Provided by Pepper Hamilton

Two initial coin offerings (ICOs) were the target of a Securities and Exchange Commission (SEC) enforcement action filed on September 29. Based on the SEC’s descriptions, both ICOs, on their face, appear to be frauds, with marketing materials that allegedly contained multiple misleading and fraudulent statements. For those in the investment management space and those who personally participate in ICOs, this enforcement action serves as a reminder that due diligence is a necessary step before making an investment. Essentially, the two ICOs in question provide a roadmap of exactly how not to conduct an ICO.

The enforcement action was against a number of organizations that were controlled by the same individual and that were engaged in ICOs “backed” by diamonds and real estate. The ICOs targeted retail investors, who were solicited on a global basis via the internet. Prospective investors were told that they could expect sizeable returns from the companies’ operations when, in fact, they had no real operations. Since the tokens or coins in the ICOs were never delivered, or even created, the ICOs seem to have been sham or fraudulent offers of nonexistent securities in which the ICO proceeds were pocketed by their promotor.

The enforcement action alleges that, among other things, the promotor of the ICO:

  • vastly overstated his success in selling tokens or coins, claiming in one case that $4 million had been raised through token sales when, in fact, the true amount raised was only $300,000
  • falsely stated that the tokens or coins were “backed” by diamonds and real estate
  • falsely stated that some of the ICO proceeds would go to a bona fide charity
  • claimed that the ICO issuers “had a team of lawyers, professionals, brokers and accountants” and “experts” who would professionally invest the ICO proceeds when no such team existed
  • falsely claimed that the ICOs were in compliance with U.S. laws
  • failed to develop any actual blockchain technology or platform for the issuance of the tokens or coins.

Further, the business operations that were supposed to issue the tokens or coins never existed; the so-called ICO was apparently a sham in which the promotor advertised a fictitious ICO and pocketed the proceeds. Based on these facts, the SEC enforcement action does not seem surprising.

The enforcement action asserts, without specific analysis, that these ICOs were offerings of securities. Implicitly, the SEC’s assertion is based on the promotion of the ICOs as investment opportunities, promising significant investment returns to be generated through the managerial efforts of the expert teams assembled by the promoter. The issuers compared the tokens being sold in the ICOs to shares of a company sold in an initial public offering (IPO), a transaction that, by definition, involves the offer and sale of securities. This set of facts can be interpreted to involve a security under a number of theories, including the so-called “Howey Test,” which is becoming a standard way to approach the question of whether an ICO involves a security. Under the “Howey Test,” an investment of money with an expectation of profits arising from a common enterprise dependent on the efforts of others — typically the issuer, a promoter or other related third party — is an investment in a security. It is not difficult to conclude that the ICOs in question in the SEC’s enforcement action involved securities.

This enforcement action is the most recent evidence of a significant SEC effort focused on the regulation of ICOs. On September 25, the SEC issued a press release describing the Enforcement Division’s new Cyber Unit “that will focus on targeting cyber-related misconduct and the establishment of a retail strategy task force that will implement initiatives that directly affect retail investors.” In particular, the Cyber Unit will focus on “[v]iolations involving distributed ledger technology and initial coin offerings.”

On July 25, the SEC issued an investigative report concluding that the tokens offered in an ICO by The DAO were securities. To date, this investigative report represents the sole written view of the SEC with respect to whether ICOs are securities offerings. (See our prior client alert on the report.)

The recent enforcement action, the formation of the Cyber Unit and the investigative report on The DAO make it clear that the SEC is scrutinizing ICOs, and it appears that this scrutiny will continue. Yet, to date, the SEC has not issued statements to the effect that ICOs are inherently flawed or that an ICO will necessarily lead to an enforcement action. It appears that ICOs properly structured in compliance with applicable law and with appropriate disclosure and marketing materials will be able to proceed. It is important to remember that ICOs potentially involve the application of multiple areas of law, including securities; commodities and broker-dealer regulation; tax and specialized areas of financial regulation, such as currency transmission; KYC (know your customer); and AML (anti-money laundering).

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.


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