How Tight is the Noose? The U.S. Federal Courts, Cryptocurrencies and the Meaning of ‘Security’

How Tight is the Noose? The U.S. Federal Courts, Cryptocurrencies and the Meaning of ‘Security’

by Rohan Sahai[i]

I. Introduction

The year 2018 was a difficult one for cryptocurrencies. Starting at a global aggregate value of over US$ 600 billion, the cryptocurrency market crashed to US$130 billion by late December 2018.[ii] Bitcoin by itself, lost about 70% of its value through the year.[iii]

Among various reasons for the crash was speculation around heightened and unclear regulatory oversight. After a slow-warming to the cryptocurrency issue, the U.S. Securities and Exchange Commission arguably had its most active year in digital assets’ regulation and enforcement. As summed up in its public statement issued in November 2018[iv], the SEC’s reach on digital assets through 2018 was sweeping and comprehensive. It found (a) a number of sellers of digital assets to have failed to register their offerings under the Securities Act of 1933 (the 1933 Act); (b) a manager of a hedge fund formed for investing in digital assets to have failed to register the fund as an investment company under the Investment Company Act of 1940 (the 1940 Act); (c) an online interface for sale and purchase of digital asset securities to have failed to register as a national securities exchange under the Securities Exchange Act of 1934 (the 1934 Act); and (d) an online platform accepting digital token purchase orders and marketing digital tokens on behalf of issuers to have failed to register as a broker-dealer under the 1934 Act.[v]

The U.S. Federal Courts’ views on digital assets’ regulation under securities laws, however, are still nascent. Several cases alleging frauds around initial coin offerings have been brought before them. However, the orders passed so far have only been on preliminary motions to dismiss. The Courts did however, consider the ‘gatekeeper’ question of whether cryptocurrencies are securities under federal law twice in the second half of 2018 and found that the tokens in both the cases were likely to be considered as ‘securities’.

This article reviews these two decisions, rendered by the U.S. District Courts in New York and New Jersey in the matters concerning Zaslavskiy[vi] and Latium[vii], respectively. It argues that despite expansive publicity to the contrary, the Zaslavskiy and Latium decisions have little impact on the key outstanding controversies around regulation of cryptocurrencies under securities laws. Specifically, the presence of tangible underlying assets in the structure of the Zaslavskiy tokens and directed publicity by the sellers towards investment benefits in the Latium tokens, would make these instruments likely to be securities under even permissive crypto jurisdictions, such as Switzerland. Consequently, while these decisions, together with SEC’s active 2018, may make it appear that the U.S. is fast moving towards being a crypto-prohibiting jurisdiction, the jurisprudence, in fact remains open.

The analysis in this article will be limited to securities laws. It will not cover the Courts’ views on the jurisdiction of other agencies, such as, the Commodities Futures Trading Commission, over cryptocurrencies.[viii]

II. The Zaslavkiy decision

In Zaslavskiy, the U.S. District Court for the Eastern District, New York denied Maksim Zaslavskiy and two of his companies’ motion to dismiss an indictment brought by the United States.[ix] The indictment alleged securities laws violations in connection with the ‘initial coin offerings’ of ‘REcoin’ and ‘Diamond’ (the Zaslavskiy tokens). The Court concluded that the indictment “alleged sufficient facts that, if proven at trial, could lead a reasonable jury to find that REcoin and Diamond constituted ‘investment contracts’”[x], and therefore, ‘securities’ within the meaning of section 2(a) of the 1933 Act.

The facts leading to Zaslavskiy’s indictment were as follows.

In 2017, Zaslavskiy founded REcoin and Diamond, incorporated in Nevada and Puerto Rico, respectively. REcoin was purported to be engaged in real estate investment and development of real estate-related ‘smart contracts’.[xi] Through a ten-month period in 2017, Zaslavskiy induced investors to invest in cryptocurrency tokens of REcoin allegedly based on materially false statements. Certain distinctive features of REcoin which were prominently highlighted in the marketing material are critical and worth dwelling upon:

(i) REcoin was to be backed by domestic and international real estate investments;

(ii) REcoin was to be led by an experienced team of brokers, lawyers, and developers towards investing its proceeds into global real estate based on the ‘soundest strategies’. [xii]

Immediately after the REcoin offering, Zaslavskiy announced an ‘initial membership offering’ for tokens of Diamond. Like REcoin, this was also a token which was backed by tangible assets, being diamonds.[xiii]

Neither the REcoin nor the Diamond tokens were ever issued nor were the underlying assets purchased by Zaslavskiy’s companies, which ultimately led to their indictment for securities fraud.

