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Another court applies the Howey investment contract analysis to crypto

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On June 25, 2020, the United States Securities and Exchange Commission brought suit in the Northern District of California against NAC Foundation LLC, also known as the NationalAtenCoin Foundation, and Rowland Marcus Andrade, the company’s CEO, alleging that the company had violated the federal securities laws by selling an unregistered, pre-functional version of an “Anti-Money Laundering BitCoin” token, to be known as AML BitCoin.

Unlike some of the other recent high-profile decisions applying the Howey Test, such as SEC vs. Telegram and SEC vs. Kik, the NAC lawsuit involved detailed allegations of fraud in connection with the sale of pre-functional tokens. Andrade was also indicted by the Department of Justice on charges of fraud arising out of the offering, and Jack Abramoff, a federal lobbyist, pled guilty to participating in the fraud.

On Jan. 8, 2021, Judge Richard Seeborg of the Northern District of California rebuffed NAC and Andrade’s motion to dismiss, finding that the SEC’s complaint had sufficiently alleged that there had been an unregistered sale of securities under the Howey investment contract test. NAC filed its motion to dismiss back in October of 2020, alleging misconduct by the SEC as well as advancing the legal claim that AML BitCoin tokens were not securities under the Howey Test because, among other things, the purchasers had been repeatedly told that they could not expect a return on their investment. The SEC responded colorfully arguing:

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“If it looks like a duck, quacks like a duck, and has the genetic makeup of a duck, it is, indeed, a duck. It matters not if the seller puts a sign on the bird exclaiming, ‘this is not a duck.’”

The crypto offering

While many of the facts about the NAC offering are in dispute, some things appear to be settled. In October of 2017, NAC posted a “White Paper of AML BitCoin (AMLBit) and its Business Model” on its website. In this white paper, NAC stated:

“AML BitCoin rests on a privately regulated public blockchain that facilitates… anti-money laundering ‘know your customer’ compliance and identifies criminals associated with illicit transactions, while maintaining and strengthening the privacy protections for legitimate users.”

The white paper also explained that the “privately regulated public blockchain” was yet to be fully developed and that the original purchasers would be issued “ABTC tokens,” which could be exchanged one-for-one with AML BitCoin when the blockchain was finished. The ABTC tokens were, in all other respects, pre- or non-functional.

The white paper proclaimed that both ABTC and the eventual AML BitCoin could be traded “on participating exchanges and trading websites” and conceded there was the possibility of appreciation through speculation. A substantial portion of the white paper explains why, in NAC’s opinion, the AML BitCoins should not be securities.

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The actual initial coin offering took place from October 2017 to February 2018, with some sales occurring both before and after that time period. Although the white paper indicated a goal of distributing 76 million ABTC tokens to the public in order to raise $100 million, the actual amount raised was approximately $5.6 million, attributed primarily to 2,400 retail purchasers in the United States. The ABTC thereafter traded on a number of online platforms, but at no time did NAC attempt to register the tokens with the SEC.

Applying the Howey investment contract test

Adopted during the Great Depression, the Securities Act of 1933 obviously does not include crypto or digital assets in the laundry list of things that are to be regulated as “securities.” However, the Securities Act, which requires securities to be registered or exempt from registration in order to be legally offered or sold, does include “investment contracts” within the scope of the securities laws. Crypto assets are generally regulated as securities if they fit within the definition of an investment contract.

In the case of AML BitCoins and ABTC tokens, both the SEC and NAC seemed to agree that the appropriate test for whether NAC had sold an investment contract (and therefore a security) was the one set out by the U.S. Supreme Court in 1945 in SEC v. W.J. Howey Co. As described in more detail elsewhere, the application of the Howey Test turns on the following questions:

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  1. Did the purchasers invest something of value?
  2. Was there a common enterprise?
  3. Was the reason for their investment an expectation of profits?
  4. Were the purchasers relying on the essential managerial or entrepreneurial efforts of others?

All of those elements must be present in order for there to be an investment contract, although the Ninth Circuit (in which California is located) has collapsed the last two elements into a single factor.

