During 2018 the US Securities Exchange Commission (SEC) has been sending letters, and in some cases summonses, to crypto firms with a presence inside the USA. This has generated a great deal of consternation, and created a chilling effect on innovation and fundraising, particularly by ICOs. In this article we examine the actual laws and procedures governing such actions by the SEC, in order to examine possible responses by a target, and hopefully determine whether all this concern is really justified.
OMG we got a letter from the SEC!
Nobody likes getting correspondence from a government agency. Even if it's from the Lottery Commission, it probably doesn't mean anything good. Because "I'm from the government and I'm here to help" is a laugh line. But is pushing the Panic button really warranted merely because the sender is the SEC?
The Securities Exchange Commission (SEC) is the agency charged with enforcing the securities laws of the United States. As such, it is a part of the executive branch of government, ultimately reporting to the President, although not without oversight by congressional committees. The first question one should ask is: why would a firm in the crypto space be getting a letter from this agency? That's actually a very good question, in that the SEC has not been given the charge to regulate the cryptocurrency space. Unless of course a cryptocurrency is, somehow, a security by definition. Well, is it? Let's look at the actual definition of a "security" in US Code, found at 15 U.S. Code § 77b:
This legal definition is what matters in court, not what some agency spokesdroid bloviated at a conference somewhere, or what a court decided nearly a century ago in some case having nothing to do with crypto. And by this legal definition, a cryptocurrency would have to work pretty hard to become a security. Perhaps an explicit "equity token" could be seen as a "certificate of interest or participation in a profit-sharing agreement", and a SAFT could probably be construed as a "temporary or interim certificate for one of the foregoing." But these are types of tokens whose issuers deliberately defined them as securities. What if a coin, token, or voucher makes no such effort at self-labeling, but instead presents itself as, say, a utility token or even a form of privately issued money? Applying the definition in that case would be impossible, in that a crypto is pretty obviously not a note, a stock, a debt, preorganization certificate (which is a share issued before the company is actually formed), a future, option, warrant, or any other type of security enumerated above. And because the definition uses the word "means," rather than the word "includes," the list given in the statute is necessarily exhaustive rather than exemplary.
This opinion, by the way, is shared by the CFTC, which sees cryptos as commodities; by FinCEN, which sees them as virtual currencies; and by the IRS, which sees them merely as property subject to capital gains taxes. Obviously these agencies cannot all be correct. And it can hardly be a coincidence that each of them sees cryptos in a manner that would justify extending their reach and authority into the emerging crypto space.
For its part, the SEC confronts a conundrum in the crypto industry, particularly when it comes to ICOs. As a prime example of an agency which has succumbed to regulatory capture by the industry it's supposed to regulate, the SEC exists, on a practical level, to maintain a regime under which the only people who can invest in new things with low risk and the potential for high returns are people who are already rich, and in which all investing activity is conducted only through large financial firms that earn fees from every trade. Widows and orphans are only allowed to buy IPOs, which occur only after the accredited investors have already made a multiple hundred percent profit on their seed and angel investments, and all the underwriting brokers and white shoe law firms have been paid their skims and cuts. Entrepreneurs, founders, and sweat equity employees are never allowed to retain the majority share. The public, that's supposed to be protected by this system, is in fact the bagholder by design, onto which all the risk is offloaded after the venture capitalist profits and all the fees and percentages have already been calculated into the IPO offer price. This is precisely why most IPO stocks crash severely in the 6-12 months following the IPO, and some never recover. The investing public are the sheep who buy the hype and take the real risks. Helluva system.
The trouble with successful ICOs (initial coin offerings) in the crypto space is twofold: the wrong people can make money (founders and team members, the general public); and worse, the right people don't make money (Wall Street firms, VCs, accredited investors, securities law firms). The "mandate" of the SEC is clearly to lasso the ICO market in particular, and ideally the crypto space in general, and get it herded back into the same corral as traditional IPOs, where the right people make the most money, and the wrong people don't. Hence the SEC's letter-writing campaign. And hence the debut of outfits run by "the right people," such as Fidelity Digital Assets, JP Morgan's Quorum, and Circle, by Goldman Sachs. Not to mention Ripple hiring Bill Clinton as a keynote conference speaker. (Lol.)
So What Does it Mean?
Let's suppose that you're a US-based firm, or conceivably even a foreign firm which sells crypto to US buyers, and you've just received a written communication from the SEC. Let's examine what this implies, and what might happen given various possible responses on your part.
