News Flash: First Ever U.S. Federal Court Decision Declaring ICOs Are Subject to SEC Jurisdiction

By John Reed Stark*

The ICO judicial decision everyone has been waiting for is finally here -- and the SEC is taking home the prize. Big-time.

A few months ago, in a case captioned U.S. v. Maksim Zaslavskiy, the first motion-to-dismiss oral argument of the first initial coin offering (ICO) litigated matter contested by the U.S. Securities and Exchange Commission (SEC) took place at the historic Brooklyn New York Federal Courthouse in a hearing before famed 70+ year old Judge Raymond Dearie. You can read all about the case here.

As I predicted here; here, here and here, Judge Dearie ruled that it will ultimately be up to a jury to decide whether the ICO at issue was a security, but the allegations in the criminal indictment were sufficient to support that the ICOs were offering securities as a matter of law. This is huge news.

Of course, Judge Dearie's decision focused on the particulars of Zaslavskiy’s ICOs, and not on other unrelated ICO transactions -- and also left most of these issues for the jury. In fact, Judge Dearie makes clear that from his vantage point, the indictment alone is solid enough to overcome dismissal, but that is where his review stops on a motion to dismiss.

Nonetheless, this first-of-its-kind ruling has far-reaching implications, reinforcing the SEC’s jurisdiction over ICOs, including issues relating to ICO registration, market manipulation and fraud. (Read Judge Dearie's Opinion here.)

Judge Dearie addressed all of the SEC/ICO hot-button issues, especially: 1) whether Zaslavskiy's ICOs peddled securities or were issuing a currency; and 2) whether SEC statutes, rules and regulations were unconstitutionally vague and therefore could not be applied to Zaslavskiy's ICO's.

The case record that Judge Dearie used to render his decision is unusually extensive, containing a litany of motions, briefs, etc. To help make sense of it all, below are:

• Some brief background notes about the case;
• Some quick highlights gleaned from Judge Dearie's decision;
• Links to all criminal filings related to Judge Dearie's decision (including links to a transcript of the hearing); and
• Links to all SEC filings related to Judge Dearie's decision.

I. Some Quick Background

• The Matter: USA/SEC versus Maksim Zaslavskiy filed in the United States District Court for the Eastern District of New York, E.D.N.Y. Docket No. 17-MJ-934 (Before the Honorable Judge Raymond Dearie). Zaslavskiy, et al, were charged by the United States Department of Justice (DOJ) and by the SEC with securities fraud in connection with several ICOs. Zaslavskiy was arrested by the Federal Bureau of Investigation (FBI) and his assets were frozen by the SEC. Now, Zaslavskiy's attorneys -- federal public defenders who represent him in the criminal case and Polsinelli LLC who represent him in the SEC case -- filed a motion to dismiss the criminal charges, asserting, among other things, that the digital coins or tokens peddled by Zaslavskiy's ICOs were not securities (and were not subject to SEC jurisdiction). 
• The Logistics: The hearing for Zaslavskiy's Motion to Dismiss took place May 8th at 2:45 pm, in Court Room 10A S in United States District Court for the Eastern District of New York, 225 Cadman Plaza East, Brooklyn, NY 11201.
• The Filings: The court filings are plentiful and robust but, for anyone interested in SEC jurisdiction over ICOs, cryptocurrency exchanges and the like, are absolutely worth reading. See for yourself below in parts III and IV.
• The Trial: The trial date or the matter is currently scheduled for January, 2019.  
• The Parties: There were actually four parties to the hearing:

-- For DOJ (who filed a criminal action against Zaslavskiy before Judge Dearie): Eastern District of New York Assistant United States Attorneys Julia Nestor and Audrey Spektor;

-- For SEC (who filed a parallel civil SEC enforcement action against Zaslavskiy before Judge Dearie): Valerie Szczepanik, Assistant Director, SEC Division of Enforcement; and

-- For Zaslavskiy: Federal Public Defenders Len Kamdang and Mildred Whalen (defending Zaslavskiy in the criminal proceeding) and Jason Nagi, Partner of Polsinelli LLC (defending Zaslavskiy in the SEC enforcement action).

II. Some Quick Highlights

Below are some highlights of Judge Dearie's momentous and notable decision:

• Judge Dearie opined that a reasonable jury could conclude that the facts alleged in the indictment satisfy The Howey Test (set forth in the seminal 1946 opinion, SEC v. Howey, which set forth the definition of "what is a security"), meticulously walking through the various prongs of the Howey Test, and noting:   

“Zaslavskiy argues that the virtual currencies promoted in connection with REcoin and Diamond are not securities (i.e. investment contracts), as alleged in the Indictment, and therefore do not fall within the Government's criminal or civil enforcement power. Zaslavskiy's reading of the relevant law is overly narrow."

• Judge Dearie tackles head-on the issue of whether an ICO is marketing a currency or a security, emphasizing:

“Per the indictment, no diamonds or real estate, or any coins, tokens, or currency of any imaginable sort, ever existed -- despite promises made to investors to the contrary . . . Simply labeling an investment opportunity as a ‘virtual currency’ or ‘cryptocurrency’ does not transform an investment contract -- a security -- into a currency.”

