Tag: Securities

The Howey Test: Would Your Crypto Offering Pass or Fail?

Posted on by Kelly McElroy

Before you launch your next crypto token, you should see if you can pass the test.

It is not the smell test with investment bankers.

The Howey test will help you understand if your crypto is one of many digital securities which would present more legal responsibilities, such as disclosure and registration requirements.

The U.S. Securities and Exchange Commission (SEC) v. W.J. Howey Co. was a 1946 Supreme Court decision about citrus grove buyers in Florida. The Howey Company sold citrus groves to investors who leased the land back to Howey. The company’s employees managed the groves and sold the fruit on behalf of the investors. Both the company and the investors profited from the venture.

The investors only needed to supply capital to the arrangement, while others took care of all the other details. An investment contract is what you get when your transaction passes the Howey test.

Of course, this concept impacts things beyond citrus fruit. It is also applicable to the cryptocurrency market. In fact, there are four factors to consider which separate a security from a commodity:

  • An investment
  • A common enterprise
  • A profit expectation
  • Generated from the work of third-parties

In the U.S., the SEC has deemed bitcoin not to be a security. The issuer, an anonymous Satoshi Nakamoto, released all 21 million tokens at once as part of a contract. None of the tokens went to him or a company treasury. When the tokens were released, they had no value, and when they gained value, Nakamoto did not receive any benefit.

In effect, he removed any possible connection between “common enterprise” from the other factors, which disqualifies the venture as a security under the Howey test.

SEC Chair Gary Gensler said, “at the core, these (altcoin) tokens are securities because there’s a group in the middle and the public is anticipating profits based on that group,” during an interview with New York Magazine.

However, Rostin Behnam, the chairman of the Commodity Futures Trading Commission (CFTC), said Bitcoin is not the only commodity. He called another crypto coin—Ethereum—a commodity during a hearing before the Senate Agriculture Committee. In fact, Ethereum has been listed on CFTC exchanges for some time.

An interagency council comprised of state and federal banking officials, as well as commodity, securities and consumer protection groups, agreed in a report that there is not a comprehensive regulatory framework for digital assets. Hence, the reason for differing stances within the industry.

Right now, asset classification dictates how digital assets are regulated. If it is a payment, then it falls under the purview of Money Services Business and the Office of the Comptroller of the Currency. Likewise, CFTC oversees commodities, and the SEC has jurisdiction over securities.

Recently, the SEC has filed a complaint against Binance and Coinbase, alleging that they are selling unregistered securities. The complaint mentioned several coins that could be viewed as securities: Polygon, Cardano and Solana. Soon after the announcement, Robinhood—another crypto exchange—delisted the three mentioned coins.

Binance.US has decided to become a crypto-only exchange, ending US dollar deposits and withdrawals. The SEC wants a federal judge to freeze the exchange’s assets, including $2.2 billion in crypto and $377 million held in dollars.

Either the Coinbase case or the Binance case could make its way to the U.S. Supreme Court, which could in effect create the path for industry regulation with its ruling. As part of a possible outcome, the High Court could also rewrite the Howey test or revise it in relation to digital assets.

At the 2023 Global Exchange and Fintech Conference, Gensler said congressional action is not needed because the laws are already on the books. “Not liking the law, not liking the rules is different than not hearing it or not getting it,” he said. However, this view fails to recognize that the current regulatory framework is not black and white for investors and institutional players.

Under federal securities laws, a company must register with the SEC before offering or selling securities. As part of the registration process, an issuer must disclose financial statements that have been audited by a public accounting firm. These documents provide important information that helps investors make informed decisions about their investments.

As the digital financial assets space grows, more large corporations can be found with crypto on their balance sheets. A 2022 Deloitte Global Corporate Treasury Survey found that 40% of interviewed finance executives said they have already implemented blockchain or they are considering it.

In the short term, issuers will need to work with a law firm with expertise in crypto and digital currencies to navigate the impact of the courtroom rulings and the subsequent new era of regulation on their business.

Make sure your company will be able to pass the test in the evolving legal landscape.

(Joseph M. Pastore III is chairman of Pastore, a law firm that helps corporate and financial services clients find creative solutions to complex legal challenges. He can be reached at 203.658.8455 or jpastore@pastore.net.)

The Modernized Marketing Rule for Financial Advisers

Posted on by Kelly Somers

On November 4, 2022, compliance with the amendments to the advertising and cash solicitation rules in Rule 206(4)‑1 under the Investment Advisers Act of 1940 (Marketing Rule), which the Commission issued on December 22, 2020 will become mandatory.

