The U.S. District Court of the Eastern District of New York ruled that virtual currencies issued through an initial coin offering ("ICO") may constitute securities under the Securities Act and Exchange Act. The ruling - which appears to be the first court decision to address this issue - is consistent with the SEC's application of the Howey test. In a Memorandum & Order, the Court dismissed an alleged cryptocurrency fraudster's argument that he could not be charged with securities fraud because the laws are "unconstitutionally vague" regarding cryptocurrency. The Court found that securities laws are not so vague as to be considered "unconstitutional" and denied the defendant's motion to dismiss the indictment. The case will proceed to trial.
The defendant was indicted for allegedly making false and fraudulent representations and omissions in connection with two virtual currency investment schemes and their related ICOs: REcoin Group Foundation, LLC ("REcoin") and DRC World, Inc. ("Diamond"). In a motion to dismiss, the defendant argued that (i) REcoin and Diamond did not involve securities and should be beyond the scope of federal securities laws, and (ii) securities laws are unconstitutionally vague as applied to cryptocurrencies. The U.S. government asserted, in response, that investments made in REcoin and Diamond were "investment contracts" and, as a result, are considered "securities." The Court ruled that securities laws are meant to be interpreted with "flexibility to effectuate [their] remedial purpose," and that Exchange Act Section 3(a)(10) and Securities Act Section 2(a)(1) are not vague.
Commentary / Joseph V. Moreno
The district court's ruling is significant because it provides further support for the SEC's position that digital currencies marketed in relation to an ICO may constitute securities under the federal securities laws. The defendant here argued that the cryptocurrencies promoted in connection with his underlying companies represented simply a form of "currency" that was being exchanged with investors for fiat currency (US Dollars), and were not securities as contemplated by the Securities Act and the Securities Exchange Act.
The judge disagreed, finding that was an overly narrow view and holding that the Howey test should apply to determine whether the cryptocurrencies at issue were in fact securities. The Howey test defines an "investment contract" (and thus a security) as a transaction where a person (i) invests money, (ii) in a common enterprise and (iii) is led to expect profits solely from the efforts of the promoter or third party. The district court did not make a final determination on this issue, finding that it was ultimately a matter of fact that should be determined by a jury.
The ruling is important, however, because it is recognition by the judiciary of a position maintained by the SEC for some time. Whether the case goes to trial or is resolved outside of court, it will be interesting to see how this ruling perseveres and impacts other civil and criminal matters involving regulatory oversight of ICOs.
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