Two SEC cases against token issuers highlight the possibilities for cooperation and the perils of continued non-compliance
Good Cop, Bad Cop: SEC Enforcement against ICOs in 2019
As the U.S. Securities and Exchange Commission (SEC) continues to work through the backlog of initial coin offerings (ICOs), two themes have emerged which are highly instructive, if not somewhat obvious.
The first is that a company willing to admit that its ICO was an unregistered securities offering will be treated with leniency, absent evidence of fraud or other malfeasance.
The second is that continuing to offer a token without registering that token as a security is an invitation to vigorous enforcement, especially where evidence of fraud and other malfeasance is present. These themes are being repeated in early 2019 as SEC position on ICOs first articulated in July 2017 (and articulated in the DAO Report and Investor Bulletin) continues to be implemented.
Case 1 - Blockvest
Blockvest developed a BLV token for testing its nascent cryptocurrency exchange platform. According to Blockvest, it only issued BLV to a small set of “test investors,” and never sold or used BLV outside the Blockvest platform. The SEC sued Blockvest in late 2108 alleging that it had offered and sold unregistered securities.
Denial of preliminary injunction
You can read a summary of the Blockvest case in our prior post but here are some highlights – they claimed that their ICO had been approved by the SEC, CFTC and National Futures Association, and had the logos of these U.S. regulators on their site along with a fictitious agency called the Blockchain Exchange Commission on their website. Despite these rather unique facts, in November 2018 a federal judge in California declined the SEC’s request to enter a requested preliminary injunction, finding that there were fact questions at issue as to whether BLV was a security under the Howey test (which states that an investment contract exists when there is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others).
The denial of that preliminary injunction request was taken by some to mean that U.S. courts might not share the SEC’s view nearly all cryptocurrencies constitute securities, leading commentators to suggest (incorrectly) that courts may not accept the expansive regulatory jurisdiction over cryptocurrency that the SEC has asserted.
Reconsideration and issue of preliminary injunction by SEC
Finding this result unsatisfactory, the SEC moved to reconsider, and on February 14, 2019, the court granted this motion and issued the preliminary injunction based upon, “a prima facie showing of Blockvest’s past securities violation and newly developed evidence which supported the conclusion that there is a reasonable likelihood of future violations.”
Digital token considered a “security”
In other words, the red flags that the SEC had documented in its initial and subsequent filings were in fact compelling evidence that Blockvest would likely commit fraud in the future. Furthermore, the court focused on an analysis of the offer proposed by Blockvest to all potential investors, rather than “test investors” in a “pre-ICO” to conclude that Blockvest’s promotion of digital tokens, met the definition of a security established under the Howey test.
Second Case - Gladius Network
Gladius Network LLC entered a consent order with the SEC on February 20, 2019 in relation to an ICO where it raised approximately $12.7 million in Ether from 1,700 investors during the fall of 2017 by selling GLA tokens. The offering was intended to raise capital for the Gladius network to rent spare computer bandwidth to defend against cyberattacks. As part of this, GLA was issued on a blockchain to be used as the currency for services on the Gladius network.
Offer sale and distribution of tokens without registration of exemption
As was common practice, the Gladius whitepaper said that GLA was “not being structured or sold as securities or any other form of investment product,” and required purchasers to warrant that ownership of GLA granted access to the Gladius Network but conferred no equity or other rights (including ownership rights).
Notwithstanding these statements, the SEC concluded that investors reasonably expected profits from Gladius’s managerial efforts, “whether or not they used the planned Gladius network” and therefore Gladius offered, sold and distributed the tokens without registration or an applicable exemption.
Self-reporting to SEC and remedial undertakings avoid penalty
Unlike so many other companies which found themselves in a similar situation, Gladius recognized the situation it was in reported itself to the SEC in August 2018. Because of this self-reporting, its subsequent cooperation and the remedial undertakings it agreed (including offering refunds to investors who participated in the ICO, revising its website and marketing materials, and registering the coins as securities), the SEC decided not to impose a financial penalty when entering into the consent order.
Key takeaways – a clear model for ICO issuers
As noted above, these two cases starkly contrast how companies can deal with the SEC. Having been granted a temporary reprieve from enforcement in the November 2018 decision, Blockvest appears to have doubled down on its efforts to market its BLV tokens rather than attempting to work with the SEC staff to remediate its offering. Alternatively, Gladius clearly benefited from its efforts to self-report its deficiencies and by cooperating with the SEC in remediating them.
Given that ICO enforcement appears to be proceeding at a rapid pace, past ICO issuers now have a clear model in how to deal with the SEC.