FINLAW: ICOs and a Soon Arriving Flood of SEC Enforcement Investigations
The Securities and Exchange Commission late last month filed charges against the person and entities responsible for two related initial coin offerings (ICOs) that defrauded investors. See SEC v. ReCoinGroup Foundation, LLC, et al, at https://www.sec.gov/litigation/complaints/2017/comp-pr2017-185.pdf In the ReCoin case, a typical securities offering fraud became far more notable because the vehicle for fraud was two ICO offerings.
ICOs are frequently discussed today as Crowdfunding 2.0. This is a stretch as Crowdfunding was authorized by federal legislation (See Jumpstart Our Business Startups (JOBS) Act at https://www.gpo.gov/fdsys/pkg/BILLS-112hr3606enr/pdf/BILLS-112hr3606enr.pdf). There are no new federal laws designed to foster a marketplace for ICOs. There is regulatory guidance, however, showing ICOs are on the SEC’s radar and that many (and likely most) ICOs are offers and sales of securities. Putting aside for now the common assertions by proponents of ICOs that the offering is occurring only offshore (maybe, but solicitations to US investors eliminate this argument) or a virtual coin is not a security but a utility token on a product that does not yet exist (good luck), the reality is that the amount of capital being raised by ICOs is so substantial and we can expect that a flood of federal and state regulatory investigations will arrive shortly. On the federal level, SEC investigations and enforcement actions will likely focus on the following issues:
- ICO offerings involving securities that are not registered, and do not meet any securities exemption, violate Section 5 of the Securities Act of 1933. Whether an offering involves a security is a facts and circumstance question, requiring a close look into the economic realities of the transaction. SEC v. W.J. Howey Co., 328 U.S. 293 (1946) and its progeny address the appropriate standard, but the question whether a security is involved has historically been interpreted quite broadly.
- For those soliciting and selling ICO offerings, unregistered broker-dealer activity violates Section 15 of the Securities Exchange Act of 1934. The SEC has been looking closely at this issue in its investigations of funding platforms, EB-5 offerings, investment adviser activities, amongsts others. Section 3(a)(4)(A) of the Exchange Act generally defines a broker broadly as any person engaged in the business of effecting securities transactions for the account of others. Individuals or entities who participate in important parts of a securities transaction, including solicitation, negotiation, or execution of a transaction, or who are otherwise engaged in the business of effecting or facilitating securities transactions, may be required to register as a broker-dealer. Receiving transaction based compensation, or compensation that is related to the size or outcome of a securities transaction, is clear cut indicia of broker-dealer activity. Looking for unregistered broker-dealer activity in its investigations of ICOs is an obvious and natural step for the SEC.
- Misrepresentations and omissions of material fact, or pump and dump ICO schemes, violate Section 10b of the Exchange Act, and Rule 10b-5 thereunder, and Section 17 of the Securities Act. Misrepresentations can involve many variations on use of proceeds, creation of the digital platform that the token allegedly will enable access, promises of returns including profit from re-sales, lies about business operations, principals behind the ICOs, risks, new technologies, etc. all can be the basis for an enforcement action. Offerors and sellers of securities are prohibited from making misrepresentations of material fact, or omitting to disclose a material fact that an investor would reasonably want to know before making an investment. Material misrepresentations or omissions are fraud, and can be charged as such by the SEC, state securities regulators, and the Department of Justice and other prosecutors in criminal cases.
ICOs of securities that do not meet the requirements of federal law pose a significant risk to investors. If ICO funding continues at its current incredible pace, the SEC and state regulators will need to act fast to protect investors. For those intending to offer ICOs, a careful review of the requirements of Howey and its progeny is required to ensure that your offering meets the requirements of the federal securities laws. While this the initial question, it is not the only securities question that regulators will be focused on when a subpoena is issued and the flood begins.
The information and materials in this article are provided for general informational purposes only and are not intended to be legal advice. The issues discussed include complicated areas of law and legal advice should be obtained from a securities attorney about your specific circumstances.