Since the advertising and cash solicitation rules were adopted (Rule 206(4)-1 in 1961 and Rule 206(4)-3 in 1979, respectively) the advent of the internet and social media, among other things, has dramatically changed the landscape of marketing professional services. The Marketing Rule is designed to modernize rules that govern investment adviser advertisements and payments to solicitors, replacing the broadly drawn limitations and prescriptive or duplicative elements in the previous rules with more principles-based provisions, as described below.

Definition of Advertisement. The amended definition of “advertisement” contains two prongs:

  • The first prong captures communications traditionally covered by the advertising and includes any direct or indirect communication an investment adviser makes that: (i) offers the investment adviser’s investment advisory services with regard to securities to prospective clients or private fund investors, or (ii) offers new investment advisory services with regard to securities to current clients or private fund investors. The first prong of the definition excludes most one-on-one communications.
  • The second governs solicitation activities previously covered by the cash solicitation rule and includes any endorsement or testimonial for which an adviser provides cash and non-cash compensation directly or indirectly (e.g., directed brokerage, awards or other prizes, and reduced advisory fees).

General Prohibitions. Under the Marketing Rule, the following advertising practices are prohibited:

  • making an untrue statement of a material fact, or omitting a material fact necessary to prevent making the statement misleading;
  • making a material statement of fact that the adviser does not have a reasonable basis for believing it will be able to substantiate;
  • including information that would reasonably be likely to cause an untrue or misleading implication or inference to be drawn concerning a material fact relating to the adviser;
  • discussing potential benefits without providing fair and balanced treatment of any associated material risks or limitations;
  • referencing specific investment advice provided by the adviser that is not presented in a fair and balanced manner;
  • including or excluding performance results, or presenting performance time periods, in a manner that is not fair and balanced; and
  • including information that is otherwise materially misleading.

Testimonials and Endorsements. The Marketing Rule prohibits the use of testimonials and endorsements in an advertisement, unless the adviser satisfies certain disclosure, oversight, and disqualification provisions:

  • Disclosure. Advertisements must CLEARLY and PROMINENTLY disclose whether the person giving the testimonial or endorsement (the “promoter”) is a client and whether the promoter is compensated. Additional disclosures are required regarding compensation and conflicts of interest. There are exceptions from the disclosure requirements for SEC-registered broker-dealers under certain circumstances. Advisers will no longer need to obtain from each investor acknowledgements of receipt of the disclosures.
  • Oversight and Written Agreement.An adviser that uses testimonials or endorsements in an advertisement must oversee compliance with the marketing rule. An adviser also must enter into a written agreement with promoters, except where the promoter is an affiliate of the adviser or the promoter receives de minimis compensation (i.e., $1,000 or less, or the equivalent value in non-cash compensation, during the preceding twelve months).
  • Disqualification. Subject to certain exceptions, “bad actors” may not serve as promoters.

Third-Party Ratings. The rule prohibits the use of third-party ratings in an advertisement, unless the adviser provides disclosures and satisfies certain criteria pertaining to how the rating was prepared.

Performance Information Generally.  In order to deter the provision of misleading information, the rule prohibits including in any advertisement:

  • gross performance, unless the advertisement also presents net performance;
  • performance results, unless they are provided for specific time periods in most circumstances;
  • any statement that the Commission has approved or reviewed any calculation or presentation of performance results;
  • performance results from fewer than all portfolios with substantially similar investment policies, objectives, and strategies as those being offered in the advertisement, with limited exceptions;
  • performance results of a subset of investments extracted from a portfolio, unless the advertisement provides, or offers to provide promptly, the performance results of the total portfolio;
  • hypothetical performance (which does not include performance generated by interactive analysis tools), unless the adviser adopts and implements policies and procedures reasonably designed to ensure that the performance is relevant to the likely financial situation and investment objectives of the intended audience and the adviser provides certain information underlying the hypothetical performance; and
  • predecessor performance, unless there is appropriate similarity with regard to the personnel and accounts at the predecessor adviser and the personnel and accounts at the advertising adviser. In addition, the advertising adviser must include all relevant disclosures clearly and prominently in the advertisement.

If you are an investment adviser, now is the time to ensure your marketing materials comply with the modernized Marketing Rule.

Is Cryptocurrency Regulation here yet?

Posted on by Kelly Somers

Is Regulation here yet? The Evolving State of Case Law and the Appropriate Characterization of Crypto as a Security or Not.

