In an enforcement action filed on November 8, 2018, the Securities and Exchange Commission (SEC) ordered that 31-year-old Zachary Coburn, founder of the EtherDelta cryptocurrency exchange, cease and desist from operating the trading platform. The SEC’s enforcement action is significant because it marks the first time the U.S. securities regulator pursued an unregistered cryptocurrency exchange, and is indicative of a growing trend of enforcement against a booming – but previously little-regulated – industry. In this case, Coburn had failed to register EtherDelta as an exchange as required by Section 6 of the Securities Exchange Act of 1934 (the Exchange Act), and was therefore found to be in violation of Section 5 of the Exchange Act.
EtherDelta was a cryptocurrency exchange established to trade the ERC20 digital token – tokens used solely on the Ethereum Blockchain – using EtherDelta’s smart contracts. A smart contract is a computerized transaction protocol that allows the execution of contracts, including terms such as payment terms, liens, confidentiality and enforcement, without the need for an intermediary. When EtherDelta’s smart contract was deployed on the Ethereum network, it created a unique blockchain address where it “resided.” Users could then buy and sell ERC20-compliant tokens using EtherDelta’s blockchain address and smart contract, and the transactions were tracked in EtherDelta’s order book. Sellers were charged a 0.3% fee per transaction, and during its 18 months of operation, users placed over 3.6 million trades on EtherDelta.
Section 5 of the Exchange Act makes it unlawful for any exchange to effect any transaction in a security unless the exchange is registered as a national securities exchange under Section 6. The SEC noted that the EtherDelta website had features similar to online trading platforms including the use of order books, daily transactions volumes, charts and a list of user confirmed trades. As such, EtherDelta clearly fell within the definition of “exchange” under Section 3 of the Exchange Act and the tokens being traded on EtherDelta were also considered “securities” under Section 3. The SEC further noted that the majority of trading on EtherDelta occurred after the release of the SEC’s 2017 Decentralized Autonomous Organizations (DAO) Report, which concluded that certain digital assets would be treated as securities by the SEC, and warning that any entity or person engaging in activities of an exchange must register as a national securities exchange or fall under an exemption from such registration. EtherDelta was not registered as an exchange and, accordingly, the SEC found that it violated Section 5. Moreover, Coburn was found personally liable for contributing to EtherDelta’s securities law violations. In light of Coburn’s cooperation and assistance in the investigation, the SEC accepted Coburn’s settlement offer, and made the following comments:
In determining to accept the Offer, including the decision not to impose a greater penalty, the Commission considered remedial acts promptly undertaken by Respondent and cooperation afforded the Commission staff. Coburn’s efforts facilitated the staff’s investigation involving an emerging technology.
The settlement offer consisted of a payment of $300,000 in disgorgement plus $13,000 in prejudgment interest and the payment of a civil money penalty of $75,000.
What To Expect In 2019
SEC Chairman Jay Clayton has made it clear that securities laws will not be updated to specifically address digital currencies. To date, Bitcoin and Ethereum are the only digital coins the SEC has specifically exempted from securities law. All other cryptocurrencies constitute as securities and will be regulated like any other security, according to Chairman Clayton.
The SEC’s 2018 annual enforcement report released on November 2, 2018 indicates that since the creation of the Enforcement Division’s Cyber Unit last year, the SEC has conducted dozens of investigations involving initial coin offerings (ICOs) and digital assets. Until recently, the SEC focused its efforts on fundraising through ICOs, but is now ramping up its efforts against unregistered digital exchanges. For example, in October 2018, the SEC suspended trading of cryptocurrency exchange American Retail Group, Inc. for falsely claiming it had been approved the SEC.
It is clear that the SEC is taking a ‘business as usual’ approach to its treatment of cryptocurrencies and will continue to enforce existing securities laws. More SEC enforcement actions suggest an increasing trend towards regulating a growing, but previously unregulated, industry. It is advisable that those seeking to engage in coin offerings or establish cryptocurrency exchanges pay close attention to the SEC’s recent enforcement actions and seek legal guidance where appropriate.