As is true for most crypto sales, the NAC sales met the first element of this test. Since purchasers of the ABTC had either used fiat currency or other convertible digital assets to pay for the pre-functional tokens, they had clearly invested property of value. Instead of arguing that element, the issues raised by NAC in its motion to dismiss focused on its contentions that there were no allegations of a common enterprise in the complaint and that the ABTC investors had not purchased with a reasonable expectation of profits.

Commonality is admittedly one of the most complicated and confusing aspects of the Howey Test, with courts disagreeing about what is required to prove this element. Some courts look to vertical commonality, where the fortunes of the investors are tied to those of the issuer, often through a profit-sharing arrangement. Obviously, crypto offerings generally do not involve profit-sharing per se because purchasers acquire no stake or interest in the issuer’s business or profits. On the other hand, this is not necessarily the only way in which vertical commonality can be proven. For example, where the fortunes of an issuer and investors are tied together by a joint interest in the success and profitability of an asset that is yet to be developed, some courts have found vertical commonality to be present.

In addition, other courts look to horizontal commonality, which occurs where the fortunes of investors are tied together, even if the issuer’s profits are determined on some other basis. Such horizontal commonality is often proven by showing that investments are placed in a common pool from which profits are distributed on a pro rata basis.

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In this case, NAC argued that this element was missing because investors were required to acknowledge that there was no pooled interest in any business or other common enterprise. Again, however, not all cases agree that a pooling agreement is necessary. Some courts have found that there is horizontal commonality where proceeds from a sale have been combined in a common fund. In its brief supporting its Motion to Dismiss, NAC pointed to a Ninth Circuit opinion that the foundation suggested required that the promoters “knew” their funds would be pooled together.

With regard to the expectation of profits from the efforts of others, NAC argued that that there was only a single mention in its white paper of the possibility that “tokens could ‘appreciate in value through speculative trading…’” NAC contends that this comment occurred in the course of explaining why AML BitCoin would operate like Bitcoin (BTC) in that profitability would “rely entirely on the expertise of the AML BitCoin’s holder.” NAC also pointed to other documents, such as the terms and conditions, which required purchasers to acknowledge that purchasers “expect no return on investment.”

The court’s ruling

Before considering the text of the Jan. 8, 2020, ruling, it is worth emphasizing that the decision was not on the merits. Because the court was responding to a motion to dismiss, the judge was required to determine whether the SEC had sufficiently alleged facts that would support a verdict if those allegations are eventually determined to be true. In other words, in making this ruling, the court assumed that the facts as stated in the complaint accurately recite what happened. The court was allowed to draw reasonable inferences from those facts in determining whether the action should continue but was not allowed to consider NAC’s opposing views as to what had been said and what happened.

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The court, therefore, focused on whether the SEC sufficiently alleged that NAC had sold securities under the Howey investment contract test. The court considered both of the two elements identified by NAC: whether there was a common enterprise and whether the purchasers were expecting profits as a result of their investment. The court very quickly dismissed the argument that there was no common enterprise here, finding that both investors and the issuer would benefit from the development of the AML BitCoin system and that they would share proportionately in any future increases in value since the foundation retained the rights to a sizeable number of AML BitCoins. In the words of the court:

“The ‘fortunes’ of ICO participants—as measured by either the trading value of their ABTC tokens or the future trading value of AML BitCoin—were ‘linked’ to the ‘fortunes’ of defendants—as measured by the trading value of their ABTC tokens, the future trading value of AML BitCoin, or the general success of their enterprise…”

In a footnote, Judge Seeborg specifically noted that this result was consistent with the recent opinion in SEC v. Telegram, where the court found commonality based on the fact that every participant’s anticipated profits depended on the issuer’s success in developing the underlying blockchain.

With regard to whether the investors “reasonably expected profits based on the efforts of others,” the court concluded that the SEC had alleged “ample facts” to suggest both that there would be profits and that those profits depended on the issuer’s efforts. The profit motive was, according to the court, apparent from the fact that there was no use for the ABTC or AML BitCoin other than to hope for appreciation. Given that the demand for these assets would “rely almost exclusively on market perception of defendants’ work product” the court had no difficulty in concluding that the SEC’s complaint adequately pled that the assets sold by NAC were securities.