Zaslavskiy moved a motion to dismiss on the grounds inter alia, that the tokens were not ‘securities’ within the meaning of the 1933 Act. Denying the motion, the Court held that the facts alleged in the indictment, if proven at trial could lead a reasonable jury to conclude that REcoin and Diamond constituted ‘investment contracts’ under the well-known Howey framework.[xiv] First, investors chose to give up specific consideration in return for a separable financial interest with the characteristics of a security; second, each of REcoin and Diamond constituted a ‘common enterprise; specifically, the fortune of each investor was tied with the fortunes of the other investors by pooling of assets and thus, met the requirements of ‘horizontal commonality’ accepted in the 2nd circuit; third, the investors were led to expect profits to be derived solely from the efforts of Zaslavaskiy and others and not any efforts of the investors themselves.[xv]

III. The Latium Decision

In Latium, the U.S. District Court for New Jersey denied the defendants’ motion to dismiss a putative class action suit brought by the plaintiffs for conducting an initial coin offering of Latium X (LATX) tokens without registering with the SEC.[xvi] Like Zaslavskiy, the Court held that the plaintiffs had sufficiently alleged that LATX tokens were ‘investment contracts’ under the Howey framework and therefore, ‘securities’ under the 1933 Act.[xvii]

The structure of LATX tokens however, was significantly different from the Zaslavskiy tokens. Latium Network Inc, the corporation which issued the tokens, was a privately held Delaware corporation operating a ‘blockchain-based tasking platform’. Latium’s platform allowed users “to create tasks, select the desired applicants and verify if it was completed to specified standards.”[xviii] The payment for use of the platform was to be made with the LATX tokens, Latium’s own cryptocurrency. LATX was sold by Latium through an initial coin offering in multiple stages between July 2017 and March 2018.[xix]

In applying the Howey framework to the LATX tokens, the Court primarily focused on the second and third prongs of the test, i.e. the requirement for a ‘common enterprise’ and the attraction of investors to the prospects of profits from the investment rather than a desire to consume the item purchased, solely from the efforts of others.

On the existence of a ‘common enterprise’, the Court, like the New York District Court in Zaslavskiy, applied the ‘horizontal commonality’ standard. It found that since the investor’s return on a LATX token was directly proportional to the amount of an investor’s financial stake and number of LATX tokens owned, the existence of a horizontal commonality was sufficiently pled by the plaintiff.[xx]

On whether the investors in the LATX tokens were attracted by the prospects of profits from the investment rather than a desire to consume the item purchased, the Court found that the plaintiff detailed many ways in which the defendants led investors to expect a profit from the purchase of the LATX tokens. Specifically, the promotional materials advertising methods, and public statements stressed the limited supply of the tokens. Latium’s initial coin offering was referred as a “unique investment opportunity” that would “generate better financial returns”. The white paper published by Latium allegedly advised that the tokens would be “used to compensate its executives with equity in the company.” Lastly, at the time of the initial coin offering, Latium’s platform only had limited functionality, and had not been launched for public use.[xxi]

In addition, once the payment for the tokens was made, the investors did not have any control over their investment and relied primarily upon the defendants’ efforts.[xxii]

IV. Zaslavskiy and LATX tokens and the Swiss framework for cryptocurrencies

Each of the Zaslavskiy and Latium decisions received much attention in the financial press. The Zaslavskiy decision, in particular, was noted as a major victory for the securities regulator. Some stated that the Court in Zaslavskiy “ruled that initial coin offerings are subject to U.S. securities-fraud rules”.[xxiii] Others went a step further to declare that the Court, in Zaslavskiy, found the SEC rules applying to bitcoins.[xxiv]

This was unusual, because, if at all, it is the Latium decision which casts a broader net for the SEC, since the LATX tokens were more likely arguable as ‘payment’ or ‘utility tokens’, than REcoin and Diamond. Each of REcoin and Diamond, were backed by tangible assets, compared to LATX, which was to be used to pay for accessing Latium’s tasking platform.

