On Sep.11, 2018, Judge Raymond Dearie of the United States District Court for the Eastern District of New York issued a Memorandum and Order in U.S. v. Zaslavskiy (Case No. 17 CR 647 (RJD) (E.D.N.Y)), confirming the position of the Securities Exchange Commission regarding the legal nature of cryptocurrencies – such assets may be (and often are) “investment contracts” subject to the Securities Exchange Act of 1933.
In Zaslavskiy, Maksim Zaslavskiy and certain unnamed co-conspirators offered two investment opportunities to the general public via promotional websites and informational white papers:
- REcoin Group Foundation, LLC (REcoin), which Zaslavskiy marketed as an investment in a new cryptocurrency allegedly backed by domestic and international real estate investments.
- Diamonds Reserve Club (Diamond), which Zaslavskiy marketed as an investment in a cryptocurrency that would allegedly be hedged via the purchase of diamonds.
In both investment offerings, Zaslavskiy stated that the offering entity would create new asset-backed cryptocurrencies that would simultaneously allow stability and significant growth opportunities using the expertise of Zaslavskiy and his co-conspirators. REcoin and Diamond, however, never produced cryptocurrencies or purchased any real-life assets to back their respective, proposed cryptocurrencies, and the investments failed. As a result, Zaslavskiy was indicted and charged with one count of conspiracy to commit securities fraud and two counts of actual securities fraud.
Zaslavskiy moved to dismiss the indictment arguing the opportunities offered investment in currencies (not securities) meaning the Securities Exchange Age should not apply, and the U.S. securities laws are unconstitutionally vague as applied to cryptocurrencies, thus providing further basis for dismissal of the indictment. The court rejected each of these arguments. In particular, the court held that U.S. securities laws are not unconstitutionally vague but intentionally broad and designed to regulate investments regardless of name or form, i.e., substance over form. Furthermore, the court held that the determination of whether an offering constituted a securities offering was a factual matter best let for the finder of fact at trial.
Noting that the definition of “security” includes an “investment contract,” the court applied the three-part investment contract test in SEC v. Howey, i.e., an investment contract is any transaction whereby a person (1) invests their money (2) in a common enterprise and (3) is led to expect profits solely from the efforts of the promoter or third party.1
Applying this analysis, the court held that a reasonable fact finder could determine that the REcoin and Diamond offerings constituted securities offerings:
- Both offerings required payment via credit card or cryptocurrencies for participation, which constitutes investments of money.
- The offerings had sufficient horizontal commonality as to establish a common enterprise; REcoin and Diamond intended to pool all investments and distribute profits to investors on a pro-rata basis.
- Marketing material stressed that the investments would generate profits via the efforts of Zaslavskiy and his co-conspirators and that the investors would have no role in dictating investment strategy.
Thus, the court determined that a reasonable fact finder could find the REcoin and Diamond offerings constituted offerings for securities. Given that the record clearly indicated that REcoin and Diamond both failed to create a cryptocurrency or pursue any of the investment strategies described in their respective marketing materials, the court determined that a reasonable fact finder could likewise find Zaslavskiy conspired to and committed securities fraud via these offerings and denied the motion to dismiss.
Important lessons to be gleaned from the Zasklavskiy are two-fold.
- Courts will likely follow the SEC’s guidance on cryptocurrencies and apply the Howey test to determine whether a particular initial coin offering or token generation event must comply with the Securities Exchange Act.
- The application of the Howey test, as it relates to cryptocurrencies and or similar tokens, is a fact-intensive analysis that must be applied to the unique facts of each case, leaving open the possibility regarding whether any particular coin or token are – in fact – investment contracts subject to regulation under the Securities Exchange Act.
1. See, SEC v. Howey Co., 328 U.S. 293 (1946)