For some investors, part of the appeal of tokenized assets is that the sector has been able to dodge regulations from institutions like the U.S. Securities and Exchange Commission (“SEC”), the U.S. Department of Treasury, and the Commodity Futures Trading Commission. Tokenized assets can be fungible or non-fungible. Fungible tokenized assets are both interchangeable and indistinguishable such as Bitcoin and other cryptocurrencies (“Crypto”). Non-fungible tokens (“NFTs”) are unique tokens that are non-divisible and cannot be replaced because each token has its own unique value.[1]

Investors and regulators alike have faced the recurring question of how to make sense of this decentralized digital space. However, more clarity on the guidelines surrounding Crypto and NFTS are forming. On March 9, 2022, President Biden signed an Executive Order on Ensuring Responsible Development of Digital Assets, calling for a closer look into the possible threats and benefits of Crypto.[2] The SEC has shouldered the weight of overseeing the majority of Crypto products and platforms. Regulatory efforts have been a challenge due in part to a major dilemma being weighed by regulators: whether cryptocurrencies should be processed as securities or commodities.

In 2021, a Connecticut federal case involving a securities class action suit against Stuart Fraser, GAW Miners, and ZenMiner began to provide a more definitive answer on how to classify cryptocurrencies; as the federal jury concluded that Paycoin and several other crypto-currency mining related assets were not securities.[3] However, as recently as June 3, 2022, U.S. District Judge Michael P. Shea has granted a motion for a new trial regarding Paycoin.[4]

Judge Shea justified the new trial by citing precedent in SEC v. Kik Interactive Inc., in which Kik Interactive Inc. (“Kik”) failed to register its digital tokens as a security.[5] The SEC was able to demonstrate that under the Howey Test, Kik met the criteria to be considered an “investment contract”. For an asset to be considered an investment contract, it must meet the three criteria of the Howey Test, which was developed and named after the Supreme Court case SEC v. W.J. Howey Co., 328 U.S. 293 (1946).[6]  The Howey Test requires that there be (i) an investment of money (ii) in a common enterprise (iii) that is subject to a reasonable expectation of profits to be derived from the efforts of others.[7] With Kik’s money being invested in a single integrated offering, the court granted the SEC summary judgement and Kik a $5 million dollar penalty.[8]

In addition to Kik, the SEC also brought a lawsuit against Ripple Labs Inc., claiming that over $1.3 billion had been raised as an unregistered digital asset security.[9] The lawsuit has made national news because XRP, the cryptocurrency developed by Ripple, is one of the most valuable in the world. Ripple has been arguing that XRP should not qualify as an investment contract because the company had never promised profits to any of its holders.[10] The case was formally served in December of 2020 and is still ongoing. However, on March 22, 2021, Judge Netburn declared that XRP has monetary value, separating it from bitcoin and Ether.[11]

A regulatory stance that aligns with the initial Paycoin decision would result in more lenient oversight over the Crypto space and likely promote further development in blockchain technology.[12] Conversely, a regulatory stance promoting SEC oversight over tokenized assets could force digital currencies, such XRP, to register as securities. Upcoming legal decisions, particularly the new trial regarding Paycoin, will be crucial in providing investors and legislators with a more concrete understanding of the legal space surrounding tokenized assets and blockchain technology.

 

[1] Tokenization: Opening Illiquid Assets to Investors, BNY Mellon (June 2019), https://www.bnymellon.com/emea/en/insights/all-insights/tokenization-opening-illiquid-assets-to-investors.html.

[2] Executive Order on Ensuring Responsible Development of Digital Assets, The White House (March 2022),

https://www.whitehouse.gov/briefing-room/presidential-actions/2022/03/09/executive-order-on-ensuring-responsible-development-of-digital-assets/.

[3] Federal jury Concludes Cryptocurrency Products NOT Securities, The National Law Review (November 2021), https://www.natlawreview.com/article/federal-jury-concludes-cryptocurrency-products-not-securities.

[4] Federal Judge Orders new Securities Trial for Crypto-Product ‘Paycoins’, ConnecticutLawTribune (June 2022), https://www.law.com/ctlawtribune/2022/06/13/federal-judge-orders-new-securities-trial-for-crypto-product-paycoins/?kw=Federal%20Judge%20Orders%20New%20Securities%20Trial%20for%20Crypto-Product%20%27Paycoins%27&utm_source=email&utm_medium=enl&utm_campaign=dailybriefing&utm_content=20220614&utm_term=clt&slreturn=20220529104704.

[5] Id.

[6] Framework for ‘Investment Contract” Analysis of Digital Assets, The U.S. Securities and Exchange Commission, https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets (last visited June 29, 2022).

[7] SEC v. Kik Interactive Inc., 492 F.Supp.3d 169, 177 (S.D.N.Y. 2020).