Categorisation of cryptocurrencies based on characteristics

At this moment, it is important to note that the SEC has not formally recognised any categorisation of cryptocurrencies based on characteristics of purpose or underlying assets. The most categorical statement of SEC’s formal opinion on the matter appears in the investigative report under section 21(a) of the Securities Exchange Act of 1934 on “The DAO”[xxv] where it stated that it would consider the “particular facts and circumstances, without regard to the form of the organization or technology used to effectuate a particular offer or sale”.[xxvi] There is very little other general authoritative guidance by the SEC on this, although there is a growing view that the SEC, in the DAO Report, presumptively blessed virtual currencies like Bitcoins.[xxvii]

This is in sharp contrast with some of the more crypto-permissive jurisdictions, such as Switzerland, where the Swiss Financial Market Supervisory Authority (FINMA) has given formal recognition to these categories. FINMA has broadly classified crypto-tokens in three non-exclusive categories: (a) payment tokens; (b) utility tokens; and (c) asset tokens.[xxviii] As a general rule, FINMA states that:

(i) it would not treat ‘payment tokens’ as securities since they are designed to act as a means of payment;[xxix]

(ii) it would not treat utility tokens as securities if their sole purpose is to confer digital access rights to an application or service;[xxx] and

(iii) it would treat asset tokens as securities.[xxxi]

Interestingly, FINMA’s classification does, in fact, converge with the third prong of the Howey framework. Accordingly, if a token is meant primarily for being a means of making a payment or solely to confer digital access rights in an application or service, it would likely not satisfy the requirement of “attracting investors to the prospects of profits from the investment rather than a desire to consume the item purchased.”

It follows that the Zaslavskiy and LATX tokens, based on the facts alleged by the plaintiffs in those cases would likely constitute ‘securities’ under FINMA’s framework as well. Zaslavskiy’s chances, in particular, would be bleak, unless it is able to prove significantly different facts upon presentation of evidence. Considering that the two Zaslavskiy tokens were to be backed by tangible assets (real estate and diamonds), each of which are common investment avenues by themselves, it is difficult to see an argument where they would not be ‘securities’.

The Latium facts present more room for argument and a potential spectrum of uncertainty for the Court to define. How much of ‘utility’ is required to exist for a Court to state that investors’ attraction was for accessing the platform rather than prospects of profit? Could the result have been different if Latium’s platform was already running at the time it made its ICO? Would it matter if the platform was operationally successful? Would it matter if the investment aspect of the token was kept minimal in the marketing of the ICO? If yes, would this mean that established businesses will find it easier to avoid their tokens being termed ‘securities’ compared to start-ups? Can future crypto-sellers hedge their regulatory risk by timing their offerings appropriately?

Munchee and marketing of digital assets

Some of the issues above were touched upon by the SEC in late 2017, in an unopposed cease-and-desist order against Munchee Inc.[xxxii]

In Munchee, a California based business created an iPhone application for people to review restaurant meals.[xxxiii] It then offered and sold block-chain based digital tokens (MUN tokens) raising about US$ 15 million.[xxxiv] The funds were to be used to support its business, including by paying rewards in the Munchee App with MUN tokens, paying employees and advisors and other activities.[xxxv] The marketing materials stated that the future use of the MUN tokens would also include diners to buy food at the restaurants on the Munchee app.[xxxvi] Munchee also proposed to run its business in ways to cause MUN tokens to rise in value in the future.[xxxvii] Munchee intended the MUN tokens to be traded on a secondary market and promised to buy or sell MUN tokens using its retained holdings to ensure a liquid secondary market.[xxxviii] Munchee did not promise investors any dividend or periodic payment.[xxxix]

The SEC, in its order, focused on the marketing approach of Munchee and found it to be specifically directed at people interested in the assets for profits, rather than a ‘utility’ for the tokens.[xl] Thus, despite the practical use of the MUN tokens, the SEC found that the they met the criteria for being a ‘security’ under the Howey framework.

Even Munchee, however, left a window open for crypto-issuers to explore, i.e. marketing the tokens for their utility rather than their investment value. The SEC’s order does hint that in such situations, the tokens may not be considered as securities after all.

We can only hope that the U.S. Federal Courts, especially in Latium, give this issue its full due and lay out a general rule which helps distinguish between genuine utility tokens and ‘securities’ sold in the guise of a digital asset. While the marketing approach of the tokens could be a primary distinguishing feature, the other factors listed in the previous sub-section could also be important in determining this question.

V. Conclusion

The SEC tightened its noose around securities fraud cases involving cryptocurrencies last year. Progressing from its cautionary investigative report in DAO in 2017, the SEC prosecuted, penalised and settled cases in 2018. In doing so, it indicated its views on at least some of the foundational issues around digital assets’ regulation. On others, it gave generous hints.

