Last week’s virtual currency hearing by the Senate Banking, Housing and Urban Affairs Committee frenzied the always-excitable crypto-crowd. The legal world was no different. Legal Eagles watched closely as SEC Chair Jay Clayton and CFTC Chair Chris Giancarlo testified.
One takeaway was the SEC’s strident view that Initial Coin Offerings (ICOs) are securities. As Clayton explained, “From what I’ve seen ICOs are securities offerings they are interests in companies much like stocks and bonds under a new label.”
That the SEC considers ICO tokens securities isn’t new. Clayton has stated so in op-eds, speeches, and bulletins.
Parcel with this stance is Clayton’s rebuke of derelict “market professionals.”
From the hearing:
- Many ICOs are being conducted illegally, their promoters and other participants are not following our securities laws. Some say this is because the law is not clear I do not buy that for a moment.
- A note for professionals in these markets, those who engage in semantic gymnastics or elaborate structuring exercises in an effort to avoid having a coin be a security are squarely within the crosshairs of our enforcement division.
- I don’t think the gatekeepers that we rely on to assist us in making sure our securities laws are followed have done their job.
Clayton sounded the same theme in a recent speech:
- First, and most disturbing to me, there are ICOs where the lawyers involved appear to be, on the one hand, assisting promoters in structuring offerings of products that have many of the key features of a securities offering, but call it an “ICO,” which sounds pretty close to an “IPO.” On the other hand, those lawyers claim the products are not securities, and the promoters proceed without compliance with the securities laws . . .
- Second are ICOs where the lawyers appear to have taken a step back from the key issues – including whether the “coin” is a security and whether the offering qualifies for an exemption from registration – even in circumstances where registration would likely be warranted.
- I have instructed the SEC staff to be on high alert for approaches to ICOs that may be contrary to the spirit of our securities laws and the professional obligations of the U.S. securities bar.
His remarks led some to speculate the SEC has unpleasantness awaiting lawyers who gave faulty advice.
Lawyers advising ICOs have had two views about SEC warnings: “Meh” and “Don’t Tase Me Bro.”
The SEC’s first declared ICOs securities last July via the defunct ‘DAO’ project. DAO had been a hotly debated (and eventually hacked) ICO.
Later that year the SEC stopped the Munchee ICO; the company returned all funds for clemency. Both projects had relied on a “utility token” defense. Essentially the tokens bought network protocol access and thus escaped the SEC’s amibt. In the Munchee order, the SEC addressed this argument: “even if MUN tokens had a practical use at the time of the offering, it would not preclude the token from being a security.”
Despite the warnings, some ICOs continue to use the utility defense.
Singular DTV is an entertainment platform that raised $7.5 million in 17 minutes in 2016. When the SEC’s DAO report emerged, the company took a devil-may-care stance, welcoming the ruling but insisting it didn’t affect them.
SNGLS tokens weren’t securities because they had utility. And anyway the company proudly boasted it had spent “large sums of money” on various law firms and lobbyists in Washington to “advise and educate” policy makers. SEC definitions, it proclaimed, were “antiquated.” “Today is a new world. We in the center of the cryptosphere know it and of course the SEC knows it. We’re looking forward to a more progressive policy being instituted in the coming years by US regulators.”
Those well-paid lawyers may care more after last week.
Lawyers for BlockMason are even more combative. They insist BlockMason sold utility tokens and distinguish them from Munchee through marketing strategy and network-protocol maturity.
Nonetheless, Mason’s legal team acknowledges it may be in trouble and thus warned the SEC any attack would contravene Supreme Court precedent. “Ambiguities in the SEC Munchee order and the SEC Chairman’s statement leave open the theoretical possibility that they could find any and every ICO token to be a security based on the mere fact that some purchasers bought tokens expecting to profit from a rise in the token value over time. If the SEC were to take such an extreme position, it would create severe tension with Supreme Court precedent and invite a test case.”
A test case may provide clarity from the courts but it’s high risk, high reward.
