Insights & News

The Stradley White-Collar Insider, June 2019

June 26, 2019
Publications
 

Introduction by Michael J. Engle

Michael J. Engle, Chair of Stradley Ronon's white-collar defense practice, introduces the inaugural White-Collar Insider.

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New Surprise Medicaid Audits in Pennsylvania

By Kristin J. Jones, Co-Chair, Health Law

Pennsylvania announced that it would begin auditing contractors in order to combat misuse of state Medicaid funds. The new Medicaid audits will target contractors who provide services to seniors and people with intellectual disabilities. If the auditors discover any fraud or misuse, then the contractors could risk civil or criminal liability.

The first six contractors who will be subject to the audits received notices in late April. Unlike provider audits, which are usually targeted at busy, high-billing providers, the first set of audits were directed contractors who were randomly selected from a pool of thousands.

Recently, Pennsylvania Attorney General Josh Shapiro announced that a grand jury had found a “systemic” misuse of Medicaid funds by providers, and the audit process could help the state identify and reduce misuse. During the last two years, Pennsylvania’s Medicaid Fraud Control Section made 292 arrests, secured 173 convictions and recovered more than $34 million for Pennsylvania.

These new audits demonstrate the Commonwealth’s commitment to combating Medicaid fraud by going a step further to ensure that vendors hired by the Pennsylvania Department of Human Services are also complying with their obligations. All Medicaid contractors should take this new audit process as a wake-up call and prepare for any future round of audits by checking their internal procedures and contractual obligations.

For more information, contact Kristin J. Jones at 484.323.1355 or kjones@stradley.com.

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Criminal Liability for Abuse of Renewable Fuel Credits

By Andrew S. Levine, Co-Chair, Environmental

As part of the Clean Air Act, Congress adopted the Renewable Fuel Standard (RFS) program to improve the nation’s renewable energy industry and reduce greenhouse gas emissions. The program is devised to encourage the production and use of renewable fuel in the United States, principally ethanol, but with specific incentives for other biofuels as well. The Environmental Protection Agency (EPA) was charged with developing, implementing and enforcing the program through various regulations that require producers or importers of renewable fuel to generate fuel credits, known as “renewable identification numbers” (RINs), in proportion to the amount and type of renewable fuel they produce or import. The RFS program also requires that nonrenewable fuel refiners and importers, known as “obligated parties,” and renewable fuel exporters obtain valid RINs and retire those RINs each year by submitting them to the EPA. Simply stated, the RIN system underlies the brief statement that appears on most gasoline pumps indicating that 10% (or more) of the gasoline consists of ethanol.

Renewable fuel producers have valid RINs only if their claim to the EPA to create the RINs is accurate and meets the regulations established by the EPA. There are billions of RINs sold annually to obligated parties, and tracking the veracity of each RIN is a daunting and nearly insurmountable task for the EPA. Consequently, the entire system floats on a sea of good faith, with the understanding that generating RINs for a volume of biodiesel that was not actually produced in compliance with EPA regulations is a civil and potentially criminal violation of the Clean Air Act. Generating RINs is permissible only when based on renewable fuel and if the production process used to make that fuel meets specific regulatory criteria. Not surprisingly, to avoid “The Producers’” Max Bialystok phenomenon (in which he repeatedly sold 100% interest in a venture), it is illegal under the regulations to generate RINs more than once for any given volume of biodiesel. Moreover, renewable fuel producers are required to report data to the EPA about the production process and the feedstock used in production, and it is illegal to knowingly make material false statements in electronic or paper submissions to the EPA. Because of the regulations, the EPA assumes that when RINs are generated by producers, biodiesel was actually produced and introduced into streams of commerce pursuant to the stringent requirements of the RFS program.

In practice, the producer of a batch of renewable fuel creates the RIN for the batch. Once the RIN is created, it remains attached to that batch of renewable fuel until the fuel is blended with nonrenewable fuel, at which point the RIN may be “separated” from the fuel and used for compliance with regulatory renewable volume obligations, held for future compliance, or traded. If the batch is divided before it is blended with nonrenewable fuel, then the RIN is also divided. The RIN sale may (at least in the past) involve a broker, commissions, premiums and revenue sharing, adding to the perceived lucrative nature of the RINs market.