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Conclusion

The ruling on the motion to dismiss in SEC v. NAC is not groundbreaking. It does not make new law with regard to when crypto assets should be considered to be securities. It does not involve anything like the amount of money at issue in either SEC v. Telegram or SEC v. Kik. It does not even dictate the final outcome in the case itself.

It is, however, an early indication in 2021 that the SEC still has crypto sales in its crosshairs, and it is further confirmation that the Howey Test is likely to control when crypto is regulated as a security, absent intervention from Congress or potentially a change in perspective from the SEC itself.

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New Survey Shows Australian’s Love for Crypto is Fueled by These Noble Drives

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Australians appear to be more knowledgeable in their investment strategies as many are beginning to buy into cryptocurrencies for the right reasons. As highlighted in a recent survey conducted by BTC Markets, it was shown that acquiring digital assets was not a function of ideas to get rich quickly, rather, investors who are purchasing digital currencies are doing so to build wealth, and for retirement purposes amongst others.

Per the survey, 70% of the respondents to the survey said their sole aim of embracing crypto is to build wealth. This is a possible scenario seeing the high rate of growth of established coins compared to traditional investment assets. 34% of respondents buy-in to crypto so they can fall back on the gains when they retire, with some 28% affirming their aim to be portfolio diversification.

Cryptocurrencies have matured when compared to the level it was in the past decade. Today, institutional investors, as well as retail buyers, are all bullish on Bitcoin (BTC), Ethereum (ETH), and other altcoins with unique fundamentals.

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“The motivations for investing in cryptocurrency are many and varied. A majority of respondents to our survey, 70 per cent, say they are looking to build wealth. A significant percentage, 34 per cent, say that one of their goals for investing in cryptocurrency is to retire early.”

The reasons for acquiring crypto also span such needs as paying down for debts (at 12%), and in starting a business claimed by 4% of the respondents.

Diversity in Investor’s Portfolio

The investors who responded to the BTC Markets survey show diversity in their investment portfolios. This trend shows that despite the rising popularity of crypto assets, the bulk of investors are not in it for the frenzy attached to meme-tokens.

Of the total respondents, as much as 63% said they have investments in stocks or shares, 29% have injected capital in investment properties, while 20% said they have funds in precious metals including Silver and Gold. Of the profiled investors, only 20% said they hold only cryptocurrencies.

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Drawing on this diversity, the report reads;

“This spread of investments across a wide range of asset classes consolidates the view that a large majority of investors are not using cryptocurrency as a “get rich quick” investment. Instead, it is as part of a carefully considered asset allocation strategy for an overall wealth portfolio”

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What changes in the cryptocurrency market with China’s new rules

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The Chinese government started a new wave of repression of cryptocurrencies in the country, continuing the bans it has already imposed on the sector in the past, in 2013, 2017 and May 2021.

The People’s Bank of China, together with the country’s main financial regulators, released on Friday (24) a document called “Notice on the Prevention and Elimination of Risks in Virtual Currency Transactions” in which it announces the tightening of measures to repress negotiations of Bitcoin and other cryptocurrencies in the Asian country.

The point that draws the most attention in the document is a new understanding that any person or company that facilitates the negotiation of bitcoin and other cryptocurrencies in the country is breaking the law.

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The text states that “the provision of services to foreign exchanges to Chinese residents over the internet is an illegal financial activity” and those who engage in this activity will be investigated in accordance with the law.

The Central Bank has explicitly said that cryptocurrencies such as Bitcoin, Ethereum (ETH) and Tether (USDT) “are not legal, should not and cannot be used as currency in the market”, stating that all “commercial activity related to virtual currency is illegal” .

The agency once again reinforced a request it had already made in June for the country’s financial institutions to help fight cryptocurrencies, preventing their clients from making transactions to foreign exchanges and over-the-counter (OTC) markets.

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China attributed the tightening of measures to the rise in the popularity of cryptocurrencies in the country, which “seriously endangers the security of people’s property” and “grows criminal activities such as gambling, illegal fundraising, fraud, pyramid schemes and money laundering”.

