On September 29, 2017 the U.S. Securities and Exchange Commission (the SEC) filed a civil complaint in the U.S. District Court for the Eastern District of New York against the sponsors of two “initial coin offerings” (ICOs) for alleged violations of U.S. securities laws.[1] This is the SEC’s first enforcement action against sponsors of an ICO, and it highlights the SEC’s increasing attention towards potential violations of securities laws involving this emerging technology.
The enforcement action follows two recent steps by the SEC towards intervention in the ICO market. On September 25, 2017 the SEC announced a new Cyber Unit that is tasked with identifying misconduct that impacts retail investors, including “violations involving distributed ledger technology and initial coin offerings.” On July 25, 2017 the SEC released a report concluding that tokens relating to the Decentralized Autonomous Organization, or “DAO”, a decentralized crowdfunding platform built atop the Ethereum network in 2016, were unregistered securities under U.S. law.[2]
Allegations and relief sought
The SEC alleges securities fraud against New York resident Maksim Zaslavskiy and two companies he controls, REcoin Group Foundation, LLC (“REcoin Group”) and DRC World, Inc. (“Diamond Reserve Club”), based on violations of Section 17(a)(1)-(3) of the Securities Act of 1933 (Securities Act), Section 10(b) of the Securities Exchange Act of 1934, and Rule 10b-5(a)-(c) thereunder.[3] In addition, the SEC alleges that the defendants engaged in the unlawful offer and sale of securities in violation of Sections 5(a) and 5(c) of the Securities Act.[4]
The SEC sought an emergency court order to freeze the defendants’ assets and seize Zaslavskiy’s passport, as well as various civil remedies, including injunctions, disgorgement, money penalties and a bar against Zaslavskiy participating in future digital token offerings or serving as an officer or director of any public company.[5]
The REcoin ICO
Zaslavskiy and REcoin Group allegedly promoted REcoin as “The First Ever Cryptocurrency Backed by Real Estate” beginning in July 2017.[6] They offered the tokens for sale on a website, which accepted payment in various forms, including cryptocurrencies such as Bitcoin and Ethereum. The REcoin website linked to a “whitepaper” which allegedly described REcoin as “an attractive investment opportunity” that “grows in value.” The REcoin website also allegedly promoted a discount scheme which gave earlier investors a discount on the coin. According to the website, the REcoin project would invest the funds raised in real estate. During the course of the website’s operation, it allegedly had a banner which suggested $2.3 million had been raised. The website also stated that the project was in full compliance with U.S. law, was advised by a team of professionals and would donate up to 70% of its profits to charitable organizations, including Live Laugh Love Global.
In reality, the complaint alleges, there were no real estate or other investments backing the ICO; Zaslavskiy had not consulted any professionals; the amount raised was fictional (in reality, apparently only $300,000 was raised from investors); no token or digital asset was developed or issued in the course of the investment period; and Zaslavskiy failed to disclose that he is the sole owner of Live Laugh Love Global. The complaint indicates that the SEC Enforcement Division contacted Zaslavskiy on August 15, 2017 to answer questions on a voluntary basis. Following this contact, the REcoin whitepaper was changed in some respects, although ultimately the REcoin project was abandoned, with the investors of REcoin transferred to the second ICO run by Zaslavskiy, the Diamond Reserve Club according to a statement made on September 11, 2017.
The Diamond Reserve Club ICO
In July 2017, Zaslavskiy allegedly started another project, the Diamond Reserve Club, which offered tokenized membership in a club which was hedged by physical diamonds.[7] In a similar manner to the REcoin ICO, Zaslavskiy sought investment from individuals and offered discounts for poorly defined benefits and returns. In one Facebook post, the defendants sought to distinguish the investment (their initial membership offering, or “IMO”) from a traditional securities offering: “IMO is a brand new instrument of facilitating tokenized membership in a digital community or a club. Although, it appears to be similar to ICO or IPO, the similarities are scarce, if not nonexistent.”
The complaint alleges that the similarities to a securities offering existed, but little else did. The project was not hedged or backed by physical diamonds and the various promises in the promotional material were false, misleading and fraudulent. The Diamond Reserve Club was also touted as being “backed by blockchain technology” but in reality no token or digital asset was issued to any investor.
What does this mean for ICOs, Issuers and Exchanges?
While the SEC’s allegations, if proven, would establish a clear case of fraud, the enforcement action presents important lessons for anyone considering participating in a token offering, even when that token offering has been structured with the best intentions:
(a) The SEC’s suit is consistent with its course of action to date, and it is possible that both the SEC and ICO investors bring allegations on the basis of similar arguments
For those keeping track of regulatory developments in the blockchain and cryptocurrency industry, an enforcement action by the SEC against ICO sponsors is not surprising. As noted above, the SEC issued an investigative report on July 25, 2017 and announced the creation of a Cyber Unit two months later. In the interim, the SEC has been monitoring developments in the ICO market and reportedly contacted other token issuers with initial questions. This enforcement action is an important reminder that the SEC has broad jurisdiction over securities transactions, whether or not they are digital or tokenized. Even where the SEC does not take action against a coin or token issuer, investors in ICOs may have private rights of action (including for rescission or to recover financial losses) if an ICO is unregistered or fraudulent. Potential issuers of coins or tokens should therefore consult with legal counsel to determine whether they may be treated as securities in the United States, and, if so, whether sales and resales can be structured to comply with U.S. federal and state securities laws.
