In 2018, the Securities and Exchange Commission (“SEC”) significantly cracked down on unregistered Initial Coin Offerings (“ICO”). Cryptocurrency issuers who previously believed that federal securities laws did not apply to their offerings are now facing SEC enforcement actions. What is notable about these cryptocurrency enforcement efforts is the increased punitive measures against crypto-companies who continued to issue securities after a seminal SEC report[1] on the now defunct Decentralized Autonomous Organization (“DAO”).
Pre-DAO Report
In 2016, the German company Slock.it UG (“Slock.It”) raised capital through an ICO in the form of Ether (i.e., Ethereum tokens) to fund projects on an autonomous basis.[2] The DAO white paper (similar to a prospectus but typically with far less disclosures) proposed “automat[ing]organizational governance and decision making.”[3] The core idea behind the DAO was that organizations (through smart contracts on the blockchain) could automate aspects of organizational governance, such as the issuance of bylaws, corporate rules, or matters.[4] When the offering was complete, approximately $150M was raised.[5]
Near the end of the DAO’s offering period, it was hit with a major hack and Slock.It was forced to take drastic measures. On June 2016, an individual or group of hackers found a vulnerability in the DAO’s code and siphoned 3.6million Ether (about $50million) to an Ethereum Blockchain address controlled by the attacker.[6] However, the DAO’s code prevented the hacker from moving Ether from the address for 27 days.[7] Driven by necessity, Slock.It’s co-founders decided to initiate a “hard-fork” which transferred all of the funds raised (including the attacker’s) to a recovery address where DAO token holders could exchange their DAO tokens for Ether.[8]
The DAO Report
The SEC took no action against Slock.It.[9] However, the SEC felt compelled to put virtual currency issuers on notice that federal securities laws apply to the issuance, purchase and sale of virtual currencies.[10] Under Section 21(a) of the 1934 Securities Exchange Act, the SEC is authorized to investigate violations of federal securities laws and to publish information concerning such violations.[11] Under this authority, the SEC published the DAO report.[12] In the DAO report, the SEC applied the Howey Test to determine whether the issuance of DAO tokens constituted an offering of unregistered securities.[13] In applying the Howey Test, the SEC concluded that investors gave money to a common enterprise (i.e., the DAO) with a reasonable expectation of profit[14] derived predominantly from the managerial efforts of others.[15] Thus, because Slock.It did not register their securities offering and did not apply for an exemption, they violated federal securities laws. But, since all of the funds were returned, and no projects were invested in via the DAO, the SEC decided not to take action against Slock.It.[16]
Enforcement Actions Post-DAO
The SEC has gone out of its way to notify the entire cryptocurrency community that unregistered offerings will face enforcement actions. In fact, SEC Chairman Clayton went so far as to “urge market professionals [in the crypto-community,]including securities lawyers . . . to closely read the [DAO report]” to avoid running afoul of securities laws.[17]
The SEC has pursued various enforcement actions against cryptocurrency issuers using the framework they established in the DAO report. For instance, in December 11, 2017, the SEC issued a cease-and-desist order against Munchee, Inc., (“Munchee”) for conducting an unregistered offering of MUN tokens to raise about $15 million in capital.[18] Munchee raised the capital to improve its iPhone application which allowed users to review restaurant meals, recruit new users to buy advertisements, write reviews, sell food, and conduct other MUN transactions.[19] The SEC concluded that MUN token were securities under Section 2(a)(1) of the Securities Act of 1933.[20] The SEC stated that “[a]mong other characteristics . . . a purchaser of MUN tokens would have had a reasonable expectation of obtaining a future profit based upon Munchee’s efforts, including Munchee revising its app and creating the MUN ‘ecosystem’ using the proceeds from the sale of MUN tokens.”[21] The SEC noted that while MUN white paper stated that the MUN constituted a “utility token,”(i.e.that the tokens were for consumptive purposes and not an offering of securities) there was no legal analysis in the whitepaper to support that assertion.[22] The DAO report further states that, “tokens, coins, or other digital assets issued on a blockchain may be considered securities under U.S. federal securities laws, and, if they are securities, issuers and others who offer or sell them in the U.S. must register the offering and sale with the SEC or qualify for an exemption from registration.”[23]
