Like most of the rest of the world, the speakers and attendees at Securities Enforcement Forum West 2020 last week had to adapt this year by trading in their microphones on the stage of a grand ballroom for an array of home offices and Zoom backgrounds. But the panels themselves, several of which have become recurring staples at the annual conference, still conducted deep dives into key enforcement issues. Topics ranged from COVID-19 impacts, cryptocurrency developments, scrutiny of private companies, financial disclosures and accounting fraud, cybersecurity, artificial intelligence and machine learning, and the SEC’s oversight of market manipulation and insider trading. Overall, the full-day forum presented by Securities Docket on May 12 underscored that securities enforcement and litigation are not slowing down, and companies and their attorneys need to be prepared to respond and defend themselves when faced with heightened SEC scrutiny.
The 2020 panelists comprised current and former senior officials from the U.S. Securities Exchange Commission and U.S. Department of Justice, top securities enforcement and white-collar defense attorneys, as well as leading industry representatives and accounting, consulting, and compliance executives in the field.
SEC Co-Director of Enforcement Steven Peikin delivered this year’s keynote address and emphasized that the Division continues investigating and litigating cases at a similar pace to pre-COVID-19 work. Peikin noted that the staff continues to work matters opened before the crisis, and to open and work new matters, some of which are related to the COVID-19 crisis. He highlighted the SEC’s newly formed Coronavirus Steering Committee, which includes two dozen SEC enforcement leaders tasked with coordinating the SEC’s activities related to COVID-19. The Steering Committee has already generated significant results, including dozens of COVID-19-related trading suspensions put in place by the Enforcement Division since February, and the Division’s accelerated enforcement actions and investigations to combat fraud associated with companies’ COVID-19-related claims. Forum participants also heard from two SEC Regional Directors—Erin Schneider (San Francisco) and Michele Wein Layne (Los Angeles)—as well as other senior SEC officials who provided commentary on specific areas of enforcement interest.
This alert focuses on three important areas of SEC enforcement activity highlighted during the 2020 forum: COVID-19, cryptocurrency and continued SEC scrutiny of private companies. All of these are among the most pressing regulatory issues facing companies and investors in Silicon Valley and beyond.
The Effect of COVID-19 on SEC Enforcement
As Fenwick’s Michael Dicke and other defense counsel recently predicted, SEC enforcement efforts will not slow because of coronavirus and shelter-in-place restrictions. Following up on official statements from financial regulators throughout the COVID-19 crisis, SEC faculty at the 2020 forum confirmed that, with the exception of adjusting to new logistics, the SEC Enforcement Division is operating as usual by remotely conducting investigations, witness interviews and testimony, issuing subpoenas, monitoring market volatility and initiating new investigations. “We remain vigilant and active,” stated Jason Lee, associate regional director in the SEC’s San Francisco Regional Office.
While there may be some room for defense counsel to request extensions and continuances or even advise their clients to enter into tolling agreements, SEC officials are largely making those determinations on a case-by-case basis, and the discussion at the forum left no doubt that SEC enforcement investigations and litigation will move forward rapidly throughout the rest of 2020.
In addition to actively pressing forward on their non-COVID-19 work, SEC enforcement attorneys have made COVID-19 related enforcement matters a top priority to protect investors from insider trading, market manipulation and disclosure violations. Peikin and Lee both highlighted the SEC’s trading suspensions where the Commission had concerns about the veracity of statements made by issuers about testing, treatments and access to personal protective equipment (PPE). SEC Associate Regional Director Monique Winkler pointed out that one of the trading suspensions involved Silicon Valley-based Arrayit Corporation due to its statements regarding blood tests for COVID-19. In late April, another one of those 30 trading suspensions escalated into the SEC’s first COVID-19-related fraud case filed against Praxsyn Corporation and its CEO in federal district court in Florida and alleging that defendants made inaccurate and misleading statements to the market “about having, and being able to obtain, large quantities of N95 masks used to protect wearers from COVID-19.”
SEC officials also emphasized the importance of “good faith” disclosures by public companies during the current health crisis. Yet industry panelists pointed out the inherent tension created by the SEC Division of Corporation Finance’s March 25, 2020, CF Disclosure Guidance: Topic No. 9, which calls for “robust, forward-looking disclosures” with the risk that companies assessing how COVID-19 impacts their future business operations could expose themselves to Monday morning quarterbacking by the SEC and private litigants. It remains to be seen in practice how the Enforcement Division’s efforts will square with the Commission’s repeated encouragement that public companies avail themselves of statutory safe harbors and how intensely the SEC will scrutinize forward-looking disclosures surrounding the impact of COVID-19 on businesses.