To track RIN transfers, the EPA developed a system called the EPA Moderated Transaction System (EMTS). After a producer generates batches of renewable fuel and creates RINs, the producer must submit the new RINs to the EMTS within five days of the RINs’ creation, after which the EPA screens the transaction for acceptance into the system. The producers have quarterly reporting obligations as well as stringent record preservation requirements to support the RINs submissions.

The EPA comprehensively regulates this very large trading scheme, which involves billions of credits and thousands of generating, blending and obligated party facilities. The EPA and many advocates view the RIN system as underlying the development and proliferation of the renewable fuels market; others view it as a systematic subsidy system for corn growers who have never seen higher commodity pricing for their crop. One important subtlety to the RIN market is that there are several categories of RINs, and which is used depends upon the nature of the renewable fuel at issue. For example, cellulosic biofuel (D3) RINs trade at a substantial premium over ethanol (D6) RINs. Even then, there are RIN definitions that defy logic. For example, the most valuable D3 RIN includes landfill gas, though it may be hard to imagine any gas as being cellulosic.

In recent years, there has been a great deal of controversy surrounding the basic fairness of a system that imposes large-scale RIN obligations on merchant refiners. At least one of them, Philadelphia Energy Solutions (PES), claimed its bankruptcy was precipitated by the cost and instability of the RIN market. From its perspective, PES saw an increase in RIN exposure in 2012-2013 of a few million dollars. In 2014, for reasons still not fully understood, RIN pricing escalated dramatically, raising prices for ethanol RINs from about $0.01 per RIN to $1.00. For a company with $2.5 million in RIN exposure in 2012, the same quantity of RINs rose commensurately to $250 million. Whether accurate or not, charges abounded of a fraudulent or contaminated RIN market poorly regulated by the EPA, which has never governed over such an expansive trading program, as well as charges of an opaque brokers’ market. With RIN pricing soaring, the RIN generators began to see more and more opportunity for profit from trading, but others embarked on a more sinister means of generating profits from the RIN process.

Given the enormity of the RIN trading landscape, the obligation of certain parties to purchase the RINs and the potential profitability of RINs trading, it is not surprising that criminal conduct has proliferated in this system. One 2019 case, United States v. E-Biofuels, demonstrates the sophistication of these schemes. In this matter, the defendant resold premade biofuel as its own, generated a RIN, and then pocketed the proceeds from the RINs and fuel sales. Company A manufactured a biofuel, entered it into the EMTS, separated the RINs and sold them off to obligated parties. However, it then sold the same fuel, stripped of its RIN, to E-Biofuels, which reported the RIN-less biofuel as a “feedstock” for its fuel, registered it and entered the biofuel on the EMTS, in effect doubling the number of RINs for the same quantity of fuel. Not surprisingly, a whistleblower’s report led to multiple convictions. Thus, E-Biofuels demonstrates a criminal prosecutorial pathway through EPA’s implementing RIN regulations.

Yet another angle from this same scheme and related to E-Biofuels emerged in United States v. Wilson, which involved a separate 2018 conviction under the SEC securities rules for selling shares of a company involved in the fraudulent production of renewable fuels.

Last year, in United States v. Keystone Biofuels, the analysis led to even broader enforcement authority. In that matter, the defendants argued that the EPA’s regulations governing biofuels were confusing and ambiguous, making them particularly inapposite for a criminal prosecution. The court noted that while that defense could prevail in the end with respect to the crimes under the Clean Air Act due to ambiguity, the government also successfully alleged that the income and reporting obligations under the IRS rules formed a separate pathway for prosecution. That is, notwithstanding the arguable ambiguity, the defendants certified compliance with specified standards. More to the point, in making that certification they availed themselves of certain renewable fuels tax credits, and defendants were found guilty of tax fraud in April 2019 for claiming such credits. The final opinion is as yet unpublished, but the conviction was based on tax fraud based on the generation of fraudulent RINs.

While the cases above demonstrate egregious and knowing conduct, the arguments raised in the defense shed light on some of the vulnerabilities of such a large and unprecedented regulatory market system. For example, a company may be in a position to further refine a pre-existing biofuel to make it more energy intensive or efficient. That secondary refiner would need to demonstrate that the original biofuel had never entered the EPA’s RIN system prior to processing the material.

