective Enforcement is that it can create the illusion that the major legal issues have been resolved, when there is still a great deal of uncertainty as to when a token is a security. The SEC’s settlement releases only represent the agency’s view that a particular token was a security. Though administrative interpretation of a statute is entitled to some weight, courts may still disagree. Some of the SEC’s most important ICO cases have turned on fine distinctions. Slightly different facts could merit different results. Yet the SEC has acted at times as if the issue of when a token is a security has been so clearly resolved that subsequent violations deserve significant sanction. Such a position is troubling.

Another danger is that by only bringing cases against more recent ICOs, the SEC risks conferring monopoly power to early movers. The ICO of Ether, the token associated with the Ethereum smart contracts platform, at least initially was the sale of a security, but the SEC has taken the position that Ether is no longer a security. Ethereum thus has a significant advantage over newer smart contract platforms that will have to comply with SEC regulation.

(You can find a copy of the full essay here). The authors take the position that regulation by enforcement has been made somewhat easier with the overlapping hammers of private class action litigation and the work of state securities regulators. They also close (weakly if you ask me, in an otherwise nice essay) that there is more work to be done in “clarifying the boundaries” of SEC jurisdiction. I’m not sure which jurisdictional boundaries need to be limned but, regardless, the interesting part of this essay to me is that the authors’ point is that selective enforcement in the space is, well, kind of a good thing and the SEC has been frankly rather patient with the ICO and token and space.

This all leads me to another arm of the government that is keenly interested in crypto, FinCEN, which has been slightly quieter on the enforcement front but still has plenty of time to act.

FinCEN is part of the U.S. Department of Treasury and is responsible for overseeing the Bank Secrecy Act, which refers to federal laws that address anti-money laundering and counter-terrorism financing. The Bank Secrecy Act has criminal penalties. Though you can be prosecuted under federal law for securities fraud, the SEC doesn’t have criminal jurisdiction. FinCEN works with law enforcement (hence the name “Financial Crimes Enforcement Network”).

FinCEN has provided guidance about virtual currencies and compliance obligations that specifically reference crypto since at least 2013 and has been relatively clear that “but it’s blockchain” doesn’t get you out of compliance with the BSA. (A recent overview from FinCEN is here). My own personal policy view is that applying an early 1970s law designed to combat money laundering doesn’t always lead to sensible results. Think for example, of a protocol that allows a person to transform a token on one chain into a token on another chain. If the token has notional financial value, is the conversion of the token money transmission? Have you moved CVC from one place to another? I mean. Maybe. But you could make the same argument about converting a database entry from MySQL to postgresql.

Anyway, I happen to think that our securities laws and enforcement framework are robust and clear enough to deal with crypto without a lot of change. FinCEN and the BSA are the ten thousand pound slightly rotting herring stinking up the space. And the problem is that whatever my own view of the statute’s overly broad and not entirely logical scope, FinCEN’s own view of the statute and its guidance is that the law is crystal clear and they have been too.

This brings me to a recent statement by FinCEN Director Ken Blanco about stablecoins, which you may or may not have read about. According to Mr. Blanco:

Despite recent reporting, stablecoins are not a new concept in this space. FinCEN has been looking at stablecoins since the earliest experiments into virtual currency in the early 2000s. FinCEN published its first piece of public guidance in this space in 2008, dealing precisely with the issues that underlie the type of convertible virtual currency we now refer to as a “stablecoin.” And, because we are technology neutral, we can say with complete clarity that for AML/CFT purposes, it should be understood that transactions in stablecoins, like any other value that substitutes for currency, are covered by our definition of “money transmission services.” This means that accepting and transmitting activity denominated in stablecoins makes you a money transmitter under the BSA. It does not matter if the stablecoin is backed by a currency, a commodity, or even an algorithm — the rules are the same. To that point, administrators of stablecoins have to register as MSBs with FinCEN.

“But Steve,” you say “our stable coin backed by an algorithimic basked of other crypto is decentralized and run by the community on weekly conference calls that are recorded and saved on github. He doesn’t mean that our basket of algorithimic stuff is governed by the BSA, does he?”

I am not going to call out any specific project by name but (to answer your question), yes, he is saying that a ‘decentralized’ price stable currency ‘controlled by the community’ is subject to the Bank Secrecy Act. Am I saying that we are going to see a wave of enforcement activity by FinCEN similar to what we have seen by the SEC? Maybe not, but the comparative quiet should not be taken for a lack of activity. And it’s worth remembering that the statute of limitations for BSA violations is five years for criminal and six years for civil. So for some the clock has barely started ticking. It’s probably unlikely that I will be making Great Aunt Mathilda and FinCEN comments in two or three years, but I’d expect to see some enforcement activity coming, and the market for and value of algorithimic stablecoins impacted as a consequence.