[8] SEC Obtains Final Judgment Against Kik Interactive for Unregistered Offering, The U.S. Securities and Exchange Commission (October 2020), https://www.sec.gov/news/press-release/2020-262.

[9] XRP vs. SEC lawsuit update, Cryptopolitan (June 2022), https://www.cryptopolitan.com/xrp-vs-sec-lawsuit-update/.

[10] The ‘Ripple’ effect: a striking development on defending digital asset securities litigation, Reuters (April 2022), https://www.reuters.com/legal/legalindustry/ripple-effect-striking-development-defending-digital-asset-securities-litigation-2022-04-21/

[11] XRP vs. SEC lawsuit update, Cryptopolitan (June 2022), https://www.cryptopolitan.com/xrp-vs-sec-lawsuit-update/.

[12] SEC vs. Ripple: Case Explained, CNBC (April 2022), https://www.cnbctv18.com/cryptocurrency/sec-vs-ripple-case-explained-13054042.htm.

Pastore Calculates RAUM of over $1 Billion for Registered Investment Advisor

Posted on by Kelly Somers

This past month, Pastore LLC assisted a registered investment advisor (RIA) with the filing of its Form ADV.  In connection therewith the firm assisted the RIA in its calculation of regulated assets under management (RAUM), which totaled over $1 billion. The Securities and Exchange Commission (SEC) uses RAUM as its  measurement of assets for registration purposes. However, RAUM has  sometimes been misunderstood as representing total assets under management (AUM) for a company, and based on the firm’s experience the SEC itself has sometimes confused RAUM with AUM.  RAUM does not include every type of asset that an RIA may manage, and in particular may not include certain real estate investments or investments in portfolio companies controlled by the fund.  When assessing the financial condition of an RIA and its funds, it is important to distinguish between the assets counted under RAUM and the assets counted under AUM.  An RIA that appears to manage a small volume of assets based on its RAUM may in fact manage a much larger volume of assets based on total AUM.

Tokenized Assets: What are They and how are They Regulated?

Posted on by Kelly Somers

As the decentralized world of blockchain continues to grow, tokenized assets have caught the eye of investors and regulators alike. Tokenized assets may be fungible or non-fungible. Fungible tokenized assets are interchangeable and indistinguishable such as Bitcoin and other cryptocurrencies (“Crypto”). Non-fungible tokens (“NFTs”) are unique tokens that are non-divisible and cannot be replaced because each token has a unique value.[1] Tokenized assets result from taking a tangible asset (such as real estate, paintings, and precious metals) or an intangible asset (such as a digital picture or a YouTube video) and converting the asset ownership into a digital token on a blockchain.[2] This process is known as tokenization.[3] By taking a real-world asset and making a digital representation, it creates a broader investor base, geographic reach, and a reduction in transaction times.[4] Moreover, placing the digital token on a blockchain ensures no single authority can erase your ownership in the tokenized asset.[5]

While tokenized assets can allow for a broader base of investors, like the Crypto market, the NFT market lacks clear regulations from the regulatory agencies such as the U.S. Securities and Exchange Commission (“SEC”) and the Commodity Futures Trading Commission (“CFTC”).[6] Moreover, state regulatory bodies have yet to issue guidance on the tokenized asset market.[7]

The current legal framework was not designed to regulate and guide the creation and trade of digital assets.[8] Moreover, the question of what category an NFT falls into depends on the particular asset that was tokenized.[9] For example, the CFTC has stated that renewable energy credits and emission allowances are commodities as defined by the Commodity Exchange Act.[10] However, the SEC has stated that depending on the facts and circumstances of a given NFT, it might be considered an investment contract under the Howey test, which would cause the NFT to be regulated under the Securities Act of 1933 and Securities Exchange Act of 1934.[11] The legal uncertainty within the NFT market led SEC Commissioner Hester Peirce to recently state that guidelines would help provide the public with an understanding of how the SEC is approaching these issues.[12] The lack of a clear regulatory framework has made investors susceptible to fraud, and it allows for bad actors to avoid domestic and international anti-money laundering laws.[13]

Additionally, there is no standardized set of rights that accompanies an NFT since the seller determines what rights follow the NFT.[14] Therefore, sellers and buyers alike should understand the limitations that a transfer, assignment, or license may have on the NFT.

While tokenized assets allow for quick cross-border investment and increased liquidity of real-world assets, investors are left without a clear regulatory framework and, at times, not knowing what rights follow the purchase of an NFT. As the decentralized world of blockchain continues to grow, it is imperative that investors and businesses use common sense, sound legal advice, and diligence to navigate this market. Given the lack of legal certainty, attorney legal opinions on these assets will likely immunize any reasonable use.