First, it indicates (obviously) that your activities are on the agency's radar screen. This in itself is probably discomfiting to many. We're just doing our thing here, being innovative and all that, and here comes Big Brother to mess with us. And of course you're not wrong: messing with you, and hopefully getting you to close up shop voluntarily (as Munchee did), is indeed their goal. See the rationale explored above to understand their motivation. But in this effort, your ignorance, and the fear it produces, will be their strongest ally.
The SEC has reputedly been sending out two kinds of communications. The first type is just a letter, a sort of polite request for information. The second is an administrative summons (sometimes loosely referred to as a subpoena, although it's technically not one). That's a much more formal demand for information, "you are COMMANDED to appear and to produce thus-and-such records," that sort of thing. Considerably less polite. The first type of request is going to be more common than the latter, if for no other reason than because the latter requires more paperwork and bureaucrats are naturally lazy.
It doesn't require much imagination to see that if you ignore the first type of inquiry, you could easily end up receiving the second in the future. What most people probably wouldn't consider is the fact that by responding to a letter requesting information, by providing the information requested, you have just implicitly admitted that the agency had a right to ask you for it in the first place. In other words, you have just volunteered a legal admission that your enterprise is indeed dealing in securities properly regulated by the SEC. Why else would you have answered their questions? At that point you are, to coin a phrase, at their mercy. If you've been doing an ICO, you can probably look forward to returning your purchasers their money, closing up your business, and promising never to flout the securities laws again, fingers and toes crossed, and feel duly grateful not to get prosecuted.
Which is not to say that responding to their nice, friendly inquisitive letter is a dumb idea. The stupidity lies in responding the way they want you to.
What if you were to respond, instead, by quoting the legal definition of a security as shown above, and then making a few factual statements of your own, such as:
- "It is our position that our cryptocurrency tokens do not fall within the statutory definition of a security under US law.
- We are not engaged in trade or business as a dealer or broker in securities.
- We therefore consider that your agency has no jurisdiction over our activities, and so respectfully decline to respond to your inquiries." ?
This is telling the SEC the opposite of what is implied by a compliant response. You are saying that you do not admit that they have any jurisdiction here. There's no law on the books which they are enforcing (Congress to date has made no laws whatsoever in respect of cryptocurrencies), nor are there even any clear court rulings on the question of cryptos being securities. (There is however one ruling by a district court to the effect that cryptos are actually commodities!) So why would you concede so easily a point which may be very difficult for the SEC to prove? Why not effectively ask them to prove it, instead?
There are logically two ways the agency could respond here: one, they drop it and move on to easier prey. Two, they escalate by sending you an administrative summons. (Unless that is what they sent you to start with.) It must be noted that this is not the same thing as a subpoena. Why? Because only courts (judicial branch) can issue a subpoena, and the SEC is part of the executive branch. The SEC can write "summons" or even "subpena" on their document, but until and unless it's signed by a federal judge, it ain't one.
This procedure is stipulated by 15 U.S. Code § 78u(c) :
In case of contumacy by, or refusal to obey a subpena issued to, any person, the Commission may invoke the aid of any court of the United States within the jurisdiction of which such investigation or proceeding is carried on, or where such person resides or carries on business, in requiring the attendance and testimony of witnesses and the production of books, papers, correspondence, memoranda, and other records. And such court may issue an order requiring such person to appear before the Commission or member or officer designated by the Commission, there to produce records, if so ordered, or to give testimony touching the matter under investigation or in question; and any failure to obey such order of the court may be punished by such court as a contempt thereof. All process in any such case may be served in the judicial district whereof such person is an inhabitant or wherever he may be found. Any person who shall, without just cause, fail or refuse to attend and testify or to answer any lawful inquiry or to produce books, papers, correspondence, memoranda, and other records, if in his power so to do, in obedience to the subpena of the Commission, shall be guilty of a misdemeanor and, upon conviction, shall be subject to a fine of not more than $1,000 or to imprisonment for a term of not more than one year, or both.
What this is saying is that if somebody blows off their administrative subpoena (or sends back an uncooperative "contumacious" response), the Commission has the right to petition the court for enforcement of their demands. And it will be up to the court to determine whether or not any refusal to comply has "just cause" behind it.
Subpoenas are governed by Rule 45 of the Federal Rules of Civil Procedure, which you can find here. It's worth a read in its entirety, but two specific sections are of particular interest here. Part (d)(2)(B), Objections, reads as follows:
(i) At any time, on notice to the commanded person, the serving party may move the court for the district where compliance is required for an order compelling production or inspection.