• Judge Dearie simplifies the entire case quite well, stating the obvious in clear and uncertain terms:

"Stripped of the 21st-century jargon, including the defendant's own characterization of the offered investment opportunities, the challenged indictment charges a straightforward scam, replete with the common characteristics of many financial frauds."

• Judge Dearie concludes that the Securities Exchange Act of 1934 and SEC Rule 10b-5 are not unconstitutionally vague and therefore "void for vagueness" as applied to Zaslavskiy's conduct, noting: 

"First, courts are clear that the securities laws are meant to be interpreted "flexibly to effectuate [their] remedial purpose." SEC v. Zandford, 535 U.S. 813,819 (2002) (explaining that "[a]mong Congress' objectives in passing the [Exchange] Act was to insure honest securities markets and thereby promote investor confidence after the market crash of 1929")"

" . . . Furthermore, the test expounded in Howey has — for over 70 years —provided clear guidance to courts and litigants as to the definition of "investment contract "under the securities laws. SG Ltd., 265 F.3d at47 ('[o]vertime, courts have classified as investment contracts a kaleidoscopic assortment of pecuniary arrangements that defy categorization in conventional financial terms'). Moreover, the abundance of case law interpreting and applying Howey at all levels of the judiciary, as well as related guidance issued by the SEC as to the scope of its regulatory authority and enforcement power, provide all the notice that is constitutionally required. "

With an almost thunderous pronouncement, Judge Dearie closes the door on Zaslavskiy's vagueness argument, heard too many times (for my tastes anyway) in cryptocurrency circles, stating unequivocally:

". . . “The Exchange Act and Rule lOb-5 set forth the types of behavior that constitutes securities fraud, and Howey and its progeny set forth the standards needed to cabin their enforcement relative to investment contracts. Furthermore, the conduct charged "falls within the core of the statute's prohibition," and its enforcement in this case is "not the result of the unfettered latitude that law enforcement officers and fact finders might have in other, hypothetical applications of the statute . . . At this juncture, Zaslavskiy's contrary characterizations are plainly insufficient to bypass regulatory and criminal enforcement of the securities laws."

III. Additional Background Materials: Criminal Zaslavskiy Filings

• DOJ PRESS RELEASE ANNOUNCING ZASLAVSKIY PROSECUTION
• COMPLAINT AND AFFIDAVIT IN SUPPORT OF APPLICATION FOR ARREST WARRANT
• INDICTMENT
• ZASLAVSKIY’S MOTION TO DISMISS INDICTMENT FOR SUBJECT MATTER JURISDICTION AND VAGUENESS (SUBMITTED BY FEDERAL PUBLIC DEFENDER, DOJ DEFENSE COUNSEL)
• DOJ MEMORANDUM OF LAW OPPOSING ZASLAVSKIY’S MOTION TO DISMISS THE INDICTMENT
• ZASLAVSKIY’S REPLY BRIEF IN SUPPORT OF HIS MOTION TO DISMISS(SUBMITTED BY FEDERAL PUBLIC DEFENDER, ZASLAVSKIY'S DOJ DEFENSE COUNSEL)
•  OFFICIAL TRANSCRIPT of the hearing for the motion to dismiss filed by defendant Zaslavskiy, which is opposed by the criminal prosecutors (from the United States Attorney's Office of the Eastern District of New York) and by the civil enforcement staff lawyers (from the Enforcement Division of the SEC).
• JUDGE DEARIE'S DECISION DENYING ZASLAVSKIY'S MOTION TO DISMISS

IV. Additional Background Documents: SEC Zaslavskiy Filings

• SEC PRESS RELEASE ANNOUNCING ZASLAVSKIY PROSECUTION
• SEC COMPLAINT AGAINST RECOIN GROUP FOUNDATION, LLC, DRC, WORLD INC. a/k/a DIAMOND RESERVE CLUB, and MAKSIM ZASLAVSKIY 
• SEC MEMORANDUM IN SUPPORT OF EMERGENCY ASSET FREEZE AND TEMPORARY RESTRAINING ORDER
• DECLARATIONS FROM SEC OFFICIALS VALERIE SZCZEPANIK AND JORGE TENREIRO IN SUPPORT OF EMERGENCY ASSET FREEZE AND TEMPORARY RESTRAINING ORDER
• SEC BRIEF IN SUPPORT OF THE UNITED STATES, OPPOSING ZASLAVSKIY’S MOTION TO DISMISS INDICTMENT
• ZASLAVSKIY'S MEMORANDUM OF LAW SUPPORTING MOTION TO DISMISS INDICTMENT (SUBMITTED BY POLSINELLI LLC, ZASLAVSKIY'S SEC DEFENSE COUNSEL)

*John Reed Stark is president of John Reed Stark Consulting LLC, a data breach response and digital compliance firm. Formerly, Mr. Stark served for almost 20 years in the Enforcement Division of the U.S. Securities and Exchange Commission, the last 11 of which as Chief of its Office of Internet Enforcement. He has taught most recently as Senior Lecturing Fellow at Duke University Law School Winter Sessions and the 2019 Duke Law Fall Semester. Mr. Stark also worked for 15 years as an Adjunct Professor of Law at the Georgetown University Law Center, where he taught several courses on the juxtaposition of law, technology and crime, and for five years as managing director of global data breach response firm, Stroz Friedberg, including three years heading its Washington, D.C. office. Mr. Stark is the author of, "The Cybersecurity Due Diligence Handbook."