[1] Tokenization: Opening Illiquid Assets to Investors, BNY Mellon (June 2019), https://www.bnymellon.com/us/en/insights/all-insights/tokenization-opening-illiquid-assets-to-investors.html.

[2]Id.

[3]Id.

[4]Id.

[5] What is asset tokenization?, Hedera, https://hedera.com/learning/what-is-asset-tokenization#:~:text=Asset%20tokenization%20is%20the%20process,either%20digital%20or%20physical%20assets.&text=Asset%20tokenization%20could%20convert%20ownership,0.0002%25)%20of%20the%20property (last visited Feb. 3, 2022).

[6] William de Sierra-Pambley, Tokenization: Opportunity and Regulation, Finding a Balance, Sheppard Mullin (Oct. 18, 2021), https://www.jdsupra.com/legalnews/tokenization-opportunity-and-regulation-5158893/.

[7]Id.

[8]NFTs: Key U.S. Legal Considerations for an Emerging Asset Class, Jones Day (April 2021), https://www.jonesday.com/en/insights/2021/04/nfts-key-us-legal-considerations-for-an-emerging-asset-class.

[9]Id.

[10]Id.

[11]Id.

[12] Sarah Wynn, SEC’s Peirce says agency guidance on nonfungible tokens needed, Roll Call (Jan. 25, 2022), https://rollcall.com/2022/01/25/secs-peirce-says-agency-guidance-on-nonfungible-tokens-needed/.

[13]NFTs: Key U.S. Legal Considerations for an Emerging Asset Class, supra note 11.

[14]Id.

Pastore Brings Claims to Thwart Violations of Securities Laws by Broker-Dealers

Posted on by Kelly Somers

Pastore LLC has brought claims to thwart violations of securities laws by broker-dealers to funnel money away from a rightful beneficiary to a wrongdoer. The scheme, as alleged in the federal complaint, conducted by the broker-dealers led to violations of their supervisory responsibilities under the Securities Exchange Act of 1934 (the “Exchange Act”) and the Investment Advisers Act of 1940 (the “Advisers Act”) as well as multiple FINRA rules. Moreover, FINRA and the SEC have previously fined these broker-dealers for conducting similar schemes. A recent article regarding this matter can be found here.

Second Circuit Affirms Jury Verdict Win for Pastore’s Hedge Fund Clients

Posted on by Kelly Somers

The Second Circuit Affirms Jury Verdict Win for Pastore’s Hedge Fund Clients in Multimillion-dollar Securities Fraud Case Brought by Billionaire Family Office

On November 15, 2021, the Second Circuit affirmed a jury verdict obtained by Pastore in a federal securities fraud case. This concluded a contentious, multi-year litigation, defeating claims of fraudulent inducement and securities fraud brought against two hedge fund executives by a billionaire family office special purpose investment vehicle. The billionaire family office, the heirs to and founders of a well-known apparel store, had invested in the fund’s General Partner limited liability company.

In 2018, The United States District Court for the District of Connecticut granted a summary judgment in favor of the defendants. The summary judgment was subsequently appealed up to the United States Court of Appeals for the Second Circuit, before being remanded back to, and concluding with, a jury trial in the United States District Court for the District of Connecticut. Pastore LLC was hired for the trial. After two weeks of evidence and 7 hours of jury deliberation, Pastore LLC was able to secure a favorable jury verdict for the clients. The jury had found in favor of the defense on a federal securities claim.

Then, the billionaire family office appealed the jury verdict to the Second Circuit and argued that it was entitled to a new trial because, it alleged, the district court’s abuse of discretion had a prejudicial impact on the jury’s verdict. Among other alleged errors, the billionaire family office alleged that evidence concerning a billion-dollar company investment agreement with one of the world’s largest private equity funds should be excluded. The Second Circuit stated, “the district court instructed the jury ‘the entity that holds an interest in a security suffers an economic loss if the investment experiences a decline in value.’ App’x 559. In other words, the district court instructed the jury that it should find that…suffered an economic loss if it determined that…owned the investment interest in…, regardless of the source of investment funds, and that this investment declined in value.”