Even more to the point, what if an obligated party purchases a fraudulent RIN? If the obligated party purchases or trades RINs that were produced by a generator using an EPA-approved Quality Assurance Plan (QAP), the obligated party may assert an affirmative defense pursuant to 40 C.F.R. § 80.1473. While that provides relief with respect to civil or criminal liability, it does not obviate the need to fulfill the obligated party’s renewable volume obligation. Thus, that party may avoid prosecution for the trade, purchase or further sale of a fraudulent RIN, but purchasing substitute RINs can be a ruinously costly process (however, there are insurance products available).

In conclusion, an obligated party would be best served by ensuring that the generator of the RIN has been vetted by a QAP and that the blender that sells that party the RIN should have similar standards. The federal government has come down aggressively on at least three fronts – through EPA’s regulations, the IRS code and even the False Claims Act – to help stem the production of fraudulent biofuels. Thus, parties generating biofuel and other renewable fuels would be well-served to have their processes audited by counsel to assess consistency with the EPA regulatory requirements, given the draconian positions the EPA has taken with respect to enforcement on this issue.

For more information, contact Andrew S. Levine at 215.564.8073 or alevine@stradley.com.

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Cut, Paste, Send, Cert.: How Three Simple Acts Changed the Securities and White-Collar Landscape

By Michael J. Engle, Chair, White-Collar Defense, and Kristen M. Gibbons-Feden, Associate

On March 27, the U.S. Supreme Court resolved a circuit split on whether liability attached for three simple acts – cut, paste and send – done at another person’s direction. Several months earlier, on December 3, 2018, when the Supreme Court was hearing oral argument on the seminal Lorenzo v. Securities and Exchange Commission case, broker-dealers and others in the industry were uncertain as to the actual scope of Rule 10b-5 and whether shareholders could privately sue actors for fraudulent statements and related acts.

It all began when Francis Lorenzo cut some text, pasted it into an email and clicked “send.” Lorenzo was the director of investment banking at Charles Vista, LLC, an SEC-registered broker-dealer. In that capacity, Lorenzo’s duties involved conducting due diligence on his clients, including reviewing their financial statements and public filings. In September 2009, Charles Vista served as the exclusive placement agent for a startup company’s $15 million convertible debenture offering. The following month, the company issued two public filings indicating that (1) its technological asset, a gasification technology, was valueless, (2) there was a total impairment of its intangible assets and (3) the company’s total assets were valued at approximately $370,000. These public filings were a reflection of the failed gasification technology.

There was no dispute that Lorenzo had access to the public filings that revealed a significant decline in the company’s financial health. There was also no dispute that prior to the release of the public filings, Lorenzo cautioned his boss about offering a $15 million convertible debenture for a company that had no assets to liquidate to protect its investors in the event of default. Nevertheless, sometime thereafter, Lorenzo emailed two investors stating: (1) the company had more than $10 million in confirmed assets, (2) the purchase orders and letters of interest totaled over $43 million and (3) Charles Vista would raise additional monies to repay debenture holders, if necessary. All statements were false. Moreover, these emails were actually typed by Lorenzo’s boss and sent to Lorenzo with the directive to send them to the two investors, which he did. Both emails noted that they were being sent at the request of Lorenzo’s boss. The primary question, then, was whether Lorenzo’s “cut, paste and send” made him liable for making untrue statements in violation of Rule 10b-5(b). And if he could not be found liable for making untrue statements, could he be found liable for employing a scheme to defraud or for engaging in an act that operated to defraud?