What this means is that as the "person commanded," you may serve on the SEC's attorney a written objection. Naturally your objection would reiterate your position as to the law, and your belief that due to the lack of subject matter jurisdiction, the subpoena is necessarily abusive. The SEC's attorney may, with notice to you, motion the court for an order to compel production, overriding your objection.
If they do that, you may then file with the court a "motion to quash" the SEC's subpoena. This is described in subsection (d)(3):
(A) When Required. On timely motion, the court for the district where compliance is required must quash or modify a subpoena that:
(i) fails to allow a reasonable time to comply;
(ii) requires a person to comply beyond the geographical limits specified in Rule 45(c);
(iii) requires disclosure of privileged or other protected matter, if no exception or waiver applies; or
(iv) subjects a person to undue burden.
(B) When Permitted. To protect a person subject to or affected by a subpoena, the court for the district where compliance is required may, on motion, quash or modify the subpoena if it requires:
(i) disclosing a trade secret or other confidential research, development, or commercial information; or
(ii) disclosing an unretained expert's opinion or information that does not describe specific occurrences in dispute and results from the expert's study that was not requested by a party.
(C) Specifying Conditions as an Alternative. In the circumstances described in Rule 45(d)(3)(B), the court may, instead of quashing or modifying a subpoena, order appearance or production under specified conditions if the serving party:
(i) shows a substantial need for the testimony or material that cannot be otherwise met without undue hardship; and(ii) ensures that the subpoenaed person will be reasonably compensated.
Section (A) lists conditions under which the court must quash the subpoena. Of interest is "undue burden," which it naturally is if the agency has no jurisdiction to begin with. Section (B) lists conditions under which the court may do so, at its discretion. Notice that trade secrets, confidential research, development (source code?) and commercial information (customer lists?) are protected from disclosure here. These provisions are aimed at preventing "fishing expeditions" where an agency asks for broad swaths of information hoping to find evidence of a crime. Court subpoenas are supposed to be very narrowly targeted to the needs of an investigation into some specific criminal, or potentially criminal, activity. There's a very good chance that the SEC's initially requested information would have been unduly broad.
There is of course no guarantee that the court will quash (rhymes with squash, and has the same meaning) the SEC's subpoena. However, at the least you will get your day in court at the motion hearing, at which you (or your attorney) can argue the point of law as to whether your crypto token is, indeed, a security. Because the entire validity of the subpoena hinges directly upon this assumption! Given the legal murk currently surrounding this determination in the absence of positive law enacted by Congress, one would be right in suspecting that this is a risk the SEC simply could not afford to take. Even if the entire matter got placed under seal, inferences can still be drawn from court dockets and appeals, as seen in these ongoing cases. If you won at your motion hearing, on the merits, the SEC's entire ability to intervene in the crypto space would be ended, finit, kaput. Most likely they would drop the whole matter long before it got to that point — after sending you a face-saving letter threatening unspecified future action due to your "contumacy," of course.
Which is why, if you are responding to the formal summons and not just to an informal letter, you might just add a point like this:
- "Having however no desire to violate US law, if your agency disagrees with our position, we invite you to petition a United States court of competent jurisdiction for an order to compel our response, pursuant to 15 U.S. Code § 78u(c). In which case we will motion the court to quash the subpoena as per FRCP Rule 45 on the grounds of lack of subject matter jurisdiction, which would render the subpoena clearly abusive. And we will then let the court decide the matter."
It's also worth pointing out that, if you really are violating securities laws and can avoid supplying the SEC with evidence of that by refusing to obey a subpoena, the statutory penalty for misdemeanor contempt (one year in jail, a $1000 fine, or both) is probably quite a bit less onerous than the penalties you'll receive if you supply them with the evidence with which to convict you of a felony. Just sayin.'
Sounds Good in Theory
Doubtless there are some readers out there going, "Yeah that all sounds good in theory, but who really knows what would happen? Who wants to play a high stakes game like this with nasty federal agencies and "just-us" system courts?" The answer of course is hardly anybody, which is exactly how the SEC (and many sister agencies) get away with these kinds of quasi-lawless intimidation campaigns waged against entire industries. But there are cases on record where ordinary folks have done this kind of thing, and won.
One good example is the case of Robert L. Schulz vs. the Internal Revenue Service (Schulz v. IRS, 04-0196). Now as nasty as the SEC may be, no agency of the US Government is as widely feared as the IRS. Just ask any American. Most of them will never have to deal with agencies like the SEC or the CFTC, but the IRS, along with the Department of Motor Vehicles, is practically ubiquitous. Not to mention its decades long history of abusive behavior ranging from discriminating against conservative organizations, to politically motivated punitive audits, to banning books, murdering pets and strip-searching teenaged girls.