Commercial Mortgage-Backed Securities, COVID-19, and the New Potential Systematic Risk

Posted on by Kelly Somers

A commercial mortgage-backed security (“CMBS”) is a group of bonds comprised of commercial real estate loans commonly contained in trusts which are then sold to investors.[1] As of 2020, the largest loan contributors to the CMBS market include large banks, such as Citibank, Goldman Sachs, Morgan Stanley, Deutsche Bank, JPMorgan Chase, Wells Fargo, and Bank of America.[2] The commercial property loans securitized by CMBS are generally compromised of commercial properties such as apartment buildings, hotels, factories, office buildings and parks, or shopping malls.[3] These bundles of bonds are also referred to as tranches.[4] CMBS loans are ranked – those with the highest rating have the lowest risk, and those with the lowest rating have the highest risk.[5] Lower risked bonds are known as senior issue, and higher risk bonds are known as junior issue.[6] After the bonds are sold, the bank receives the money from the sale.[7] The bank then lends these proceeds to a subsequent borrower to collect additional fees.[8]

Investing in CMBS poses a lower risk to borrowers than a residential mortgage-backed security (“RMBS”) loan because commercial mortgages typically have a fixed term.[9]  CMBS loans are also compromised of fewer loans than RMBS loans.[10] Many investors seek out this loan because they are interested in obtaining property for an extended period of time and CBMS loans provide lower interest rates.[11] Other incentives of CMBS loans include a higher leverage financing, and CMBS loans are nonrecourse loans, and thus have a wider range of accessibility, because investors with lower credit are more readily able to obtain these loans. [12]

Although there are numerous advantages of CMBS loans, there are several disadvantages tied to a CMBS loan investment. First, these loans have prepayment penalties, which penalize a borrower for paying back a loan outside of the fixed term, even in the circumstance where the borrower pays the loan back earlier than the predetermined date.[13] Second, CMBS loans go through a defeasance profess before prepayment, which can be a painstaking process involving the borrower consulting with a financial advisor in order to set up alternative securities to replace any collateral and interest that the lender no longer is obligated to.[14] Lastly, the terms of CMBS loans are more difficult to negotiate, and a borrower has little or no say in the terms of the loans.[15]

The CMBS market has been greatly impacted by the COVID-19 pandemic. A shift towards working from home has created a failure of roughly $5.5 billion commercial mortgage loans since the summer of 2020.[16] The delinquency rate of CMBS loans in June 2020 was reported to be 10.32%. [17] The delinquency rate continued to increase during October of 2020, during the second wave of the pandemic.[18] The trends of CMBS loans due to the financial crisis that the pandemic has caused are almost identical to the trends of CMBS loans during the 2012 financial crisis, which poses an alarming issue when considering the impact the 2012 crisis had on the CMBS market.[19] The rise of delinquency rates is directly correlated to the effects that COVID-19 has had on commercial real estate: apartment owners, retail owners, restaurants, and hotels are bringing in substantially less income, and are left unable to pay mortgage and other commercial property-related debts.[20]

The last financial crisis in 2012 led to grave delinquencies in the CMBS market, which may signal that the CMBS market will undergo similar disruption in the future, indicative of a similar systemic risk.[21] However, much has been learned from former financial crises and the risks they pose on all types of mortgage backed-security loans, to avoid unnecessary risk in the CMBS market. Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act after the 2007-2008 financial crisis, which affects CMBS by “including risk-retention requirements for asset-backed security sponsors, increased disclosure requirements, the Volcker Rule and enhanced capitalization requirements for banks.”[22]

These protective measures are an attempt to make the CMBS market a safer space for investors by decreasing the systematic risk that the CMBS market decline may have on the overall economy.[23] An unforeseen consequence has been an increase in the price of entry into the CMBS market which affects retail investors, and aspects such as the Volcker Rule, which decreases market liquidity and restricts proprietary trading by preventing a bank from holding inventories of secondary market securities and disallowing a banks from investing in real estate.[24]

While the effects from the COVID-19 pandemic may affect the CMBS market and make these loans less accessible to borrowers, overall, the Dodd-Frank reforms have likely mitigated a majority of the risk to the CMBS market directly tied to COVID-19 and will provide a lasting benefit by decreasing this systematic risk impacting the overall economy.

[1] Owen Haney, The Virus, Risk, and Commercial Mortgage-Backed Securities: Examining Dodd-Frank’s Impact in the Midst of a Pandemic, 26 Fordham J. Corp. & Fin. L. 391, 394 (2021)

[2]Id.

[3]Carol M. Kopp, Commercial Mortgage-Backed Securities (CMBS), Investopedia, (October 25, 2020), https://www.investopedia.com/terms/c/cmbs.asp

[4]Thomas Kenny, What are Commercial Mortgage-Backed Securities?, The Balance, (October 7, 2021), https://www.thebalance.com/what-are-commercial-mortgage-backed-securities-cmbs-416910

[5]Id.

[6]Id.

[7]Id.

[8]Id.