Four years later, the SEC charged Lorenzo, his boss, and Charles Vista with violating antifraud provisions of the federal securities laws. Lorenzo’s boss and Charles Vista settled with the SEC – but Lorenzo did not. Among the SEC’s charges against Lorenzo were claims for violating all three subsections of Rule 10b-5, which accused Lorenzo of making a fraudulent statement and engaging in a fraudulent scheme. Specifically, Rule 10b-5 provides that

[i]t shall be unlawful for any person directly or indirectly … (a) [t]o employ any device, scheme or artifice to defraud, (b) [t]o make any untrue statement of a material fact … or (c) [t]o engage in any act … which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

17 C.F.R. 240.10b-5 (emphasis added). The SEC did not charge Lorenzo with aiding or abetting a fraudulent act.

The SEC prevailed against Lorenzo in administrative proceedings where the judge found Lorenzo violated all three subsections of Rule 10b-5. The judge imposed stiff penalties, including banning Lorenzo from the industry for life. He appealed to the full commission, but it sustained the administrative judge’s decision, finding that Lorenzo knew the statements in the emails were false and misleading when he sent them. Lorenzo took an appeal to the U.S. Court of Appeals for the District of Columbia Circuit, but he lost once again, in a 2-1 decision.

Relying on guidance in Janus Capital Group Inc. v. First Derivative Traders, a 2011 Supreme Court 5-4 decision authored by Justice Thomas, the court decided Lorenzo did not “make” a statement under subsection (b) of Rule 10b-5, because he had no authority and control over the statement. “One ‘makes’ a statement by stating it … For purposes of Rule 10b–5, … [o]ne who prepares or publishes a statement on behalf of another is not its maker.” 564 U.S. 135, 142-143 (2011) (emphasis added). The court found, however, Lorenzo’s conduct of transmitting misinformation directly to the investors made his involvement transparent, and violated Rule 10b-5 subsections (a) and (c). This made him liable as a fraudulent schemer under an aiding and abetting or substantial assistance theory, a holding the majority cited as supported under Janus. See Janus, 564 U.S. at 143 (“Rule 10b-5’s private right of action does not include suits against aiders and abettors. Such suits – against entities that contribute ‘substantial assistance’ to the making of a statement but do not actually make it – may be brought by the SEC, see 15 U.S.C.A. § 78t(e), but not by private parties.”) (emphasis added). Notably, Justices Breyer, Ginsburg, Sotomayor and Kagan, all dissented in this case.

In dissent, Judge Brett Kavanaugh (now Associate Justice of the U.S. Supreme Court) opined that Lorenzo could not be deemed a schemer, because the statements were made by his boss – not him. In other words, the SEC should have been required to show more than a misstatement in proving that Lorenzo violated Rule 10b-5(a) and (c). According to Judge Kavanaugh, holding otherwise equates to “legal jujitsu” and eliminates the distinction between primary liability (direct violation) and secondary liability (aiding and abetting). Judge Kavanaugh harshly criticized the SEC, claiming it is attempting to “unilaterally rewrite the law” and “expand the scope of primary liability under securities law.” Judge Kavanaugh’s position has commanded majorities of panels in the Second, Eighth and Ninth Circuits.1 However, Justice Kavanaugh recused himself from determining Lorenzo’s fate for obvious reasons, leaving a bench of eight that included the Janus dissenters.

While Lorenzo’s fate seemed to be sealed based on the assumption that the four dissenters in Janus would decline to extend it (which would result in the affirmance of the lower court’s decision, and perhaps a clarified scope of 10b-5(b)), Justice Alito posed some very interesting questions that shed some light on the way he might rule. During oral argument, Justice Alito pressed Robert Heim, counsel for Lorenzo, on numerous occasions, to explain how Lorenzo’s conduct was not violative of Rule 10b-5(c), eventually asserting, “[Lorenzo is] a principal under (c)…he did the act that is described in (c).” Transcript of Oral Argument at 13, Lorenzo v. Securities and Exchange Commission (No. 17-1077). As Christopher Michel argued on behalf of the SEC, affirming Lorenzo’s liability would be consistent with Justice Alito’s prior stance in a tax evasion case, where Justice Alito opined that “enumeration” of tax evasion in a statute that covered both criminal deceit and tax evasion did not preempt application of that statute to conduct that was solely criminally deceptive. Id. at 54-55. Mr. Michel analogized that case to Lorenzo, stating, “the enumeration of statements in Rule 10b-5(b) does not preempt or foreclose acts of conduct that fall within the text of the statute.” Id. at 55.

