SEC Gets Tough on ICOs, Files First Fraud Case
By Benjamin T. Brickner, Associate, Corporate and Finance | Samantha J. Katze, Associate, Litigation
The SEC has filed charges against multiple ICO sponsors alleging securities law violations.
The Securities and Exchange Commission (the Commission) has put its digital money where its mouth is. After concluding in a July 2017 investigative report that sales of coins and tokens in so-called initial coin offerings (ICOs) are likely subject to securities regulation, last week the Commission commenced its first civil enforcement action against ICO sponsors alleged to have violated federal securities laws.
Background
On Sept. 29, 2017, the Commission filed a federal civil complaint in the Eastern District of New York alleging that two companies—REcoin Group Foundation, LLC, and DRC World Inc., also known as the “Diamond Reserve Club,” and their sole owner, Brooklyn resident Maksim Zaslavskiy—fraudulently sold cryptocurrency tokens to investors and failed to register securities offerings with the Commission. Absent an exemption, offerings of securities must be registered. Zaslavskiy was also charged personally with aiding and abetting these violations.
The Commission alleges the defendants made false and misleading statements on their websites and in white papers, on social media, and through press releases, to induce investors to purchase coins and tokens that did not exist. As alleged in the complaint, the defendants touted the supposed safety of the investments, claiming they were “backed” by real estate or “hedged” by physical diamonds. According to the Commission, however, the defendants never purchased real estate or diamonds, nor did they have any plans to do so.
The defendants also allegedly vastly overstated (by an order of magnitude) the amount previously raised from investors, in order to create the appearance of interest in their products. While the defendants claimed to have raised as much as $3.8 million, the Commission asserts they raised only about $300,000. In addition, while the defendants claimed to have relied on “an experienced team” of professionals to manage the offerings, the Commission alleges that the offerings were led solely by Zaslavskiy.
In a move that seems at once prophetic and self-defeating, the defendants also claimed in a September press release that they were forced to shut down the REcoin offering due to government “interfere[nce]” and not because, as the Commission alleges, the digital assets promised to investors were “impossible” to develop.
Pending further proceedings on the Commission’s application for a preliminary injunction, the Commission has obtained a temporary restraining order freezing the defendants’ assets and barring them from activities that run afoul of the securities laws alleged to have been violated.
The Offerings
According to the Commission, the REcoin website launched by Zaslavskiy promoted REcoin as “the first ever cryptocurrency backed by real estate.” In a white paper typical of those released by ICO sponsors, REcoin described the purported tokens as “an attractive investment opportunity [that] grows in value.” Despite raising at least $300,000 from hundreds of individuals, the Commission contends that none received any form of digital asset in return, and that no tokens or coins had ever been developed.
With respect to the Diamond Reserve Club, the Commission alleges the defendants sought to “skirt” federal securities laws by characterizing the sale as an offering of tokenized “memberships in a club” that purportedly owned digital assets “hedged” by the nonexistent physical diamonds. The defendants described the transaction as an “initial membership offering” or “IMO.” Nevertheless, the Commission asserts that the “memberships” offered by the Diamond Reserve Club were functionally equivalent to owning the tokens that the defendants claimed existed.
Surprisingly, the defendants seemed to realize that they were offering securities, admitting in a Diamond Reserve Club press release that in an ICO, “coins (tokens) are similar to shares of a company sold to investors in an Initial Public Offering (IPO) transaction.” As with REcoin, the Commission alleges that there were no Diamond Reserve Club coins or tokens (nor any physical diamonds) and that investors received nothing of value in exchange for their money.
Based on the foregoing, the Commission contends that the REcoin and Diamond Reserve Club products offered by the defendants are securities within the meaning of the Securities Act of 1933 (Securities Act), which were offered publicly and without any exemption from registration.
Important Takeaways
- Coins and Tokens Are Likely Securities. As the Commission explained in its July 2017 investigative report, all cryptocurrency coin and token sales are potentially subject to securities regulation. In particular, coins or tokens that meet the three-part test articulated by the Supreme Court in SEC v. W. J. Howey Co. are almost certainly securities and will be regulated as would any other securities offering.
Under the Howey test, a security exists where investors (1) invest money (2) with a reasonable expectation of gaining profits (3) that are derived from the efforts of others. From the facts and allegations contained in the Commission’s complaint, the coins and tokens offered by REcoin and the Diamond Reserve Club clearly meet these criteria.
- Multiple Securities Laws Apply. Once an offering of securities is involved, a range of securities law provisions will apply. First and foremost is the requirement to register a securities offering in compliance with Sections 5(a) and 5(c) of the Securities Act (unless an exemption is available).
Additionally, false and misleading statements in connection with an offering violate Section 17(a) of the Securities Act, Section 10(b) of the Securities Exchange Act of 1934 (the Exchange Act), and the related Exchange Act Rule 10b-5. Moreover, the parties involved are potentially liable as “aiders and abettors” of securities law violations, even when they are not primary violators of the law.
In Zaslavskiy’s case, he is alleged to have aided and abetted violations of Sections 5(a), 5(c) and 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Rule 10b-5. State securities laws likely apply as well.
- Coin and Token Sponsors Must Proceed With Great Caution. The Commission’s message is clear: Coin and token issuers and other market participants must tread very carefully and fully consider the regulatory implications of offerings prior to launch. If the coins or tokens being offered are securities, registration with the Commission will be required, unless an exemption is available, such as in private placements to accredited investors under Regulation D and foreign offerings to overseas investors under Regulation S.
Even a valid private placement exemption is not enough. The anti-fraud securities rules will still apply, and sponsors need to carefully consider the disclosures they are making (or omitting). The Commission sounded a warning in its July 2017 investigative report and has made clear in its complaint that securities law violations in this area will not be tolerated.
Conclusion
In commencing an action against REcoin, the Diamond Reserve Club and Zaslavskiy, the Commission has demonstrated it will approach ICOs like other public securities offerings and will pursue charges against issuers and sponsors it believes are flouting securities laws. This action underscores the need for increased vigilance with respect to ICOs and reinforces the message conveyed in the July 2017 investigative report—that issuers and sponsors of ICOs must comply with securities laws.
By all appearances, the Commission is closely monitoring cryptocurrency activities and carefully examining the applicability of federal securities law to each iteration of coin and token sales as these forms of raising capital evolve. Issuers considering an ICO or token sale and other participants in the coin and token ecosystem should consult securities law and digital finance experts, including competent legal counsel, before undertaking such activities.
Related Links
Complaint, Securities and Exchange Commission v. REcoin Group Foundation, LLC et al., 17 Civ. 5725 (E.D.N.Y., Sep. 29, 2017), available at https://www.sec.gov/litigation/complaints/2017/comp-pr2017-185.pdf
Securities and Exchange Commission, Press Release, SEC Exposes Two Initial Coin Offerings Purportedly Backed by Real Estate and Diamonds (Sep. 29, 2017), available at https://www.sec.gov/news/press-release/2017-185-0
Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Exchange Act Release No. 81207 (July 25, 2017), available at https://www.sec.gov/litigation/investreport/34-81207.pdf
DRC World Inc., a/k/a Diamond Reserve Club, https://drc.world/
REcoin Group Foundation, LLC, https://101recoin.com/