ABA Journal’s 10th Annual Blawg 100
On December 8, 2014, the SEC settled charges against a creative, but ill informed, entrepreneur for acting as an unlicensed broker-dealer and for violations of Section 5 of the Securities Act of 1933, as amended. Ethan Burnside and his company, BTC Trading Corp., operated two online enterprises, BTC Virtual Stock Exchange and LTC-Global Virtual Stock Exchange, that traded securities using virtual currencies, bitcoin or litecoin. Neither of these exchanges were registered as broker-dealers or stock exchanges. In addition, Burnside and his company conducted separate transactions in which he offered investors the opportunity to use virtual currencies to buy or sell shares in the LTC-Global exchange itself and a separate litecoin mining venture he owned and operated. These offerings were not registered with the SEC as required under the federal securities laws.
According to the SEC release on the matter, “the exchanges provided account holders the ability to use bitcoin or litecoin to buy, sell, and trade securities of businesses (primarily virtual currency-related entities) listed on the exchanges’ websites. The venues weren’t registered as broker-dealers despite soliciting the public to open accounts and trade securities. The venues weren’t registered as stock exchanges despite enlisting issuers to offer securities for the public to buy and sell.” The exchanges charged and collected transaction-based compensation for each executed trade on the platforms.
“Burnside operated two online enterprises that weren’t properly registered to engage in the securities business they were conducting,” said Andrew M. Calamari, Director of the SEC’s New York Regional Office. “The registration rules are vitally important investor protection provisions, and no exemption applies simply because an entity is operating on the Internet or using a virtual currency in securities transactions.”
Because Burnside cooperated with the SEC, he was able to settle the charges for only $68,000 and a bar from acting in the securities industry with the right to re-apply after two years. The SEC release notes that “the penalty amount reflects prompt remedial acts taken by Burnside as he cooperated with the SEC’s investigation.”
The SEC did not make any allegations related to fraud. The SEC’s news release did not contain any negative inflammatory language against Burnside or his entities, and his penalty was extremely light for today’s regulatory environment. Burnside has the ability to apply to re-enter the securities business after two years. Clearly Burnside tried to create and operate a valid business, and more than that, he did a good job of it.
Burnside, however, failed to comply with and (obviously) seek the advice of experienced securities counsel. On the highest level, Burnside failed to follow the most basic premises of securities transactions: (i) registration or exemption as a broker-dealer; (ii) registration or exemption of an exchange; (iii) registration or exemption for the sale of DTC and LTC securities; and (iv) ensuring either registration or exemption for the sale of listed issuer’s securities. Admittedly, the process for each of these items can be complicated, expensive and time-consuming, but every entrepreneur that is considering engaging in a business that involves securities on any level needs to consider these basic high-level issues before proceeding.
How BTC and LTC Worked
Both BTC and LTC operated as online bitcoin- and litecoin-denominated stock exchanges. Using bitcoins or litecoins as the currency, users bought, sold and traded securities in both initial and secondary offerings of businesses listed on the website. Although the sites were open to anyone, they became popular with virtual currency enthusiasts, and most of the issuers on the site were currency-related businesses, including virtual currency mining operations. According to the SEC release, a virtual currency “miner” is “an individual or entity that participates in a decentralized virtual currency network by running special software to solve complex algorithms in a distributed proof-of-work or other distributed proof system used to validate transactions in the virtual currency system. Certain virtual currencies (e.g., bitcoin and litecoin), self-generate units of the currency by rewarding miners with newly created coins.”
There were no restrictions on who could open an account, which account opening was completed using a simple online registration form. The only information required was an e-mail address, and accordingly, account holders could be anonymous. There were no restrictions or even information requests related to accreditation or sophistication. Once registered, users could view their account history and balance online. Deposits of bitcoins and litecoins were made using software, and such deposits were maintained by BTC and LTC and commingled in a single virtual wallet. Users could withdraw their currency at any time. The sites strictly operated in bitcoins and litecoins and did not offer any method to convert the virtual currency to USD or other currencies.
Users could place trades in the securities of the listed issuers, including straight purchases and sales and option trades. Users would enter a bid or ask through an online order book. Trades were matched using a software system and all trades, quotes and dividends were publicly displayed on the site. The site also reported such information as trading volume for issuers. The trading on the sites was completely self-contained; that is, no trades were routed to outside venues or sources. BTC and LTC charged transaction-based compensation for executing trades
In order for an issuer to offer and sell securities, it would submit an online application and an investment contract for the purchase of its securities. The issuer’s application included a description of its business and the investment being offered. LTC and BTC charged a flat fee for listing. The issuers also agreed to a “terms of service” that included various representations and warranties by the issuer, including that its business was “legal in the United States.” BTC and LTC shareholders approved all issuers through an online voting process.
Once approved, the issuer could list and sell securities. No certificates were issued for sold securities, but rather ownership of shares was recorded in line account statements that were updated and provided to shareholders every 12 hours. The issuers were able to upload and post business plans and other marketing materials, post updates and new releases and otherwise communicate with their shareholder base and prospective investors. BTC and LTC acted as limited moderators over the postings. Burnside also regularly posted on his own sites and others soliciting users for the sites.
BTC and LTC also listed and sold its own securities on the sites. Each of the issuers, including BTC and LTC, engaged in general solicitation in the sale of securities. Upon being contacted by the SEC, Burnside promptly completed an orderly wind-down of both sites.
None of the issuers registered their securities or the offerings with the SEC. None of the issuers took steps to ensure an exemption from registration was available, such as limiting the offerings to accredited investors only, verifying accredited status when using general solicitation, providing specified disclosure documents, or complying with state blue sky laws.
