Morrison and Cryptocurrencies: Is it Time to Revisit the Extraterritorial Application of Rule 10b-5?

• Publication year: 2020

Morrison and Cryptocurrencies: Is It Time to Revisit the Extraterritorial Application of Rule 10b-5?

Eleanor B. Eastham^*

Table of Contents

I. Introduction................................................................................564

II. Background.................................................................................565

A. Cryptocurrencies...............................................................565
B. Initial Coin Offerings........................................................567
C. The Howey Test.................................................................567
D. Howey Test and Cryptocurrencies—The DAO Report.....569
E. SEC Response....................................................................571

III. Current State of the Law.........................................................573

A. The Securities and Exchange Acts.....................................573
B. §10(b) and Rule 10b-5.......................................................574
C. The Courts' Interpretation of the Laws' Extraterritorial Application........................................................................575
D. Congress Passes Dodd-Frank...........................................577
E. Uncertainty About the Impact of Dodd-Frank on SEC Enforcement Actions..........................................................579

IV. Private Causes of Action..........................................................583

A. Morrison Transactional Test in Private Causes of Action 583
B. Tezos Decision..................................................................584

V. Analysis........................................................................................587

VI. Conclusion...................................................................................589

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I. Introduction

Recently, cryptocurrencies have been the topic of discussion everywhere from boardrooms to celebrities' social media accounts. They are a new form of investing that seems to make money magically appear, but is it too good to be true? Global regulators are unsure of how these new cryptocurrencies should be treated.¹ The United States Securities and Exchange Commission (SEC) has taken a position on the matter and declared that some of these investments are considered "securities" under U.S. law, meaning they are subject to the vigorous securities regulation regime.² Declaring these investments securities adds a layer of protection to investors who might fall victim of fraud resulting from cryptocurrencies.³

The United States is not the only country that has taken notice of the potential need for regulation in the cryptocurrency markets. Regulators in Asia have also responded to the growing cryptocurrency market.⁴ China has banned initial coin offerings (ICOs), discussed below, and closed cryptocurrency exchanges over concerns of fraud.⁵ South Korean regulators have begun investigating cryptocurrency-related compliance in large banks and have also prohibited ICOs.⁶ Australian legislators are considering legislation which would put regulation of cryptocurrencies within the reach of AUSTRAC, Australia's financial intelligence agency.⁷

Regulatory bodies across the globe have not been uniform in responding to cryptocurrencies.⁸ How can investors have any confidence in the market with so much uncertainty? Opening U.S. tribunals, and thus its securities

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antifraud regime, to investors who have been harmed in fraudulent cryptocurrency transactions may increase investor confidence and potentially foster capital markets.⁹ There are two ways that the United States deters fraudulent securities transactions.¹⁰ First, our securities regulation regime allows the SEC to bring enforcement action and, second, for individuals to bring private rights of action.¹¹

This Note aims to evaluate how the doctrine of extraterritoriality applies to securities regulation in the cryptocurrency market. Specifically, this Note will examine how the extraterritorial application of Rule 10b-5 applies to the emerging cryptocurrency market for both SEC enforcement actions and private rights of actions. Part I will provide some background information about what a cryptocurrency is and how Initial Coin Offerings (ICOs) work. Part II will discuss how the U.S. defines a security that falls within our regulation regime, how some Initial Coin Offerings fall within the purview of our securities regime, and how the SEC has responded to Initial Coin Offerings. Part III will discuss the current state of the law of extraterritorial application of securities regulation, both for SEC enforcement actions and private actions. Finally, Part IV will provide some analysis about the future of private 10b-5 causes of action for foreign investors.