(b) The SEC action forms part of a broader international regulatory response to ICOs generally
Given the decentralized nature of digital coins and tokens, ICOs have the potential to implicate the securities laws of any country into which they are offered, sold or traded. During August and September this year a number of national securities regulators worldwide, including those in Singapore, Canada, Hong Kong and the United Kingdom, warned market participants that, depending on the form and underlying representation of tokens offered, they may represent securities under national laws.[8] Regulators in some countries, such as China and South Korea, have banned ICOs altogether.[9] Others, such as Switzerland and Australia, have issued cautious statements.[10] The SEC’s enforcement action, alongside the recent pronouncements of other national securities regulators, provides a strong message for those involved in ICOs that buyers, issuers and exchanges should beware.
(c) The complaint alleges an unregistered securities offering in violation of Section 5 of the Securities Act
While the complaint focuses primarily on allegedly fraudulent conduct by the defendants, the SEC also charged the defendants with making an unregistered securities offering without a valid exemption. That element of the complaint is of concern to anyone planning an ICO, even if they plan to provide accurate and complete information to investors. Note that the fact that no tokens or digital assets were issued would not preclude the application of Section 5 of the Securities Act, as subsections 5(a) and 5(c) encompass both the sale and the offer of sale of a security.[11] The SEC did not provide analysis in the Complaint as to whether the security in question related specifically to the presales of the proposed tokens or the proposed tokens themselves, although based on the description of the proposed tokens such a distinction may have been immaterial. In addition to potential enforcement action by the SEC, sponsors of token sales in violation of Section 5 of the Securities Act may face private lawsuits from investors for rescission or damages. Making information about a token publicly available through whitepapers, websites, forums, social media accounts or otherwise may violate U.S. securities law, even if the sponsor has no intent to defraud investors. It is important that issuers considering an ICO structure their token sale appropriately and consult competent counsel before discussing their plans publicly, including online or through whitepapers.
(d) Exchanges should take considerable care when deciding to list tokens
As the SEC previously indicated in its DAO Report, a cryptocurrency exchange that lists tokens that meet the definition of a security may themselves be an “exchange” under the U.S. federal securities laws and would therefore be required register as a national securities exchange or operate pursuant to an appropriate exemption.[12]
15Section 17(a)(1)-(3) of the Securities Act, 15 U.S.C. § 77q(a)(1)-(3); Section 10(b) of the Securities Exchange Act of 1934 (the Exchange Act), 15 U.S.C. § 78j(b); Rule 10b-5(a)-(c), 17 C.F.R. § 240.10b-5(a)-(c).
[4] Sections 5(a) and 5(c) of the Securities Act, 15 U.S.C. §§ 77e(a), 77e(c).
[5] The Complaint, paragraphs 13, 14.
[6] See the Complaint paragraphs 26-57.
[7] See the Complaint paragraphs 58-88.
[8]The Monetary Authority of Singapore, ‘MAS clarifies regulatory position on the offer of digital tokens in Singapore, August 1, 2017, available at: http://www.mas.gov.sg/News-and-Publications/Media-Releases/2017/MAS-clarifies-regulatory-position-on-the-offer-of-digital-tokens-in-Singapore.aspx; The Canadian Securities Administration Staff Notice 46-307, “Cryptocurrency Offerings”, August 24, 2017, available at: http://www.osc.gov.on.ca/documents/en/Securities-Category4/csa_20170824_cryptocurrency-offerings.pdf; the Hong Kong Securities and Futures Commission, “Statement on initial coin offerings”, September 5, 2017, available at: http://www.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/doc?refNo=17PR117; The U.K Financial Conduct Authority, “Consumer Warning about the risks of Initial Coin Offerings (‘ICOs’)”, September 12, 2017, available at: https://www.fca.org.uk/news/statements/initial-coin-offerings.
[9] The Ministry of Industry and Information Technology of the People’s Republic of China, Website statement, September 4, 2017, available at: http://www.miit.gov.cn/n1146290/n4388791/c5781140/content.html (see also Bloomberg.com, “Bitcoin Tumbles as PBOC Declares Initial Coin Offerings Illegal”, September 4, 2017, available at: https://www.bloomberg.com/news/articles/2017-09-04/china-central-bank-says-initial-coin-offerings-are-illegal ); Republic of Korea Financial Services Commission, Website statement, September 29, 2017, available at: http://www.fsc.go.kr/info/ntc_news_view.jsp?bbsid=BBS0030&page=1&sch1=&sword=&r_url=&menu=7210100&no=32085; (see also Bloomberg.com, “Cryptocurrencies Drop as South Korea Bans ICOs, Margin Trading”, September 29, 2017, available at: https://www.bloomberg.com/news/articles/2017-09-29/cryptocurrencies-drop-as-south-korea-bans-icos-margin-trading).
[11] Sections 5(a) and 5(c) of the Securities Act, 15 U.S.C. §§ 77e(a), 77e(c).
[12] Section D, the DAO Report. See Section 6 of the Exchange Act, 15 U.S.C. §78e; Section 3(a)(1) of the Exchange Act, 15 U.S.C. § 78c(a)(1); and Rule 3b-16, 17 C.F.R. § 240.3b-16(a).