Although not addressed during the forum, we have learned in the last few days that the SEC Enforcement Division is conducting a “sweep” inquiry into public companies that received loans through the SBA’s Paycheck Protection Program (PPP). As part of its investigation, the SEC is requesting a select number of loan recipients produce all materials considered by management and the Board when concluding that the company met the “necessity” requirement to receive a loan, as well as all internal and external communications about the loan application and continued evaluation of whether the company continues to meet all criteria required to receive a loan. Further, the SEC appears likely to be evaluating companies’ public disclosures about their business and prospects against internal analyses and representations made to obtain a PPP loan. This new development demonstrates that the SEC will seek opportunities to investigate COVID-19 related cases, especially those that concern publicly reporting companies.
Cryptocurrency: SEC Scrutiny Continues and Heads to the Courtroom, Led by the Telegram and Kik Cases
Fenwick’s Michael Dicke moderated this year’s panel on cryptocurrency. For the first time in the four years of hosting a cryptocurrency panel, the forum included a panelist from the digital asset industry, Kristin Smith, executive director of the Blockchain Association, a group of blockchain and cryptocurrency industry leaders advocating for policy change. She was joined by SEC Assistant Director Steven Buchholz and Cornerstone Research economist Dr. Nicole Moran. All panelists agreed that the most significant development in this area was the move from SEC guidance and settled enforcement actions to contested court decisions over the application of the federal securities laws to digital asset projects. At the forefront of current SEC cryptocurrency-focused efforts are two enforcement actions filed in 2019 against Telegram and Kik Interactive for allegedly offering unregistered securities in violation of Section 5 of the Securities Act.1
- SEC v. Telegram: In October 2019, the SEC filed an emergency action to stop Telegram from completing its issuance of its “Gram tokens and putting at risk the $1.7 billion Telegram had already raised to develop and launch its TON blockchain On March 24, 2020, the U.S. District Court for the Southern District of New York granted the SEC’s motion for a preliminary injunction to prevent Telegram’s distribution of Gram tokens to initial purchasers, which the SEC had argued were part of a larger pre-sale scheme designed for those initial purchasers to serve as “underwriters” and resell Grams into a secondary public market in an unregistered securities offering. Applying the Howey test2 thecourt held that the SEC showed a substantial likelihood of success in proving that Telegram’s integrated scheme to distribute Grams (which included the pre-sale to accredited investors through the distribution of the tokens on the secondary market) would constitute an unregistered securities offering in violation of Section 5. Telegram immediately appealed the decision to the Second Circuit and the case is stayed pending those proceedings. During the cryptocurrency panel at the 2020 forum, the SEC’s Buchholz called the Telegram ruling a “very significant decision” for the SEC, stating that it was correctly decided and is consistent with the SEC’s application of Howey as it has progressed since July 2017 when the SEC provided notice to the crypto industry that virtual tokens can be securities in its investigative report analyzing tokens offered and sold by Decentralized Autonomous Organization (DAO). Buchholz also emphasized that the Telegram court’s holistic view of the Gram offering was critical, rather than breaking it up into multiple components when, according to Buchholz, Telegram’s clear goal was to get its tokens in the hands of the public. The moderator and other panelists, in contrast, thought that rather than affirming long-standing law, the Telegram ruling upset settled views about the legality of issuing securities to accredited investors under the Regulation D (“Reg D”) exemption to the securities registration rules.
- SEC v. Kik: Relatedly, the SEC initiated an action against Kik in June 2019, alleging that Kik’s 2017 offering of its Kin tokens constituted an unregistered securities offering in violation of Section 5. After discovery, both Kik and the SEC have fully briefed cross-motions for summary judgment and the motions are pending decision by the court. In its briefing, the SEC urges the district court to apply the reasoning from Telegram. Meanwhile Kik notes that the preliminary injunction and summary judgment legal standards are entirely distinct, and factually Kik’s offering differs from Telegram—most significantly because Kik pre-sold the rights to obtain Kin tokens to accredited investors in addition to selling Kin to the general public. The 2020 forum panelists pointed out that the Kik decision will be significant because, unlike Telegram, which was decided before a secondary market for Grams even emerged, Kik already has a fully functioning distributed network. The district court’s forthcoming summary judgment rulings will likely be the next significant message to the crypto industry on the viability of token issuances designed to be done in phases.
- So…What Constitutes a Valid Issuance? Given that Telegram and Kik tried to comply with the Reg D exemption, but the SEC still found that registration provisions were violated, Buchholz addressed the question on every crypto participant’s mind: What steps need to be taken to avoid an SEC enforcement action and have a valid token issuance under Reg D? The issue, according to Buchholz, has to do with whether the same tokens pre-sold to early purchasers are ultimately distributed into the hands of the public as the means by which the expectation of profits is created for the early purchasers: “It’s that tie together that creates the problem,” he said. In response, Smith explained that the problem for the blockchain industry is that the network needs to be financed on the front end in order to be built in the first place, and without the pre-sale of tokens to accredited investors, the industry would need another pathway for crypto companies to turn their ideas into fully functioning networks.
