Jay Clayton, chairman of the U.S. Securities and Exchange Commission (SEC), listens during a Senate Appropriations Subcommittee hearing in Washington, D.C., U.S., on Tuesday, June 27, 2017. Clayton and the Commodity Futures Trading Commission (CFTC) acting chairman defended their agency budget requests for fiscal 2018, both pledging to shift resources toward compliance efforts based on risk analysis. Photographer: Andrew Harrer/Bloomberg
On the most recent episode of blockchain-focused podcast Epicenter, co-hosts Brian Fabian Crain and Sébastien Couture interviewed former SEC Enforcement Division attorney Nick Morgan. During the discussion, Morgan provided some insight into which kinds of initial coin offerings (ICOs) could gain the attention of the SEC.
Throughout the interview, Morgan made the case that the SEC’s next case involving an ICO would likely focus on fraudulent activity; however, he also noted that non-fraudulent activity and digital asset exchanges could also be targeted.
The Key Part of the Howey Test for ICOs
In the early part of his appearance on Epicenter, Morgan discussed the Howey Test, which is the test that is generally used to determine whether a particular asset is legally considered a security in the United States. In Morgan’s view, the key part of the Howey Test in terms of ICOs is whether the expectation of profit relied on the effort of others.
“What [the SEC are] trying to do is decide whether the investors are really passive investors or whether they’re actively involved in creating value,” said Morgan.
As a defense attorney, Morgan noted that this is the area where he would focus most of his energy in these kinds of cases because this is the “closest call” in how the Howey Test is usually applied to ICOs, especially in the case of The DAO, which the SEC released a report on in late July.
Which ICOs Will Get the SEC’s Attention?
When first asked about which ICOs would gain the attention of the SEC and potentially lead to enforcement action, Morgan pointed out that it makes sense to view these sorts of matters from the perspective of a staff attorney at the SEC.
According to Morgan, an investigation would begin by someone at the SEC getting wind of an ICO and then beginning an “information gathering process”. It would make sense to start with cases where fraud is involved because, according to Morgan, the SEC would be cautious in bringing action in a case where fraud did not exist. An example of fraudulent activity would be someone raising funds through an ICO and then doing something completely different from what they said they were going to do with the raised funds.
From Morgan’s perspective, two key factors the SEC would consider before bringing a case are how strong the violation was and how many victims were involved.
“The cases — the types of fact situations — that will get the most attention are ones where disgruntled investors are coming in very upset at: ‘I was told this. I was told X and what happened was not X,’” explained Morgan. “Those are the kind of fact scenarios that are going to get a staff attorney incentivized to go — and the institutions of the SEC as a whole — incentivized to go after something.”
In addition to complaints from disgruntled investors, Morgan pointed out that the SEC’s whistleblower program could be another source of an investigation. Through this program, whistleblowers are awarded a percentage of monetary remedies that are imposed and collected by the SEC if and when enforcement action takes place.
According to Morgan, some bounties in the SEC’s whistleblower program have been worth tens of millions of dollars.
“I wouldn’t be surprised, particularly given the difficult nature of enforcing the securities laws in this context, if an ICO case comes out of a whistleblower seeking a bounty,” said Morgan.
In general, Morgan noted his belief that the SEC will take “cautious, thoughtful approaches” to the ICO market. He used what he perceives as a trend of relaxed capital raising regulation requirements, specifically the JOBS Act and comments regarding the overregulation of the IPO market from the current chair of the SEC, to back up this theory.
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