Schulz was the boss wog of a non-profit foundation called the We The People Foundation. This foundation was a citizen lobby group which lobbied for three things: repeal of the federal income tax, repeal of the Federal Reserve Act, and repeal of the War Powers Act. The IRS sent Schulz an administrative summons seeking the members and contributors list of the Foundation, which was a 501(c)(3) non-profit organization. (Evidently Lois Lerner had nothing to do with processing its application!) Mr. Schulz was sharp enough to realize (not that this would be hard) that the data was wanted in order to harass and punish all those who would dare to support an organization lobbying for the termination of the IRS. So, since he lived in the Northern District of New York, he went to the US District Court there and filed a motion to quash the summonses he'd received from the IRS.
Surprise, the magistrate ruled against him! But the grounds were very interesting: because the court had no jurisdiction, there being no matter before the court upon which to rule. The problem was that Schulz had filed his motion to quash too soon, before the IRS had asked the court for an order to compel compliance. Nevertheless, Schulz, who was acting pro se (i.e. without an attorney) appealed, saying essentially, "But if I can't get a ruling from the District Court, then where can I get one?" The appeal was eventually decided by the Second Circuit Court of Appeals (of which NY is a part). But before we examine its ruling, it is worth quoting the statute governing IRS summons and court orders, which parallels that quoted above (15 U.S. Code § 78u(c)) in relation to the SEC:
Notice this follows the exact same sequence: if the person summoned refuses to obey, the agency (IRS in this case) may apply to the court for an order to compel obedience. If the target still disobeys, the court can treat it as contempt of court and punish it as such. (The standard punishment for contempt is six months incarceration.)
Now let's examine the ruling of the Second Circuit, decided January 25, 2005, because its language is really quite extraordinary. First, the court affirms the lower court's ruling striking down Schulz's motion to quash. (Note: this means the IRS "won" its case.)
Magistrate Judge Homer further found that if the IRS did attempt to compel Schulz to produce testimony and documents named in the summonses, the enforcement procedure described in §7604 would provide Schulz with adequate opportunity to contest the requests. Schulz filed an appeal and objection in the District Court. By order dated December 3, 2003, the District Court denied those objections and dismissed the appeal. Schulz now appeals from that final decision of the District Court. We assert jurisdiction pursuant to 28 U.S.C. §1291 and affirm.
The appellate judges go on to cite some case law involving some previously contradictory rulings, which they harmonize and clarify with the present ruling. They conclude by saying:
So the IRS won the case, but lost the war. Their response to the decision quoted above was to ask for a rehearing. Complaining that they wouldn't want the public to feel safe in ignoring IRS summonses, the AUSA representing the IRS very helpfully provided the three judge appellate panel with a pre-written version of the decision which they preferred, which contained merely the affirmation of the lower court's decision without all the accompanying dicta. The Second Circuit judges were not amused. Understandably irked by the arrogance of the IRS, the rehearing resulted in another decision in which they added even more verbiage which the IRS would prefer that no member of the public ever read, and sarcastically invited the IRS to take it up again for a rehearing en banc (meaning before the entire Second Circuit). Finally realizing that they were just digging the hole deeper, the IRS dropped the matter. They also dropped the investigation of the We The People Foundation, and the members and supporters of the Foundation taped a copy of the Second Circuit's decision to the door of every IRS branch office in the country. Quite appropriately, this was done on the anniversary of Martin Luther nailing The 95 Theses against the practice of Indulgences on the church door at Wittenberg in 1517.
Just like the IRS, the SEC is an Article II Executive Branch agency, not an Article III Judicial Branch agency. Therefore, the exact same logic cited in this IRS case re 26 U.S.C. §7604 applies with equal force to 15 U.S.C. §78u(c), or 15 U.S.C. §77v(b), or any other similar statute involving an administrative summons from any executive agency.
In short, you always have the ability to contest the agency's request before a federal court! In this particular situation, the SEC is extremely unlikely to agree to allow such a hearing to occur. It would after all become public record, and we now live in an age where news can go viral in hours, in which nobody would need to affix papers to any SEC office doors.
Disclaimer: this article is not an offer of legal advice. If you ever want to mix it up with a federal government agency, retaining qualified counsel first might be a smart move. Assuming of course that you can find counsel willing to help you resist at all, instead of just urging you to capitulate meekly. ;-)