There is a purpose behind the SEC wanting participants to register their token offerings. While digital assets like virtual currencies may be code, the way in which they are sold resembles an investment.[24] Because digital assets resemble investments, certain disclosures are necessary. According to SEC Director Hinman, the purpose of the 1933 Securities Act is to remove informational asymmetry between issuers and investors so that the latter can make more informed investment decisions.[25] Thus, material information about an issuer’s background, financing, business plans, and financial stake are all important and should be available to securities investors.[26] And while Chairman Clayton has stopped short of saying that all ICOs are offerings of securities, he did say that “[b]y and large, the structure of [ICO] that I have seen promoted [did]involve the offer and sale of securities, and directly implicate securities registration requirements.”[27]
The SEC has recently ratcheted up its enforcement actions. On November 16, 2018, the SEC announced its first civil penalties solely targeting ICO securities registration violators in reference to settled charges against ICO issuers CarrierEQ, Inc., (“Airfox”) and Paragon Coin, Inc. (“Paragon”).[28] Stephanie Avakian, Co-Director of the SEC’s Enforcement Division, stated that “[w]e have made it clear that companies who issue securities through ICOs are required to comply with existing statutes and rules governing the registration of securities.”[29] Unlike Slock.It, which faced no penalty, Airfox and Paragon were each ordered to: 1) pay $250,000 in penalties, 2) register their tokens pursuant to the Securities Exchange Act of 1934, and 2) to file periodic reports with the SEC for at least a year.[30]
Conclusion
At this point, the SEC cannot make themselves any clearer: issuers of digital tokens must register their offering in compliance with federal securities laws to avoid an enforcement action if their tokens sales bear similar characteristics to cases like the DAO, Munchee, Airdrop, or Paragon. Given these enforcement actions, prudent issuers should retain legal counsel or, at the very least, speak with the SEC about whether their offering could be considered a securities offering and whether their offering qualifies for an exemption. ICO issuers are now on notice and should heed the lessons of the DAO report.
[1] SEC Release No. 81207, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (July 25, 2017), https://www.sec. gov/litigation/investreport/34-81207.pdf [hereinafter the “DAO Report”].
[2] Id. at 2, 4.
[3] Id.
[4] Id.
[5] Id.at 3.
[6] Id.at 9.
[7] Id.
[8] Id.
[9] Id. at 1.
[10] See id. at 2.
[11] Id., n.2.
[12] Id.
[13] Id. at 11-13.
[14] Id. at 11-12.
[15] Id. at 12.
[16] Id. at 1.
[17] Jay Clayton, Chairman, Sec. & Exch. Comm’n, Statement on Cryptocurrencies and Initial Coin Offerings (Dec. 11, 2017), https:// www.sec.gov/news/public-statement/statement-clayton-2017-12-11 [hereinafterthe“Clayton Statement”].
[18] In re Munchee Inc., Order Instituting Cease-and-Desist Proceedings Pursuant to Section 8A of the Securities Act of 1933, Making Findings, and Imposing a Cease-and-Desist Order, SEC Administrative Proceeding File No. 3-18304, 1 (Dec. 11, 2017), https://www.sec.gov/litigation/admin/2017/33-10445.pdf.
[19] Id. at 1.
[20] Id. at 2.
[21] Id.
[22] Id. at 3-4.
[23] See id. at 8.
[24] See William Hinman, Dir., Div. Corp. Fin., Sec. & Exch. Comm’n, Digital Asset Transactions: When Howey Met Gary (Plastic)(June 14, 2018), https://www.sec.gov/news/speech/speech-hinman-061418.
[25]Id.
[26] Id.
[27] Clayton, supra note 19.
[28] Press Release, Sec & Exch. Comm’n, Two ICO Issuers Settle SEC Registration Charges, Agree to Register Tokens as Securities (Nov. 16, 2018).
[29] Id.
[30] Id.