- Private Litigation: The panel also discussed the continued increase in private actions in the digital asset space, most notably the 11 class actions filed in the Southern District of New York on a single day in early April against four of the world’s largest crypto-asset exchanges and seven digital token issuers for violations of the registration provisions of Securities Act Section 5. Further, in what Northern District of California Judge Richard Seeborg called “new terrain,” on April 30, 2020, the court preliminarily approved a first-of-its-kind $25 million class action settlement of claims brought on behalf of investors against the Tezos Foundation related to its July 2017 initial coin offering.
Dicke also raised emerging areas of crypto that are not yet the subject of public SEC enforcement. When asked how the SEC views stablecoins, which are cryptocurrencies designed to maintain price parity with fiat currency such as the U.S. dollar, Buchholz commented that the SEC is “very much aware” of stablecoins but “as with all matters in this space it really is a facts and circumstances specific analysis.” Buchholz reiterated that the Telegram decision could prove useful in any determination of whether stablecoins are a security, and thus conferring jurisdiction on the SEC to enforce Section 5. As for the crypto industry, despite frustrations with the SEC’s “facts and circumstances” approach, that very approach could limit the widespread applicability of Telegram. As a trial court decision, Telegram is not binding on any court, and can be distinguished based on the facts and timing of other blockchain projects. Kik, for example, argues vehemently that Telegram “has no bearing” on the court’s evaluation of its token offering.
While stakeholders on both sides of the courtroom anxiously await Second Circuit proceedings in Telegram and the summary judgment ruling in Kik, Dicke closed out the crypto panel by predicting that one of the judges in the myriad of private suits would write a comprehensive and persuasive opinion that disagrees with the SEC’s sweeping views of the applicability of the federal securities laws to digital asset projects. In doing so, he noted, courts will help swing the pendulum back from the SEC’s broad pronouncements that effectively find that every token issuance is covered by the federal securities laws.
Private Companies Are Not Immune from SEC Scrutiny
While public companies are readily familiar with the risks of enforcement actions, SEC officials at the 2020 forum noted that private equity funds, venture capital firms and their portfolio companies—particularly “unicorn” venture-backed startups valued over $1 billion—cannot avoid SEC scrutiny either. Panel participants at the 2020 forum agreed that in the past year, the SEC has renewed its focus on private company enforcement actions, with its April 2019 charges against the founder of Jumio Inc. as the prime example. After alleging that the founder and former CEO of the Silicon Valley mobile payments startup “grossly overstated” 2013 and 2014 revenues and then sold his own personal shares to investors to the tune of $14 million and hid the sales from Jumio’s board of directors, the SEC ultimately reached a settlement with the founder. The SEC also settled a separate action against the former CFO of Jumio, who had cooperated with the SEC.
Associate regional director Winkler pointed out that private equity and venture capital players are also subject to anti-fraud rules, noting settled charges in April 2020 filed against New York-based private equity fund adviser Monomoy Capital Management for failing to fully disclose or obtain consent for a financial arrangement where Monomoy was charging its private fund portfolio companies for the costs of certain services.
Just two days after the 2020 enforcement forum, on May 14, the SEC filed charges in the District of Connecticut against the former CEO of Sonic Cavitation LLC, a private liquid purification technology company, under the anti-fraud provisions of the securities laws. The SEC complaint alleges that the former CEO falsely told current and prospective investors that a publicly traded oil and gas company was set to acquire a 10%-12% stake in the private company, despite the fact that he knew the public company did not believe the private company’s technology was viable. In allegations reminiscent of Theranos, the SEC further alleges that the former CEO misrepresented the liquid purification technology’s testing history, capabilities and performance in real-life applications. The SEC charged the former CEO with violations of Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5.
The SEC’s enforcement interest in this area could equally target both well-positioned and distressed private companies. On the financially secure end of the spectrum, panelists predicted that unicorns will remain a focus of SEC enforcement. For example, companies that have chosen to undergo late-stage financing rounds to raise private capital rather than avail themselves of the IPO process could see enhanced scrutiny. Meanwhile, as the coronavirus and related shutdowns threaten the financial health of other private companies, discussions at the 2020 enforcement forum underscored that the SEC could scrutinize statements made during difficult fundraising and valuation discussions when leadership is trying to breathe life back into a distressed private company. As Winkler cautioned during the forum’s Silicon Valley Spotlight panel: “I don’t think focus will ever be off of what happens in the Valley.”
1 The cases are SEC v. Telegram Group Inc. et al., Case No. 1:19-cv-09439-PKC (S.D.N.Y.) and SEC v. Kik Interactive Inc., Case No. 19-cv-05244-AKH (S.D.N.Y.).
2 Section 2(a)(1) of the Securities Act defines a “security” to include an “investment contract,” which the U.S. Supreme Court in SEC v. W.J. Howey Co., 328 U.S. 293 (1946) defined as “a contract, transaction or scheme” whereby a person (1) invests money (2) in a common enterprise (3) with the expectation of profit (4) solely from the efforts of the promoter or a third party.