While Lorenzo was simply looking for removal of the penalty imposed on him, the Supreme Court granted review to resolve the disagreement about the scope of Janus and the distinctions between primary and secondary liability under Rule 10b-5, particularly as it applies to actions instituted by the SEC. In the 6-2 Court’s opinion written by Justice Breyer, the Supreme Court expressed its displeasure with Lorenzo’s behavior, noting “we see nothing borderline about this case…[Lorenzo] sent false statements directly to investors, invited them to follow up with questions, and did so in his capacity as vice president of an investment banking company.” Finding Lorenzo’s conduct a “paradigmatic example of securities fraud,” the Supreme Court rejected the argument that subsection (b) exclusively regulates conduct involving false or misleading statements, noting “[w]e do not know why Congress or the Commission would have wanted to disarm enforcement in this way.” In a dissent joined by Justice Gorsuch, Justice Thomas argued that interpreting Rule 10b-5(a) and (c) to encompass primary liability solely for false statements rendered Janus a “dead letter.”

Undoubtedly, the SEC and private parties will rely on this case to pursue Rule 10b-5(a) and (c) claims against those who knowingly disseminate statements with the intent to defraud investors, yet do not “make” the statement. Defendants will likely seek to distinguish their actor’s conduct from Lorenzo’s and argue factual distinctions to the courts. Regardless of the party, it will be interesting to watch how the courts, particularly in the Second, Eighth and Ninth Circuits, which had previously narrowed the scope of liability under Rule 10b-5(a) and (c), decide cases where the actor’s conduct is more “borderline” and the intent to deceive and the material falsity of the statement is less clear.

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1See, e.g., Public Pension Fund Group v. KV Pharmaceutical Co., 679 F.3d 972, 987 (8th Cir. 2012); WPP Luxembourg Gamma Three Sarl v. Spot Runner, Inc., 655 F.3d 1039, 1057 (9th Cir. 2011); Lentell v. Merrill Lynch & Co., 396 F.3d 161, 177 (2d Cir. 2005).

For more information, contact Michael J. Engle at 215.564.8737 or mengle@stradley.com, or Kristen M. Gibbons-Feden at 215.564.8076 or kfeden@stradley.com.

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Ashley E. Shapiro Discusses U-Haul Case

Ashley E. Shapiro, white-collar criminal defense counsel, discusses the prosecution of U-Haul and her representation of an employee of U-Haul who was charged with violating hazardous materials regulations in connection with a food truck explosion. She highlights the key takeaways and important lessons from this case.

For more information, contact Ashley E. Shapiro at 215.564.8113 or ashapiro@stradley.com.
 

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The Supreme Court’s Recent Ruling on Excessive Fines Strengthens Property Rights of the Accused in State Civil Forfeiture Actions

By Michael J. Engle, Chair, White-Collar Defense, and Adam J. Petitt, Associate

On Feb. 20, in Timbs v. Indiana, 586 U.S. __, No. 17-1091, the Supreme Court unanimously ruled that the Eighth Amendment’s ban on excessive fines applies to the states and their civil in rem forfeitures under the Fourteenth Amendment’s Due Process Clause. Under the Eighth Amendment, “[e]xcessive bail shall not be required, nor excessive fines imposed, nor cruel and unusual punishments inflicted.” Central to the Court’s opinion is the phrase “nor excessive fines imposed,” which serves to limit the government’s power to extract payments, whether in cash or in kind, as punishment for some offense. The Court unanimously held that the Fourteenth Amendment incorporates and renders this Bill of Rights protection applicable to the states. “If a Bill of Rights protection is incorporated, there is no daylight between the federal and state conduct it prohibits or requires.”

In 2015, after pleading guilty to a drug offense, Indiana prosecutors sought civil forfeiture of Tyson Timbs’ SUV, charging that it had been used to transport heroin. The trial court denied the request because the $42,000 SUV was worth more than four times the maximum fine that could be imposed ($10,000) and requiring forfeiture would be “grossly disproportionate to the gravity” of Timbs’ crime and therefore unconstitutional under the Eighth Amendment. An intermediate appellate court upheld that decision, but the Indiana Supreme Court reversed on grounds that the Excessive Fines Clause constrains only federal action and does not apply to the states.