[9]Carol M. Kopp, Commercial Mortgage-Backed Securities (CMBS), Investopedia, (October 25, 2020), https://www.investopedia.com/terms/c/cmbs.asp

[10]Maegan E. O’Rourke, The New Normal: How the Dodd-Frank Risk Retention Rules Affect the Future of CMBS, 51 Suffolk Univ. L. Rev. 77, 81-82 (2018).

[11]Understanding CMBS and CLO Markets, Signet Investments, “https://signetinvestments.com/understanding-cmbs-and-clo-markets/” https://signetinvestments.com/understanding-cmbs-and-clo-markets/ (Last visited November 6 2021)

[12]Commercial Mortgage-Backed Securities (CMBS): A guide, Quicken Loans (January 27, 2021), https://www.quickenloans.com/learn/cmbs

[13]Id.

[14]Id.

[15]Id.

[16]Dorothy Neufield, Commercial Mortgage Delinquencies Near Record Levels, Visual Capitalist (July 16, 2020), https://www.visualcapitalist.com/mortgage-delinquencies/

[17]U.S. CMBS Delinquencies Resume Increase in October, Fitch Ratings (November 6, 2020), “https://www.fitchratings.com/research/structured-finance/us-cmbs-delinquencies-resume-increase-in-october-06-11-2020” https://www.fitchratings.com/research/structured-finance/us-cmbs-delinquencies-resume-increase-in-october-06-11-2020

[18]Id.

[19]Owen Haney, The Virus, Risk, and Commercial Mortgage-Backed Securities: Examining Dodd-Frank’s Impact in the Midst of a Pandemic, 26 Fordham J. Corp. & Fin. L. 391, 394 (2021)

[20] Peter J. Irwin et al., CMBS Loan Workouts During COVID-19: A Borrower’s Perspective, Debevoise & Plimpton (May 14, 2020), https://www.debevoise.com/-/media/files/insights/publications/2020/05/20200514-cmbs-loan-workouts-during-covid-19.pdf https://www.debevoise.com/-/media/files/insights/publications/2020/05/20200514-cmbs-loan-workouts-during-covid-19.pdf

[21]Steven L. Schwarcz, Systematic Regulation of Systematic Risk, 2019 Wis. L. Rev. 1, 1 (2019).

[22]Owen Haney, The Virus, Risk, And Commercial Mortgage-Backed Securities: Examining Dodd-Frank’s Impact in the Midst of a Pandemic, 26 Fordham J. Corp. & Fin. L. 391, 401 (2021)

[23]Craig Furfine, The Impact of Risk Retention Regulation on the Underwriting of Securitized Mortgages, 58 J. FIN. SERVS. RSCH. 91, 93 (2020).

[24]Volcker Rule, The Real Estate Round Table https://www.rer.org/policy-issues/capital-credit/volcker-rule https://www.rer.org/policy-issues/capital-credit/volcker-rule (Last visited November 6, 2021)

Federal Jury Rules Four Cryptocurrency products are not Securities

Posted on by Kelly Somers

A recent decision in the United States District Court for the District of Connecticut appears to be the first of its kind in the nation. In the case Audet et al v. Garza et al, a federal jury recently weighed in on whether cryptocurrency products were considered securities.[1] The jury held that four digital-asset products linked to cryptocurrency were not securities.[2]

In the case, a class of customers brought an action against GAW Miners LLC (“GAW Miners”) and ZenMiner LLC (“ZenMiner”) for running a cryptocurrency Ponzi scheme.[3] When GAW Miners and ZenMiner were faced with demands from customers for the physical cryptocurrency mining equipment which they could not meet, GAW Miners and ZenMiner turned to Hashlets, Hashpoints, Paycoin and HashStakers (collectively the “Digital Assets”). [4]  These Digital Assets provided customers with a portion of the computing power without owning the physical hardware.[5] Moreover, the Digital Assets served as virtual wallets for the promissory notes and virtual currency of GAW Miners and ZenMiner.[6] The plaintiffs argued that these Digital Assets were investment contracts and therefore were unregulated securities.[7]

The plaintiffs asked Judge Michael Shea to rule as a matter of law that the Digital Assets were securities under the Howey test. [8] The Supreme Court in Howey stated an investment contract exists when “a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” [9] However, in an unusual decision, Judge Shea declined to rule as a matter of law that the Digital Assets were securities.[10] Instead, the judge left the issue of how to classify the Digital Assets for the jury.[11] Despite the SEC previously referring to one of the Digital Assets, Hashlets, as a security in a case against one of the former defendants in this case,[12] the jury ruled that the Digital Assets were not investment contracts, and therefore, they were not securities.[13]

The issue of how to define cryptocurrencies is an ongoing debate, and the federal jury’s ruling in this case does not settle it.