Finally, there is the “Great Santori Disappearing Act” (Act). Marco Santori was a New York City lawyer with Cooley LLP. His firm profile page states: “I help innovators navigate financial regulations. Sometimes, we rewrite those regulations together and make them better.” (Mr. Santori has apparently recently accepted a new position.)
Mr. Santori and his team invented a security vehicle that disappears when used. Some issuers accepted his handiwork. “A few of our clients are already testing it in the wild.”
The Act holds utility tokens are securities in presale before a useable network protocol. These SAFT security tokens disappear and reappear as utility tokens once the protocol is live. “So, the SAFT framework calls for securities laws when the buyer takes on enterprise risk, and calls for the consumer protection laws when the buyer takes on product risk. That struck us, the authors of the white paper, as the right state of affairs, and we think the SAFT gets us there.”
Critics widely panned “The Great Santori Disappearing Act” and given Clayton’s remarks, it’s probably untenable. The Cardozo Blockchain Project at Cardozo Law School critiqued the Act and concluded: “Artificially dividing the overall investment scheme into multiple events does not change the fact that accredited investors purchase tokens (albeit through SAFTs) for investment purposes, and likely will not prevent a court from considering these realities when assessing whether these tokens are securities.”
It’s unclear whether Santori’s clients in the wild will stick with the Act particularly since the magician has left.
- Don’t Tase Me Bro
Some lawyers have been more cautious and advised ICOs to follow some combination of equity-crowdfunding titles from the JOBS Act: Reg CF, Reg D, and/or Reg A+.
Lawyers exemplified this posture at an LA conference late last fall where industry professionals discussed SEC-less ICOs. According to an article, “Concerned audience members eagerly asked the expert panelists whether there was ability for a company that did unregulated ICOs to come into the fold and now adhere to regulations.” The answers were grim.
One expert reminded the audience that firms that gave legal opinions handed their clients “lottery tickets.” “If you get sued or regulated by the SEC, CTFC, or someone else, you can then go sue your law firm for giving you bad advice. It doesn’t actually save you.” Another one grimly described an SEC investigation as “living in hell without dying.”
How hard the SEC pursues lawyers who advised ICO clients their tokens were not securities or that the security-yoke magically evaporates is unknown. It’s also possible utility tokens do exist somewhere beyond the SEC’s reach.
But after last year’s wild ride, most lawyers will avoid the taser this year.
By Jossey PLLC
Initial Coin Offerings (ICOs) will revolutionize raising business capital as more companies and blockchain networks develop and prosper. Last year ICOs raised over $3.7 billion. January started strong with a record $1.4 billion reported from 67 ICOs.
But with any nascent fundraising tool scammers and regulators play cat and mouse. The SEC has taken an increasingly hard line, which augurs higher compliance costs per dollar raised. In a recent op-ed, SEC Chairman Jay Clayton stated, “The SEC is devoting a significant portion of its resources to the ICO market.” The message is clear: play by our rules or get an experience one seasoned securities lawyer described as “living in hell without dying.”
So in the spirit of the new paradigm facing the ICO world, here are five ways not to ICO.
- Don’t pick a fight you can’t win
Arise Bank is a Texas-sized con. Two guys claimed they were creating a digital bank of the future that would support over 700 virtual currencies. Their ICO hoped to raise over a billion dollars but didn’t bother to register with the SEC or state regulators. They also claimed to have bought a couple 100-year old FDIC insured commercial banks with the goals of solving compliance problems—an apparent outright lie. Nor did they mention one of the principal’s violent criminal history and prison record.
When the SEC came calling Arise posted an epic Facebook rant about their upcoming fight with the SEC. “Several branches of the various governments within the United States are run by cowards, liars and downright frauds . . .” In failing to register their offering, lying about their transactions, and failing to disclose previous criminal history they positioned themselves as ‘fighting for all our rights.’ The courageous duo spoke for WE THE PEOPLE (all caps!), and proudly fought the corrupt “system.” (“It’s the system, man” is a common refrain among scoundrels ranging from Harvard law professors to two-bit criminals.)
Both state and federal regulators have filed actions against Arise, it won’t end well.
