Implications of United States Broker-Dealer Regulations on Securities Tokens Transactions


Security token transactions have become rather common in day-to-day operations with regard to both initial private and public offerings and secondary markets. As a result of the active position of the United States Securities and Exchange Commission (the “SEC”) in setting the regulatory framework for securities offerings by means of distributed ledger technology, blockchain investors and issuers are well-educated (sometimes, in a hard way) about their eminent compliance obligations to either register security tokens or ensure that the relevant transaction falls under an exemption from registration.

Nevertheless, a significant number of market participants whether they are individuals or legal entities remain ambivalent to a less obvious but not less important consequence of trading securities in their tokenized form: namely, the extensive broker-dealer regulations that may be applicable to the activities of said market participants.

It seems that there are two main reasons for such a peripheral status of the matter. First, the topic of broker-dealer regulations in the context of trading security tokens remains novel to some extent, partially, because the SEC has not commenced any newsworthy proceedings to date relating to broker-dealer regulations in the token trade realm. Therefore, the lack of awareness is anticipated. Secondly, the unique nature of the blockchain transactions may actually discourage market participants from registration due to fear of not being able to comply with their reporting obligations and with the best practices standard. Interestingly, the SEC admitted that “the ability of a broker-dealer to comply with aspects of [… the relevant regulations] may not be available or effective in the case of certain digital assets” (Joint Staff Statement on Broker-Dealer Custody of Digital Asset Securities). Audacious registered brokers who are willing to commit to the industry are not in abundance.

On the one hand, broker-dealer activity is inevitable in any developed securities market. Thus, numerous individuals and legal entities fulfill the needs of the global communities (with or without second thoughts whether such activity would subject them to the SEC’s jurisdiction). Simply put, in the situation of demand, the supply will commensurate regardless of the license status. On the other hand, the broker-dealer compliance cases may very well become the second “wave” of federal enforcement actions brought by the SEC. Based on the aforesaid, it’s worth choosing an awareness of potential law enforcement risks over prevarication of pointed questions, if and when asked. Consequently, this article is intended to describe some of the aspects of the broker-dealer regulations and the possible implications of the said regulation on the securities tokens market.

Types of Tokens

The instant article addresses solely security tokens. For the purpose of clarification, a token can be deemed a security whether it was intentionally designed to fit within the rubric of securities laws or regarded as such by a regulator based on the Howey test (four-pronged SEC v. W.J. Howey, 328 U.S. 293 (1946) under which an instrument is a security if it relates to (i) an investment of money (ii) in a common enterprise (iii) with a reasonable expectation of profits (iv) to be derived from the entrepreneurial and managerial efforts of others).[1] Standalone cryptocurrency trading or trading of utility tokens may also have consequences related to broker-dealer regulations, but they will not be discussed here.

The International Token Market

Whether it fits the scope of the current U.S. regulations or not, from the very beginning of the use of blockchain technology for the purposes of issuance and trading “tokens of value” (commodities, securities, or cryptocurrencies), the token market was destined and designed for use of the global community. Any exchange or broker would inevitably face the challenge of trading in multiple jurisdictions and dealing with issuers/investors from all over the world.

Additionally, the nature of tokens determines a significant distinction of the blockchain market from a traditional securities market: an issuer needs to create a blockchain platform or use an existing one to issue tokens. As a result, the terms “future tokens” and “simple agreement for future tokens” (SAFT) may very well be treated as distinct securities instruments of the new era: different from options or futures, these tokens represent variations of the unique investment model. Unlike the situation of traditional investment tools, blockchain investors frequently do not receive their tokens instantaneously, rather, the post-investment waiting may take years. Furthermore, an issuance of tokens usually involves the use of ancillary instruments such as cryptographic wallets associated with tokens or other devices that issuers utilize to create and control future marketplace for their security tokens.

As a result, the “future securities tokens” market has developed and actively exists, where initial subscribers are willing to assign their rights to such tokens earlier than tokens are actually issued and become tradable. Whether issuers oppose such practices or not, various agreements and tactics designed to avoid formal non-transferability of future tokens are utilized to arrange the transfer, and profits apparently justify business risks. Said market, since the securities are not registered, is not public. It, nevertheless, exists in the form of communities or clubs, and legal entities that function as “blockchain advisers,” intermediaries, and agents between the potential sellers and potential purchasers of issued or future tokens. The SEC, in its staff statement, drew attention to this matter stating that “an entity that buys, sells, or otherwise transacts or is involved in effecting transactions in digital asset securities for customers or its own account is subject to the federal securities laws, and may be required [my emphasis] to register with the [… SEC and] FINRA.” At this point, the question exists as to how such activity will be interpreted by the SEC, if and when it becomes subject to its review, especially with regard to U.S. entities.

Broker-Dealers. Factors indicating that certain activity may require registration.