[1] Elise Hansen, Crypto Mining-Linked Products Weren’t Securities, Jury Finds, Law360 (Nov. 2, 2021), https://www.law360.com/articles/1436790/crypto-mining-linked-products-weren-t-securities-jury-finds.

[2] Id.

[3] HHR Wins Groundbreaking Jury Verdict in Crypto Fraud Trial, HHR (Nov. 3, 2021), https://www.hugheshubbard.com/news/hhr-wins-groundbreaking-jury-verdict-in-crypto-fraud-trial.

[4] Id.

[5] Hansen, supra note 1.

[6] Id.

[7] Id.

[8] Alison Frankel, In apparent first, Conn. class action jury finds crypto products are not securities, Reuters (Nov. 3, 2021), https://www.reuters.com/legal/transactional/apparent-first-conn-class-action-jury-finds-crypto-products-are-not-securities-2021-11-03/.

[9] SEC v. W. J. Howey Co., 328 U.S. 293, 298­–99 (1946).

[10] Id.

[11] Id.

[12] HRR, supra note 3.

[13] Hansen, supra note 1.

Recent Landmark Decision in Cryptocurrency Law

Posted on by web

A recent decision in the United States District Court for the Southern District of New York has sent shockwaves through the world of cryptocurrency investing.  In re Bibox Group Holdings Ltd. Securities Litigation, the Court ruled that a plaintiff did not have standing to assert class claims on cryptocurrency assets he did not own.  However, it was what the court didn’t rule on that made this a landmark case in the legal field developing around cryptocurrency, as the Court took no issue with the fact that the Plaintiff brought a case alleging securities violations against a cryptocurrency issuer and exchange.

The background on this matter is as follows.  In October 2017, Bibox Group Holdings Ltd. and their affiliates funded the launch of their new crypto exchange by launching a new ERC-20 cryptocurrency called BIX.  In this offering of BIX, Bibox raised approximately $19 million in funding.  Bibox told investors that they could exchange BIX for tokens on their exchange, and Bibox would use a portion of the funds raised in the offering to buy back some of the BIX that was issued.  BIX was one of six ERC-20 tokens on the exchange, with the others being EOS, TRX, OMG, LEND, and ELF.

The Plaintiff, Mr. Alexander Clifford, was one of the initial investors who bought BIX.  Mr. Clifford ended up exchanging his BIX for Bitcoin in December 2018.  Mr. Clifford never purchased or owned any of the other tokens.  On April 3, 2020, Mr. Clifford then filed an action in the Southern District of New York against Bibox and their affiliates.  In his complaint, Mr. Clifford alleged that Bibox had violated federal securities law and state Blue Sky law in connection with the trading activities of the six tokens.  Defendants moved for a motion to dismiss, arguing that Mr. Clifford lacked standing since he was asserting claims based on the five tokens he did not purchase, and that his claims pertaining to the one token he owned were time-barred.

Judge Denise Cote of the Southern District of New York granted the motion to dismiss as to all claims, ruling that Plaintiff lacked standing to assert claims based on the five tokens he had never purchased.  This was for two reasons.  First, the Plaintiff did not suffer any injury from the unpurchased tokens.  Second, the Court precluded standing on the grounds that “such conduct implicates the same set of concerns as the conduct alleged to have caused injury to other members of the putative class[1]” because all the tokens were made by different entities and had distinct characteristics and advertising history, meaning the injuries could not be proven in a similar enough way to allege standing.

The Court also dismissed the remainder of claims Plaintiff asserted on the token he did purchase, BIX.  In doing so, the Court rejected the argument that the one-year statute of limitations began to run when the cryptocurrency Plaintiff discovered the token could qualify as a security.  This is because the SEC had previously issued a publication on April 3, 2019 stating that cryptocurrencies may be qualified as securities under the Howey test in the right circumstances.  Rather, the Court held that the statute of limitations began to run when Plaintiff became aware of his injury, which was his last transaction in April 2018.

The main takeaway here is that the Court did not rule that securities laws did not apply to crypto, but rather took issue with the Plaintiff’s standing.  It makes it clear that cryptocurrency issuers and exchanges could be held liable under securities law for their actions.  In addition, while the Court precluded the “same set of concerns is implicated” argument, it is possible another court could find otherwise.  This is due to the fact that the six tokens were on the same exchange, used the same blockchain and were based on the same technological standard.  In conclusion, the rapidly developing field of law around cryptocurrency is one that continues to require close monitoring because of major developments such as this.

[1] Ret. Bd. of the Policemen’s Annuity & Ben. Fund of the City of Chicago v. Bank of N.Y. Mellon, 775 F.3d 154, 161 (2d Cir. 2014)