But You Will Have to Register With the SEC and Offer to Return the Money You Raised
The Securities and Exchange Commission on November 16 announced the institution and simultaneous settlement of two proceedings regarding initial coin offerings. In determining in each action that the instrument being offered was a security, the SEC applied its standard analysis that investors bought the cryptocurrencies in anticipation of earning a profit from the appreciation of the coins resulting from management efforts. In these first cases where no fraud was involved, however, the SEC imposed civil penalties and other requirements, including that the ICO issuers offer to rescind the coin sales.
In the AirFox action and the Paragon action, the SEC considered two ICOs completed toward the end of the summer of 2017, both of which offered what has become known as a “utility token” — a cryptographic instrument similar to Bitcoin and Ether, but sold “only to be used to purchase a good or service available through the network on which it was created.” (Remarks of William Hinman, Director, Division of Corporation Finance at the Yahoo Finance All Markets Summit: Crypto, June 14, 2018) In the AirFox offering, tokens would be used to allow prepaid mobile phone users free or discounted airtime or data by interacting with ads. In the Paragon structure, participants in the cannabis industry would be able to exchange tokens for lease payments for office or warehouse space rather than using traditional banking channels that might be closed to them.
Without requiring either AirFox or Paragon to admit or deny that they had engaged in an unregistered offering of securities (within the definition of the federal securities laws), the SEC did obtain agreements from both to:
- Issue a press release notifying the public of the availability of the claim remedy described below within 14 days of November 16, 2018.
- File a general registration statement on Form 10 with the SEC within 90 days that would result in the entity’s becoming an SEC reporting company, and maintain that status for at least one year from the effectiveness of the filing, effectively requiring each company to “go public” with none of the benefits of a traditional IPO.
- Within 60 days of the filing’s effectiveness, offer to return all investors’ funds raised in the ICO, using a claim form that will be subject to SEC approval.
- Allow any ICO claimants three months to pursue this remedy, and complete all related payments not later than three months after the deadline for claims forms.
- Prepare a report for the SEC regarding the rescission offer and its handling of all claims received not later than seven months following the effective date described above.
- Pay a civil penalty of $250,000.
While the SEC used a light touch in penalizing only the issuer (no individuals or advisers were named in either proceeding) and allowing ample time for each issuer to conduct its rescission offer, open questions remain, including whether the Form 10 filing will result in the application of the SEC’s proxy rules, how financial statements will be prepared and audited in three months, and how required beneficial ownership disclosures will be made in a system designed to preserve the anonymity of the holder of the digital asset.
In a public statement — the Statement on Digital Asset Securities Issuance and Trading – issued on the same date, the SEC staff noted that these two cases were among a number of enforcement actions the SEC had brought involving digital asset securities, stating that “market participants must still adhere to our well-established and well-functioning federal securities law framework when dealing with technological innovations, regardless of whether the securities are issued in certificated form or using new technologies, such as blockchain.”
The staff discussed a recent action against EtherDelta, which operated an unregistered securities exchange, and another against TokenLot, which engaged in unlicensed broker-dealer activity. EtherDelta’s system, among other things, brought together buyers and sellers by maintaining an order book and posting orders, and it used “‘established non-discretionary methods’ under which [the] orders interact.” TokenLot marketed and facilitated sales of digital asset securities, accepted orders and funds for payment and disbursed proceeds to issuers, and made markets in security tokens.
In the statement, the staff also noted the September 2018 Crypto Asset Management Order, which applied the legal framework of the Investment Company Act of 1940 to a hedge fund formed for the purpose of investing in digital assets. In that case, by investing more than 40 percent of the vehicle’s assets in digital asset securities and engaging in an unregistered, nonexempt public offering of interests in the fund, the manager caused the fund to operate unlawfully as an unregistered investment company as well as to violate the Securities Act. The order also found that the fund’s manager was an investment adviser and that the manager had violated the anti-fraud provisions of the Investment Advisers Act of 1940 by making misleading statements to investors in the fund.
From its recent enforcement actions and statements, it is now clear that the SEC has reached the end of its regulatory “preseason” and will approach crypto securities violations in light of the policies laid out in pronouncements made beginning last year.