Section 15(a)(1) of the Securities Exchange Act of 1934 (the “Exchange Act”) provides that it is unlawful for any broker or dealer to make use of the mails or means or instrumentalities of interstate commerce to effect transactions in any security, or to induce or attempt to induce the purchase or sale of any security [my emphasis], unless that broker or dealer is registered pursuant to the Exchange Act. See 15 U.S.C.A. § 78o (West).[2]

The Exchange Act defines “broker” as “any person engaged in the business of effecting transactions in securities for the account of others.” 15 U.S.C.A. § 78c (West). The term “dealer” is defined to mean “any person engaged in the business of buying and selling securities for his own account,” provided that a person is not in the category “insofar as he buys or sells securities… not as a part of a regular business.[3]” In case law and administrative actions, however, the analysis is usually conducted in a such a manner that a broker and a dealer or a “broker-dealer” is discussed as one category without further classification regarding which definition has been satisfied by the person’s activities.

The list of the activities that may be interpreted as constituting an obligation to register as a broker-dealer can be found on the SEC website and is broad. It includes such examples as 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 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; persons that operate or control electronic or other platforms to trade securities; 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 etc. The factors may be weighted differently, but a commission proportionate to the sale of securities is traditionally considered as one of the strong indicators that tilts the balancing test in favor of the conclusion that the activity is likely to require broker-dealer registration.

Essentially, every issue should be evaluated on an ad hoc basis. In determining whether a particular person falls within the definition of broker-dealer, both the SEC and the courts review the circumstances of the matter from a perspective whether such person is participating in securities transactions “at key points in the chain of distribution.” S.E.C. v. Martino, 255 F. Supp. 2d 268, 283 (S.D.N.Y. 2003) quoting SEC v. Hansen, No. 83 Civ. 3692, 1984 WL 2413, at *10 (S.D.N.Y. Apr. 6, 1984). Although sales-based compensation could be considered as the main “badge” or factor of broker-dealer activity, the “key point” test is extremely flexible and allows to deem an individual or a legal entity as a broker-dealer irrespective to the novelty of the instruments of solicitation or type of securities.

Undoubtedly, certain conclusions can be made based on the existing examples in the SEC’s no-action letters. For instance, the distinction of a broker-dealer from a trader, from the SEC’s point of view, is, inter alia, in the regularity of the subject activity. When a person generally inquires “whether it would be permissible under the federal securities laws… to advertise in an effort to purchase or sell securities for your own account, thereby avoiding use of a broker,” the answer is whether the described activity is engaged in “on a single, isolated basis,” when the registration as broker-dealer is not required, or “is engaged in more often than on a single isolated basis, and if the advertisements encompass offers to buy as well as to sell, broker-dealer registration would be required. Joseph Mcculley Sales, Fed. Sec. L. Rep. P 78,982 (Sept. 1, 1972). Further, there is one peculiar case that may be relevant to the international market of blockchain-based transactions. There, an individual purchasing securities registered with the SEC solely with a registered broker-dealer and further selling them to foreign persons (in Israel) did not require registration as a broker-dealer (although, without an analysis from the SEC whether the factor that the individual intended from a single registered broker-dealer only was relevant). Samuel M. Krieger, 1982 WL 29327, at *1 (July 12, 1982).

It should be additionally noted that the SEC staff has taken and maintained the position that a person who is engaged in the purchase or sale of securities is either a broker-dealer or an associated person. National Ass’n of Sec. Dealers, Inc., SEC No-Action Letter, 1989 WL 246098, Fed. Sec. L. Rep. (CCH) 77,303 (June 18, 1982). “[A] person cannot lawfully engage in the securities business unless he or she is either registered with… [FINRA] as a broker-dealer or as a person associated with a broker-dealer.” Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1573 (9th Cir. 1990).

The implication of the broker-dealer registration requirement on blockchain traders and advisers.

First of all, it is extremely likely that blockchain “advisers,” “experts,” and traders should, at least, consider evaluating their activities as to whether they might be required to register as a broker-dealer. For instance, if a person or an entity can be considered as a “key point” of a token distribution chain, they may face the necessity to register as a broker-dealer.

Secondly, having completed the aforementioned “first step,” an individual or entity may attempt not to subject itself to the U.S. jurisdiction in order to obviate the registration requirements. A lot of unregistered individuals or entities make a decision to “abandon” the United States and function as an offshore entity. Counterintuitively, however, this approach is far from being safe. At the outset, dealing with the U.S. investors by means of interstate commerce automatically subjects persons to the Exchange Act even though a legal entity may be registered abroad: there is no exception for foreign broker-dealers. Further, even exclusion of United States customers from its operations does not automatically release the business having an office in the territory of the United States from the SEC’s jurisdiction. The anti-fraud and consumer protection provisions will still be applicable, and even the registration requirement obligations remain uncertain.

