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SEC Suggests Framework to Address Unregistered ICOs

On November 16, 2018, the U.S. Securities and Exchange Commission (SEC) announced settlements with Paragon Coin, Inc., and CarrierEQ, Inc., also known as AirFox.  Both companies had conducted Initial Coin Offerings (ICOs) that the SEC determined were unregistered securities offerings.  Both companies had issued digital blockchain tokens to raise capital that they intended to use to develop a new or expanded business and online ecosystem (Paragon in the cannabis industry, AirFox in the prepaid mobile telecommunications business).  While the settlements do not provide much additional insight into how the SEC will apply the so-called “Howey test”[1] to determine whether a particular ICO is a securities offering, they do reinforce the framework that the SEC will use to analyze and address ICOs that was articulated in the SEC’s Report of Investigation relating to The DAO (July 2017) and its settlement with Munchee Inc. (December 2017).  With settlement of these new actions, the SEC appears to be establishing a path to retroactive compliance for companies that raised money through ICOs of tokens that in the SEC’s view, under the Howey test, should have been treated as securities, but that did not register the offering under the Securities Act of 1933 (the “Securities Act”) or comply with an available exemption from registration.

In the DAO Report, while declining to pursue an enforcement action, the SEC concluded that blockchain tokens may constitute securities under the US federal securities laws and that the test established in Howey and subsequent cases is the appropriate standard to determine whether a blockchain token that is not an equity or debt security is an “investment contract” that is a security. (That test is whether an arrangement involves (1) an investment of money or other item of value, (2) in a common enterprise, (3) where there is a reasonable expectation of profit from the investment, and (4) the profit comes from the entrepreneurial or managerial efforts of a promoter or third party.)  

In the Munchee matter, the SEC settled its first enforcement action in this arena without imposing fines or other civil penalties or recommending criminal charges, though Munchee agreed to refund investors in its $15 million token sale.

According to the SEC, both Paragon and AirFox offered and sold their tokens to the general public, including investors in the United States, neither filed a registration statement covering these offers and sales, and the offerings did not qualify for any exemption from registration.  The SEC alleged that each of Paragon and AirFox in its marketing of its ICO described how its token would increase in value “as a result of [the issuer’s] efforts” and that the tokens would, or were expected to, trade on secondary markets (exchanges).  AirFox is alleged to have aimed its marketing efforts at digital token enthusiasts and investors who had previously invested in other digital tokens, rather than at people who would be likely to make use of its “ecosystem.”  Because of these factors, the settlements leave unanswered how the SEC will look at ICOs in which some or all of these elements were (at least explicitly) missing, but which arguably still meet the four prongs of the Howey test. 

The Paragon and AirFox settlements go beyond the DAO Report and Munchee action.   Without admitting or denying the SEC’s findings, both issuers agreed to pay a civil penalty of $250,000 (relatively modest in relation to the amounts raised in their ICOs—$12 million by Paragon, $15 million by AirFox), to register their tokens as a class of securities under Section 12(g) of the Securities Exchange Act of 1934 (the “Exchange Act”), and to maintain that registration and timely file all annual (Form 10-K), quarterly (10-Q), current (8-K) and other reports required under Section 13(a) of the Exchange Act until eligible to terminate registration pursuant to Rule 12g-4 under the Exchange Act (but not less than one year).  Each company also agreed to a “Claim Form” process to notify investors (token purchasers) of their potential claims under Section 12(a) of the Securities Act (to sue to recover the price paid for the tokens with interest upon surrendering the tokens, or for damages if the investor no longer owns the tokens).  The companies are required by the settlements to pay the amounts due under Section 12(a) to any investor who submits a Claim Form within three months after the Exchange Act registration becomes effective, and to make such payments within three months after such deadline.  The companies have to provide regular, detailed reporting to the SEC concerning claims and repayments and certifying compliance with the settlement.  The SEC statement noted that these two cases (AirFox and Paragon) are the SEC’s first cases imposing civil penalties solely for ICO securities offering registration violations. 

In the SEC press release announcing the Paragon and AirFox settlements, Steven Peikin, Co-Director of the SEC’s Enforcement Division, stated, “By providing investors who purchased securities in these ICOs with the opportunity to be reimbursed and having the issuers register their tokens with the SEC, these orders provide a model for companies that have issued tokens in ICOs and seek to comply with the federal securities laws.”  Stephanie Avakian, Co-Director of the Enforcement Division, said, “These cases tell those who are considering taking similar actions that we continue to be on the lookout for violations of the federal securities laws with respect to digital assets.”  An SEC public statement on Digital Asset Securities Issuance and Trading, released the same day as the Paragon and AirFox settlements were announced and referring to them, stated, “These two matters demonstrate that there is a path to compliance with the federal securities laws going forward, even where issuers have conducted an illegal unregistered offering of digital asset securities.”  It seems clear that the SEC is inviting ICO issuers that sold to the general public tokens that may be investment contract securities to voluntarily register the tokens, provide public-company level reporting and offer reimbursement to investors.  The implication is that those that do not could face enforcement actions that could include more significant monetary penalties and other civil or criminal actions against issuers and possibly their principals. 

The SEC’s announcement regarding the Paragon and AirFox settlements comes on the heels of the SEC revealing settled charges against Zachary Coburn, founder of the decentralized exchange EtherDelta, related to running an unregistered securities exchange.

Aside from highlighting the trend in the SEC’s increased focus on digital assets and a gradual but increasingly aggressive approach in its enforcement approach, what does this mean?  For ICO investors and token holders, these settlements have the potential to affect the value of your investment.  For companies that have conducted an ICO without registering or qualifying for an exemption, the SEC has provided a framework to analyze the potential benefits of a voluntary remediation.   Any company that has concerns that its ICO may have violated US securities laws should consult with counsel to evaluate options, which will be highly dependent of the particular facts and circumstances.  CKR’s Blockchain and Digital Currency group is well positioned to assist you in this analysis.  Reach out to any of the attorneys listed below or your regular contact at CKR Law.

For more information please contact:

Barrett S. DiPaolo                             bdipaolo@ckrlaw.com

Joe A. Tagliaferro III                        jat@ckrlaw.com

Alexandra Levin Kramer                akramer@ckrlaw.com

Jill M. Williamson                             jwilliamson@ckrlaw.com

Kristie M. Blase                                 kblase@ckrlaw.com 

[1] This test was first established by the U.S. Supreme Court in SEC v. W. J. Howey Co. (1946), a case involving whether an offering of units of a citrus grove development, coupled with a contract for cultivating, marketing and remitting the net proceeds to the investor, was a “security” within the meaning of the Securities Act.