- Disclaimers won’t help
Some ICO promoters try to avoid SEC jurisdiction by imaginative labeling and disclaimers. “Utility tokens” they claim aren’t securities but just in case lather their whitepapers with warnings about potential SEC trouble.
Munchee was a restaurant-based app trying to raise money by selling “utility” tokens. Its white paper has three pages warning that even though they had analyzed Munchee for SEC issues and concluded none existed, trouble might still arrive. “Munchee Inc.’s representations and securities assessment is not a guarantee that the SEC or any other regulatory authority will not determine the tokens to be securities subject to registration.”
Trouble came. Noting the token’s marketing materials and audience were ICO-like the SEC analyzed the token and concluded unsurprisingly they were securities. “Determining whether a transaction involves a security does not turn on labelling – such as characterizing an ICO as involving a “utility token” – but instead requires an assessment of ‘the economic realities underlying a transaction.’”
Munchee quickly halted the sale.
- Don’t make ridiculous promises
R2B coin is a token that sounds too good be true and adheres to the axiom against such offers. Hong Kong-based but selling globally, promoters incredulously promised on their now “under maintenance” website “r2b coin if you study the history, only goes one way, and that’s up. We’re only going up, we’re never going down in value.” They further promised to hit a certain benchmark within two years and “will be among top 10 currencies in 1–1.5 years.”
The busy Texas State Securities Board filed an emergency cease and desist order to stop R2B from selling tokens in the Lone star State.
Munchee earns an honorable mention for promising to “ensure that MUN token is available on a number of exchanges in varying jurisdictions to ensure that this is an option for all token-holders.” This was impossible to guarantee with the acknowledged specter of SEC trouble.
- Don’t incorporate overseas
Just as Hong Kong registration couldn’t stop action against R2B, a Massachusetts man played a too-clever-by-half game with Bay State regulators and lost.
Kirill Bensonoff a resident of Brookline—a bedroom community near Harvard—sold “Caviar tokens” for his property-flipping scheme. To avoid U.S. regulators Bensonoff incorporated in the Cayman Islands. In reality, he ran Caviar from wealthy Brookline.
Bensonoff’s plot involved dodging US authorities by avoiding U.S. investors. He even blogged his strategy beforehand. But the plan failed. When regulators investigated, one tried to purchase Caviar tokens using the name of a famous cartoon character (rumored to be Mickey Mouse) and provided a false photo ID fetched from an internet search. The third-party verifier tasked with blocking U.S. residents cleared Mr. Mouse for investment in 29 minutes.
And regardless of incorporation, regulators concluded “Respondents’ offers to sell Caviar tokens originate from within the Commonwealth of Massachusetts.”
State regulators have sued Bensonoff it won’t end with either champagne wishes or Caviar dreams for Mr. Bensonoff.
- Celebrities don’t care about you.
Three token sales secured celebrity endorsements. But when the law came knocking the stars bailed. The various promotional social-media posts had the desired effect of profile raising. Unfortunately all later turned out be scammy and stars the deleted their posts faster than they buy Twitter followers.
Hotel heiress Paris Hilton tweeted she was “looking forward to participating” in the LydianCoin ICO. But the coin’s originators had some untoward skeletons that burst open after the reality star’s nod. She has now deleted the post.
Boxing superstar Floyd Mayweather stepped in the ring for Centra ICO. But he threw in the towel when class action lawsuits arrived and deleted his posts.
And even Arise Bank managed to tap boxing legend Evander Holyfield to promote their fraudulent sale.
Unsurprisingly the SEC warned both the public and the celebrity promoters. “Any celebrity or other individual who promotes a virtual token or coin that is a security must disclose the nature, scope, and amount of compensation received in exchange for the promotion . . . Persons making these endorsements may also be liable for potential violations of the anti-fraud provisions of the federal securities laws . . .”
For all the foolish don’ts there is one very smart do. Hire legal representation. ICOs along with the underlying technology may be the future, but the path of least resistance is filled with prosecutors and regulators looking to make their names on your creation.
By Jossey PLLC