In a 9-0 decision, the Supreme Court strongly disagreed. In an opinion by Justice Ruth Bader Ginsburg, tracing the lineage of the Excessive Fines Clause back to the Magna Carta in 1215, the Court had little difficulty finding that the “historical and logical case” for concluding that the excessive fines ban equally applies to the states is “overwhelming.” Indeed, “[p]rotection against excessive fines has been a constant shield throughout Anglo-American history for good reason: Such fines undermine other liberties.” When a Bill of Rights protection is incorporated, the protection applies identically to both the federal government and the states.

The state of Indiana did not meaningfully challenge the incorporation of the Excessive Fines Clause; rather, it argued that the Clause does not apply to the state’s use of civil in rem forfeitures. But the Court held in Austin v. U.S., 509 U.S. 602 (1993), that such forfeitures fall within the Clause’s protection when they are at least partially punitive. While the Indiana Supreme Court held that the Clause does not apply to the states at all, it did not address the Clause’s applicability to civil in rem forfeitures. Given that, the Court declined the state’s invitation to reconsider its unanimous judgment in Austin. Moreover, and perhaps most importantly, the Court held that it doesn’t matter whether the particular application of the Excessive Fines Clause to civil in rem forfeitures is itself a fundamental right. Rather, what matters is that the Clause’s broader right to be protected from excessive fines is a fundamental right that is incorporated under the Fourteenth Amendment and applicable to the states.

Importantly, the Supreme Court’s decision adds a critical layer of protection for property rights of persons accused of white-collar crimes. Under federal and state forfeiture laws, law enforcement and prosecutors can seize a person’s property and assets long before there is a guilty plea or conviction. They need only probable cause to believe the assets or property were being used as part of criminal activity, and can then keep the value of the seized property as profit. These forfeiture practices have come under increased scrutiny over the past couple years, and the Timbs decision may be the tipping point to effectuate reform of the controversial practice. While it is unclear just how courts will evaluate new challenges to excessive forfeitures under the Eighth Amendment in light of the Timbs decision, the Supreme Court’s unanimous judgment should make it easier to challenge such excessive forfeitures and deter law enforcement from the seizures in the first place.

For more information, contact Michael J. Engle at 215.564.8737 or mengle@stradley.com, or Adam J. Petitt at 215.564.8130 or apetitt@stradley.com.

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To Be or Not to Be – An Exchange: SEC Enforcement Action Against Unregistered Crypto Exchange

By Gregory D. DiMeglio, Chair, Securities Enforcement, Sara P. Crovitz, Partner, Nicole M. Kalajian, Counsel, and J. Patrick Green, Associate

On Nov. 8, 2018, the SEC instituted and simultaneously settled an important enforcement action against an unregistered cryptocurrency exchange, EtherDelta, a digital “token” trading platform.1

Background

According to the SEC, Zachary Coburn launched EtherDelta’s website on July 12, 2016. Through December 15, 2017, EtherDelta executed over 3.6 million buy and sell orders in ERC20 tokens over the website.2 The SEC order held that the ERC20 tokens included “securities,” as defined by the Securities and Exchange Act of 1934 (“Exchange Act”). However, the order failed to specify which ERC20 tokens, in particular, were deemed to be securities by the SEC. In addition, approximately 92% (i.e., 3.3 million) of the orders were entered after the SEC issued the DAO Report on July 25, 2017.3 In the DAO Report, the SEC advised that a platform that offers trading of digital assets that are “securities” and operates as an “exchange,” as defined by the federal securities laws, must register with the SEC as a national securities exchange or be exempt from registration.

What is an exchange?

Exchange Act Rule 3b-16(a) (the “Rule”) provides a functional test to determine whether a platform, referenced in the DAO Report, meets the definition of “exchange” under the federal securities laws. The Rule states that an organization, association, or group of persons will meet the definition of an exchange if it satisfies the following conditions: (1) it brings together the orders for securities of multiple buyers and sellers; and (2) it 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.