Historically, a registration was not required of broker-dealers when their activities did not involve selling securities to American citizens or residents (See § 1:34. Generally, 15 Broker-Dealer Reg. § 1:34). In fact, the SEC itself in Barons Mortg. Co. of Am. and Intl. Monetary Services, Inc., 1986 WL 67709, at *1 (Aug. 1, 1986) agreed that where securities “will be sold exclusively in foreign countries to non-U.S. residents and non-U.S. citizens” i.e. activities are not involving the US investors, the broker-dealer registration was not necessary. Since then the situation has drastically changed. The Registration Requirements for Foreign Broker-Dealers, 54 FR 30013-01 reads as follows:

the Commission uses an entity approach with respect to registered broker-dealers. Under this approach, if a foreign broker-dealer physically operates a branch in the United States, and thus becomes subject to U.S. registration requirements, the registration requirements and the regulatory system governing U.S. broker-dealers would apply to the entire foreign broker-dealer entity.

To put it simply, the SEC may consider a potential activity of BVI company that trades Swiss-originated securities tokens between China and Singapore, if the BVI company decided that New York is a nice place for its headquarters.

The aforementioned position seems too austere, but it is not likely that an inveterate approach will be easily changed. There is some good news: at least in one instance, solely with regard to the duty to register as a broker-dealer[4] the court found that foreign broker’s failure to be registered in the U.S. was found not actionable when no U.S. investors were involved: “a broker’s failure to register under Section 15(a) of the Act is not actionable in those cases where the ultimate and intended purchase and sale was foreign and thus, itself, outside the scope of the Act.” U.S. S.E.C. v. Benger, 934 F. Supp. 2d 1008, 1013 (N.D. Ill. 2013). Such approach, essentially negating the effect of the SEC’s release addressing foreign-broker dealers was also supported by the Quantum Capital court that straightforwardly called the position “unpersuasive” and agreed with the S.E.C. v. Bengerdecision. See Quantum Capital, LLC v. Banco de los Trabajadores, 1:14-CV-23193-UU, 2015 WL 12259226, at *12 (S.D. Fla. Dec. 22, 2015). The decision as to whether to rely on said case or to stand irresolute seems to be far from obvious. 

Based on the aforesaid, blockchain-oriented businesses should take necessary due diligence steps to make sure that their activities are consistent with the U.S. broker-dealer regulations. Moreover, such notion is relevant not just to the U.S. based entities, but also to registered foreign brokers and international companies with offices in the U.S. It is unclear as to whether the courts will choose the approach of limiting the SEC’s jurisdiction over registration requirements of individuals and legal entities facilitating transactions solely outside of the U.S., as described in S.E.C. v. Benger, or extend the territorial approach beyond the antifraud provisions of the Exchange Act. This uncertainty may raise certain concerns that the U.S. will fall behind other countries in attracting blockchain-related businesses, especially if the allegations about “stonewalling[5]” the broker-dealer applications from companies dealing in crypto assets are justified. It seems, nevertheless, that ultimately, the broker-dealer registration issue is unavoidable and should be preventively addressed by market participates either through a no-action letter or through litigating their own law.

 Kirill Y. Nikonov, Esq. is an attorney at Carmel, Milazzo & Feil LLP

Disclaimer: This article is available for educational purposes only as well as to give readers’ general information and a general understanding of the relevant securities laws, not to provide legal advice of any kind.

[1] Howey test’s prongs were subject to interpretation by numerous court’s decisions, therefore, the reader is respectfully noted that it’s in no event a standalone test. For instance, “investment of money” is also an investment of digital currency (e.g., BTC) or tokens used as money, as interpreted by courts. See Sec. & Exch. Comm’n v. Shavers, No. 4:13-CV-416, 2013 WL 4028182, at *2 (E.D. Tex. Aug. 6, 2013), adhered to on reconsideration, No. 4:13-CV-416, 2014 WL 12622292 (E.D. Tex. Aug. 26, 2014)

[2] The Exchange Act additionally reads: transactions that are exclusively in exempted securities, commercial paper, bankers’ acceptances, or commercial bills do not trigger the registration requirements. This, however, is not applicable to blockchain truncations at this point.

[3] Certain specified exempt activities, such as activities of banks, are not discussed here as irrelevant for the instant article.

[4] An exterritorial approach of the antifraud provisions of Exchange Act are well-established: “in extraterritorial reach of the antifraud provisions… it is clear that Congress “affirmatively and unmistakably” directed that those provisions apply extraterritorially.” Securities and Exch. Commn. v. Scoville, 913 F.3d 1204, 1215 (10th Cir. 2019) Moreover, this aspect of extraterritorial application serves an obvious purpose: avoiding of situations where the masterminds of Ponzi schemes avoid liability by implementing them from the US territory.


Report this

Published by