The legal standard for determining when a particular cryptocurrency token may become a ‘security’, however, needs to be set by the Courts. The decisions of the federal district courts in the preliminary motions in Zaslavskiy and Latium have been widely perceived to be heading in a negative direction. However, the cynicism is premature. The Courts in these cases, ruled on tokens, which were likely to be considered securities anywhere, including in permissive crypto-jurisdictions.

The status of genuine payment and utility tokens remains open. The final decision in Latium, once delivered, may provide us some guidance on the direction in which this jurisprudence is headed. A determination on the band of uncertainty between utility and prospects of profitability, likely to be in issue in Latium, has the potential of providing crypto sellers and their advisors guidance on structuring a legitimate coin offering. Even if the Court finds the LATX tokens to be securities, it will likely not rule out that properly marketed utility tokens may not always be ‘securities.

The noose is not as tight as it looks. The writing is not on the wall. At least, not yet.


* * *

[i] Master of Laws (LL.M.) Candidate, University of California, Berkeley (2019). B.A. LL.B., W.B. National University of Juridical Sciences, Kolkata, India (2011). Managing Associate, L&L Partners (formerly Luthra & Luthra Law Offices), Mumbai, India. The views expressed are personal.

[ii] Mike Orcutt, Cryptocurrencies crashed in 2018. Now they’re right where they should be, available at (Last accessed January 2, 2019)

[iii] Id.

[iv] U.S. Securities and Exchange Commission, Statement on Digital Asset Securities Issuance and Trading, November 16, 2018, available at (Last accessed January 2, 2019)

[v] Id.

[vi] United States v. Zaslavskiy, No. 17 CR 647 (RJD), 2018 WL 4346339, (E.D.N.Y. Sept. 11, 2018)

[vii] Solis v. Latium Network, Inc., No. 18-10255 (SDW) (SCM), 2018 WL 6445543, (D.N.J. Dec. 10, 2018)

[viii] Earlier, in 2018, the U.S. District Court for the Eastern District, New York, found virtual currencies to be ‘commodities’ subject to CFTC’s regulatory protections. See Commodity Futures Trading Comm’n v. McDonnell, 287 F. Supp. 3d 213 (E.D.N.Y.), adhered to on denial of reconsideration, 321 F. Supp. 3d 366 (E.D.N.Y. 2018)

[ix] Zaslavskiy, supra note vi, at 9

[x] Id. at 5

[xi] Id. at 2

[xii] Id. at 2

[xiii] Id. at 2

[xiv] SEC v. W.J. Howey Co., 328 U.S. 293

[xv] Zaslavskiy, supra note vi, at 5-6

[xvi] Latium, supra note vii, at 4

[xvii] Id. at 3

[xviii] Id. at 1

[xix] Id. at 1

[xx] Id. at 2

[xxi] Id. at 3

[xxii] Id. at 3

[xxiii] Alexander Osipovich, Judge Lets Cryptocurrency Fraud case go forward, in win for SEC, Wall Street Journal, September 11, 2018, available at (Last accessed January 2, 2019)

[xxiv] Anthony Noto, Brooklyn judge says SEC rules apply to Bitcoin, and ICOs, New York Business Journal, September 12, 2018, available at (Last accessed January 2, 2019)

[xxv] Securities and Exchange Commission, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Release No. 81207, July 25, 2017

[xxvi] Id. at 10

[xxvii] For instance, see Edmund Mokhtarian and Alexander Lindgren, Rise of the Crypto Hedge Fund: Operational Issues and Best Practices for an Emergent Investment Industry, 23 Stan. J. L., Bus. & Fin. 112, at *117 (2018).

[xxviii] Swiss Financial Market Supervisory Authority, Guidelines for enquiries regarding the regulatory framework for initial coin offerings (ICOs), February 16, 2018, available at (Last accessed January 2, 2019).

[xxix] Id. at para 3.2.1

[xxx] Id. at para 3.2.2

[xxxi] Id. at para 3.2.3

[xxxii] In re Munchee Inc., Securities Act Release No. 10445, December 11, 2017

[xxxiii] Id. at 1

[xxxiv] Id. at 1

[xxxv] Id. at 3

[xxxvi] Id. at 4

[xxxvii] Id. at 4

[xxxviii] Id. at 5

[xxxix] Id. at 9

[xl] Id. at 6, 9