A recent enforcement action by the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) in the Fintech space serves as a cautionary tale for innovators who fail to heed traditional regulations. On July 13, 2020, the SEC and CFTC each filed settled enforcement actions against California-based cryptocurrency app developer Abra and its related company, Plutus Technologies Philippines Corporation. Abra’s bold idea was to provide its global users with a way to invest in blue-chip American securities, all funded via Bitcoin. In executing this idea, Abra took pains to focus its products outside of the United States and hoped to avoid the ambit of US securities laws. As further detailed below, however, the SEC and CFTC both found that Abra’s new product violated US laws. This post details Abra’s product, why the regulators came to the view that the new idea ran afoul of long-established provisions under federal securities and commodities laws, and the key takeaways from the regulators’ actions.
- Abra’s Product
In 2018, Abra began offering users synthetic exposure, via Bitcoin, to dozens of different fiat currencies and a variety of digital currencies, like Ethereum and Litecoin. Users could fund their accounts with a credit card or bank account, and Abra would convert those funds into Bitcoin. When a user wanted exposure to a new currency, the user would choose the amount of Bitcoin he or she wanted to invest, Abra would create a “smart contract” on the blockchain memorializing the terms of the contract, and the value of the contract would move up or down in direct relation to the price of the reference currency.
In February 2019, Abra announced that it planned to expand its business to provide synthetic exposure to US stocks and ETF shares, rather than just currencies. Abra advertised that users could enter into smart contracts to invest in their chosen stocks and ETFs. For example, Abra said in a blog post that:[I]f you want to invest $1,000 in Apple shares you will place $1,000 worth of bitcoin into a contract. As the price of Apple goes up or down versus the dollar, bitcoin will be added to or subtracted from your contract. When you settle the contract – or sell the Apple investment – the value of the Apple shares will be reflected in bitcoin in your wallet which can easily be converted back to dollars, or any other asset for that matter.
Abra said it planned to hedge the smart contracts by purchasing—in the US securities markets—the actual securities referenced in a given contract.
- The Securities and Commodities Law Violations
The SEC’s cease-and-desist order found that the contracts Abra offered were swaps because they tracked the value of the underlying securities without also conveying any ownership in those securities. Abra did not set any asset requirements to enter into these swaps, nor did it make any effort to confirm the identity or financial resources of its customers, including whether those customers were “eligible contract participants,” as defined by the securities laws. More than 20,000 people joined the waitlist to buy swaps from Abra. After being contacted by the SEC and CFTC in February 2019, Abra shut down the swaps project before it went live and removed mention of it from its website.
In May 2019, however, Abra rebooted the project, this time limiting offers to non-U.S. persons and making Plutus, Abra’s related Filipino company, the counterparty to the swaps, apparently under the belief that doing so would avoid exposure to U.S. securities laws. While the app was run via Asian servers and Abra’s website was coded to show the swap opportunity only to users outside the United States, California continued to be Abra’s brain center. Employees in California designed the details of the contracts—including prices—sought out investors, marketed the swaps, and hedged the contracts by actually purchasing the underlying securities. Though Plutus was the legal party to the swaps, Abra lent it the hedging money.
Abra and Plutus ultimately sold more than 10,000 swaps, including a small number to customers in the United States, despite efforts to avoid doing so. The SEC’s order found that Abra and Plutus violated Section 5(e) of the Securities Act of 1933 —which prohibits offers to sell security-based swaps to any person who is not an eligible contract participant without an effective registration statement—when they marketed and sold swaps to thousands of unidentified customers without a registration statement in place. For similar reasons, the order found that Abra and Plutus also violated Section 6(1) of the Securities Exchange Act of 1934, which prohibits effecting security-based swaps with a person who is not an eligible contract participant, unless the transaction is effected on a national securities exchange.
The CFTC order similarly found that from December 2017 to October 2019, Abra entered into thousands of digital-asset and foreign currency-based smart contracts via its app. Those contracts, according to the CFTC, constituted swaps under the Commodity Exchange Act (CEA). Because Abra offered these swaps to persons who were not eligible contract participants, and did so outside of a board-of-trade-designated contract market, the swaps violated Section 2(e) of the CEA. Further, in soliciting and processing the swaps, Abra violated Section 4(d)(a)(1) of the CEA by operating as a futures commission merchant without registering with the CFTC.
In bringing the action, the SEC and CFTC also emphasized the messages they hoped the filing of the action would send: namely that it was important that Fintechs comply with the relevant laws as they seek to bring innovative products to the market. In filing the action, the SEC emphasized that parties could not avoid the reach of the securities laws easily when key parts of their operations occurred in the US. In the press release announcing the action, Dan Michael, the head of the Complex Financial Instrument, said, “businesses that structure and effect security-based swaps may not evade the federal securities laws merely by transacting primarily with non-U.S. retail investors and setting up a foreign entity to act as a counterparty, while conducting crucial parts of their business in the United States.” For its part, in its press release, the CFTC emphasized that it would continue to focus on ensuring responsible development of digital products. As stated by the CFTC’s Enforcement Director, “Rooting out misconduct is essential to furthering the responsible development of these innovative financial products.”