II. Background

A. Cryptocurrencies

To begin the inquiry into the extraterritorial application of U.S. securities law in the context of cryptocurrency markets, the first step is understanding what cryptocurrencies are. Both cryptocurrency and traditional forms of currency are only as valuable as society believes they are. Traditional currencies' bills and coins are just tokens we use to exchange goods and services based on how valuable we believe it is.¹² Cash has no inherent value; it is a piece of paper.¹³ As technology has developed over the years, there is no longer a need for currency to take the form of a physical token, like cash.¹⁴ Transactions began moving away from a physical token of currency long before

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cryptocurrencies were even an idea.¹⁵ This is illustrated by the development of written checks and eventually debit cards.¹⁶ No cash ever changes hands in transactions involving these methods.¹⁷ The bank simply reduces your balance and increases someone else's by updating a ledger.¹⁸

Cryptocurrencies are somewhat similar to the idea of debit cards and written checks, but there are some key differences.¹⁹ First, they are not backed by a government.²⁰ Instead, cryptocurrencies are created and controlled by algorithms.²¹ The algorithms determine how transactions are made and recorded and how new cryptocurrencies are released.²² Instead of completing transactions through banks or another intermediary, cryptocurrency users and their recorded transactions create a system known as the blockchain.²³ This blockchain system of "peer-to-peer" transactions instead of government issued currencies is the first major distinction between traditional currencies and cryptocurrencies.²⁴

The second difference is that the total amount of a cryptocurrency in circulation is limited.²⁵ This differs from traditional currency because governments can, and do, simply print more money to increase the amount in circulation.²⁶ As economies grow, governments create more currency to allow for the growth.²⁷ Adding more currency into the circulation of that currency is what causes inflation.²⁸ Because of this, traditional currencies are based on an inflationary model.²⁹ Cryptocurrencies, on the other hand, are exactly the opposite because they operate on a deflationary model.³⁰ The total supply of a cryptocurrency in circulation is restricted.³¹ As the economy grows, instead of adding more cryptocurrency into circulation, each unit of cryptocurrency has more buying power than it previously had.³² For example, something that

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costs one unit of cryptocurrency today will cost a fraction of the same unit as time passes and the economy grows.³³

B. Initial Coin Offerings

On its face, the concept of cryptocurrency might seem to be outside of the SEC's scope of enforcement. However, the concept of initial coin offerings (ICOs) makes it clear that cryptocurrencies are within the SEC's scope of power. Promoters have been selling virtual tokens, a unit of cryptocurrency, in ICOs.³⁴ Those who wish to purchase the virtual tokens through an ICO can use traditional currency to make their purchase.³⁵ Sometimes these promoters lead purchasers to believe that they will receive a return on their investment.³⁶ Sometimes those in need of capital (i.e. start-ups or online projects) use ICOs as a way to raise capital without going through the hassle of issuing stock or finding venture capitalists to invest.³⁷ In this regard, ICOs are similar to crowdfunding,³⁸ which is regulated by the SEC.³⁹

C. The Howey Test

The Securities Act of 1933 (Securities Act) defines what a security is.⁴⁰ That definition includes a catchall provision listing "investment contracts" as a security falling within the purview of the Securities Act and the Securities Exchange Act of 1934 (Exchange Act).⁴¹ In 1946, the Supreme Court gave guidance on what the broad sweeping "investment contract" means.⁴² An investment contract, and thus a security within the reach of the SEC's

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regulation, is any instrument that meets the requirements of the Howey test.⁴³ The Howey test was established in SEC v. W.J. Howey Co.⁴⁴ The defendants in that case were two Florida corporations under the same control and management.⁴⁵ The company owned large tracts of citrus farms in Florida. Leading up to the case, the company would offer up half of its acreage to the public to "help [them] finance additional development."⁴⁶

Each prospective customer was offered both a land sale and service contract.⁴⁷ The land sale contract allowed the purchasers to get a portion of the acreage of the citrus farm.⁴⁸ The service contract allowed Howey's other company, one under the same management and control, to cultivate the land, making it profitable for the purchaser.⁴⁹ Additionally, the company told potential buyers that it was not feasible to invest in a land contract unless they also purchase the service contract.⁵⁰ The service contract gave the cultivating company a leasehold interest in the purchased land and "full and complete" possession for ten years with no cancellation option.⁵¹

The purchasers were mostly out-of-state residents and professionals with no knowledge or skills necessary to cultivate a...