Registration or exemption as a broker-dealer
Subject to limited exemption, the Exchange Act makes it unlawful for any broker or dealer to “effect any transaction in, or to induce or attempt to induce the purchase or sale, of any security…unless such broker or dealer is registered.” The Exchange Act defines a “broker” as “a person, including a company, engaged in the business of effecting transaction in securities for the account of others.” Case law indicates that a person is engaged in the business of effecting securities transactions if he or she “regularly participates in securities transactions at key point in the chain of distribution.”
In addition, in accordance with the SEC Guide to Broker-Dealer Registration, providing any of the following services may require the individual or entity to be registered as a broker-dealer:
- “finders,” “business brokers,” and other individuals or entities that engage in the following activities:investment advisers and financial consultants;
- Finding investors or customers for, making referrals to, or splitting commissions with registered broker-dealers, investment companies (or mutual funds, including hedge funds) or other securities intermediaries;
- Finding investment banking clients for registered broker-dealers;
- Finding investors for “issuers” (entities issuing securities), even in a “consultant” capacity;
- Engaging in, or finding investors for, venture capital or “angel” financings, including private placements;
- Finding buyers and sellers of businesses (i.e., activities relating to mergers and acquisitions where securities are involved);
- persons that market real estate investment interests, such as tenancy-in-common interests, that are securities;
- persons that act as “placement agents” for private placements of securities;
- persons that effect securities transactions for the accounts of others for a fee, even when those other people are friends or family members;
- persons that provide support services to registered broker-dealers; and
- persons that act as “independent contractors” but are not “associated persons” of a broker-dealer
There are several exemptions from broker-dealer registration.
Title II of the JOBS Act created a limited exemption to the broker-dealer registration requirements for certain intermediaries that facilitate Rule 506 offerings. In particular, Section 4(b) of the Securities Act of 1933 (“Securities Act”) added an exemption to the broker-dealer registration requirements such that an individual or entity will not be deemed a broker-dealer as a result of the following:
(A) That person maintains a platform or mechanism that permits the offer, sale, purchase, or negotiation of or with respect to securities, or permits general solicitations, general advertisements, or similar or related activities by issuers of such securities, whether online, in person, or through any other means;
(B) That person, or any person associated with that person, co-invests in such securities; or
(C) That person, or any person associated with that person, provides ancillary services with respect to such securities.
Ancillary services are defined as (i) the provision of due diligence services in connection with the offer, sale, purchase, or negotiation of such security, so long as such services do not include, for separate compensation, investment advice or recommendations to issuers or investors; and (ii) the provision of standardized documents to the issuers and investors, so long as such person or entity does not negotiate the terms of the issuance for and on behalf of third parties and issuers are not required to use the standardized documents as a condition of using the service.
The exemption from registration as a broker or dealer also requires that such person and each person associated with such person (i) does not receive any compensation in connection with the purchase or sale of the security; (ii) does not have possession of customer funds or securities in connection with the purchase or sale; and (iii) is not subject to statutory disqualification pursuant to Section 3(a)(39) of the Exchange Act (i.e., bad boy provisions).
Burnside could potentially have operated a Title II exempt website geared towards bitcoin and litcoin investments. For a discussion as to how this could be structured, see my blog HERE.
Registration or exemption of an exchange
Section 5 of the Exchange Act of 1934, as amended, makes it unlawful for any broker, dealer, or exchange, directly or indirectly, to effect any transaction in a security, or to report any such transaction, in interstate commerce, unless the exchange is registered as a national securities exchange or is exempted from such registration. Section 3(a)(1) of the Exchange Act defines an “exchange” as “any organization, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as that term is generally understood….” Exchange Act Rule 3b-16 further defines an exchange to mean “an organization, association, or group of persons that: (1) brings together the orders for securities of multiple buyers and sellers; and (2) uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of the trade.” The Commission has also stated that “an exchange or contract market would be required to register under Section 5 of the Exchange Act if it provides direct electronic access to persons located in the U.S.”
Clearly LTC and BTC operated as an exchange, without registration or an exemption. Under almost any analysis, LTC and BTC would have been required to register as an exchange to operate as it did.
Registration or exemption for the sale of securities
Burnside offered and sold securities of BTC, LTC and his virtual currency mining business without either an effective registration statement or available exemption. In addition, each of the issuers on the BTC and LTC websites offered and sold securities without either an effective registration statement or available exemption. All issuers engaged in general solicitation in relation to the sale of securities.
Section 5 of the Securities Act of 1933 makes it is unlawful for any person to directly or indirectly “offer” or “sell” securities without a valid effective registration statement unless an exemption is available. Companies desiring to offer and sell securities to the public with the intention of creating a public market or going public must file a registration statement containing all material information concerning the company and the securities offered with the SEC and provide that filed registration statement to prospective investors. The registration statement is filed using a form S-1. None of the issuers in this case filed a registration statement with the SEC.
In lieu of registration, each issuer would need to satisfy an exemption from registration. Although other exemptions may have been available, the most obvious potential exemption for the issuers in this case would be 506(c). Rule 506(c) permits the use of general solicitation and advertising to offer and sell securities under Rule 506, provided that the following conditions are met:
1.the issuer takes reasonable steps to verify that the purchasers are accredited;
2.all purchasers of securities must be accredited investors, either because they fit within one of the categories in the definition of accredited investor, or the issuer reasonably believes that they do, at the time of the sale; and
3.all terms and conditions of Rule 501 and Rules 502(a) and (d) must be satisfied.
For an in-depth discussion on Rule 506(c), see my blog HERE.
Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
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