At this pace, the document indicates that ordinary people who lose money in investing in cryptocurrencies will no longer be protected by law.

Keeping an eye on exchanges

Chinese journalist Colin Wu, one of the biggest references in the coverage of the cryptocurrency market in the country, told the Bitcoin Portal that it is still difficult to see in practice what changes in the cryptocurrency market with the new wave of repression in China.

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“We have to wait, it’s hard to say now. The expectation is to find out how big exchanges like Huobi and OKEx will tackle this, as they still operate OTC tables here. They have a strong government relationship and will make a rational choice”, he explained.

He pointed out that it is already possible to identify that most Chinese companies operating in the cryptoactive sector are looking for friendlier jurisdictions to base their operations on, such as Singapore.

“Singapore is open and tolerant of cryptocurrencies, not just Chinese companies, but many international companies in the area are also moving there, such as 3ac,” explained Wu. “Another reason is that Singapore’s culture is similar to China.”

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The government’s hardening has already been able to scare some market participants. The world’s largest Ethereum mining pool, the Spark Pool, announced today that it will no longer provide its services to users in mainland China as a way of “complying with the latest industry regulatory policies.”

Second Wu, the popular NBMiner mining software also confirmed that it will no longer offer technical support services to Chinese customers.

Attack on miners intensifies

At the same time as the Central Bank issued the new restrictions, China’s state planning body, the NDRC, also issued a “Virtual Currency Mining Rectification Notice” that focuses on combating mining.

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The text orders electricity providers to stop serving miners through hotlines and increase the cost of energy to $0.05 per kilowatt-hour for identified miners.

The NDRC also urges local authorities to increase the search for illegal mining farms and generally crack down on activities in their territories as a way of phasing out the industry.

According to Colin Wu, larger miners are likely to continue the trend started during the May crackdowns and leave China to operate in other countries such as the United States.

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“Meanwhile, small miners must find some factories to mine secretly. If they cannot find a safe place, they will probably have to sell their machines,” he told the report.

Bitcoin remains resilient in the long run

Bitcoin prices were not immune to this Friday’s negative news coming out of China. According to CoinMarketCap, the currency has devalued 3.6% in the last 24 hours, trading at US$42,220.

Although it is already common for the price of bitcoin to react negatively to the Chinese government’s statements, the drop tends to be a passing event, with the cryptoactive being able to recoup its losses in the long run.

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According to data from Kraken disclosed by analyst Pete Humiston, bitcoin typically appreciates an average of 53% about 90 days after the FUD news — fear, uncertainty and doubt — departs from China.

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Netflix Eyes Mysterious Disappearance of $190,000,000 After Death of Crypto Exchange CEO

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One of the biggest mysteries in the cryptocurrency sector is getting fresh scrutiny in a Netflix documentary.

The online video streaming giant says in a tweet that it will air an investigative documentary titled “Trust No One: The Hunt for the Crypto King”.

The documentary focuses on Gerald Cotten, the founder and CEO of QuadrigaCX, Canada’s biggest cryptocurrency exchange until two years ago.

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Cotten, a Canadian, died in December of 2018 while on a honeymoon in India, but his death went unannounced until January 2019.

The QuadrigaCX CEO was allegedly the only one with the private keys required to access the crypto assets in the exchange’s custody, believed to be worth $145 million (C $190 million) at the time of his death.

Netflix says the documentary will air starting next year.

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“TRUST NO ONE: THE HUNT FOR THE CRYPTO KING

Follow a group of investors turned sleuths as they try to unlock the suspicious death of cryptocurrency multimillionaire Gerry Cotten and the missing $250 million they believe he stole from them. Premieres in 2022″

Cotten’s sudden death in a foreign land and the disappearance of millions of dollars worth of crypto assets led to conspiracy theories that included suspicions that Cotten might have faked his death.

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report by Canadian Broadcasting Corporation in May quoted Cotten’s widow denying the theory, saying through her lawyer that “she was with Mr. Cotten at the time of his death and he is most certainly dead.”

QuadrigaCX entered bankruptcy proceedings soon after Cotten’s death, and by May, the amount recovered to pay the roughly 76,000 creditors totaled $36,357,894 (C $46 million).

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