(1) Bringing together orders of securities of multiple buyers and sellers

The SEC found that EtherDelta operated as a marketplace for bringing together the orders of multiple buyers and sellers in tokens that included “securities,” as defined by the federal securities laws. While the specific tokens at issue were not listed in the order, the SEC determined that the tokens had all the hallmarks of a security under the 1946 Supreme Court case of Howey – namely the investment of money with the reasonable expectation of profits, including through the increased value of their investments in secondary trading, based on the managerial efforts of others.4

(2) Non-discretionary methods for executing trades agreed to by buyers and sellers

EtherDelta brought together orders by receiving and storing orders in tokens in the EtherDelta’s order book and displaying the top 500 orders (including token symbol, size, and price) as bids and offers on the EtherDelta website. EtherDelta thus provided the means for these orders to interact and execute through the combined use of the EtherDelta website, order book, and pre-programmed trading protocols defined in the EtherDelta smart contract. These established non-discretionary methods allowed users to agree upon the terms of their trades in tokens on EtherDelta.

Coburn’s fate

Ultimately, the SEC found that, because EtherDelta was operating as an “exchange,” as defined in the Exchange Act, it should have registered with the SEC or qualified for an exemption. The SEC also determined that Coburn “should have known” that his actions would contribute to EtherDelta’s violations. Because Coburn wrote and deployed EtherDelta’s smart contract and exercised complete and sole control over its operations, the SEC found that he caused EtherDelta’s violation of the Exchange Act. The action is yet another example of the Commission’s stated priority of holding individuals accountable, even in the absence of finding fraud or scienter-based conduct.

Coburn, without admitting or denying the findings contained in the SEC’s order, individually agreed to pay $300,000 in disgorgement plus $13,000 in prejudgment interest along with a $75,000 penalty. The SEC recognized Coburn’s prompt remedial acts and cooperation during the investigation, which resulted in its decision not to impose a greater penalty. Going forward, Coburn agreed to testify in any related enforcement action.

What does this mean going forward?

Along with the SEC’s recent actions against crypto hedge funds, broker-dealers and securities offerings, this additional action against a crypto exchange is likely more evidence of further crypto-enforcement actions to come.

In response, many crypto firms are seeking to legitimize their existing businesses to ensure compliance. For instance, firms in need of fund-raises are seeking to offer compliant ICOs (such as securities token offerings – STOs – under Regulation 506). Likewise, many crypto trading platforms are taking advantage of the alternative trading system (“ATS”)5 option under Regulation ATS, which generally exempts an ATS from registering as an exchange under the Exchange Act if it registers as a broker-dealer and files an initial operation report with the SEC on Form ATS prior to commencing operations.

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1 See copy of Coburn Order here. The SEC had previously brought and settled a similar case alleging failure to register as an exchange against cryptocurrency firm BTC Trading Corp. (see BTC Order here). The SEC likewise brought an action against Bitfunder (see Bitfunder Complaint here), which remains ongoing.

2 ERC20 tokens refer to digital assets issued and distributed on the Ethereum blockchain using the ERC20 protocol, which is the standard coding protocol currently used by a significant majority of issuers in initial coin offerings (“ICOs”). If a programmer includes certain required functions in the token’s smart contract, then the token is a ERC20 token.

3 See copy of the DAO Report here.

4 See SEC v. W.J. Howey Co., 328 U.S. 293 (1946).

5 An ATS is “any organization, association, person, group of persons, or system: (1) [t]hat constitutes, maintains, or provides a marketplace 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 within the meaning of [Exchange Act Rule 3b-16]; and (2) [t]hat does not: (i) [s]et rules governing the conduct of subscribers other than the conduct of subscribers’ trading on such [ATS]; or (ii) [d]iscipline subscribers other than by exclusion from trading.”

For more information, contact Gregory D. DiMeglio at 202.419.8401 or gdimeglio@stradley.com, Sara P. Crovitz at 202.507.6414 or scrovitz@stradley.com, Nicole M. Kalajian at 312.964.3507 or nkalajian@stradley.com or J. Patrick Green at 202.507.5151 or jgreen@stradley.com.

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Information contained in this publication should not be construed as legal advice or opinion or as a substitute for the advice of counsel. The articles by these authors may have first appeared in other publications. The content provided is for educational and informational purposes for the use of clients and others who may be interested in the subject matter. We recommend that readers seek specific advice from counsel about particular matters of interest.

Copyright © 2019 Stradley Ronon Stevens & Young, LLP. All rights reserved

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