United States: Wild West No Longer: The SEC Brings Enforcement Actions Against Two Initial Coin Offerings

Last Updated: October 20 2017
Article by Kyle DeYoung, John T. Moehringer, Joseph V. Moreno, Jeffrey L. Robins and Lex Urban

Most Read Contributor in United States, November 2018

Ending months of speculation about when regulators would wade into the world of Bitcoin and other digital currencies, the U.S. Securities and Exchange Commission ("SEC") recently brought its first enforcement actions against two Initial Coin Offerings ("ICOs") which it alleges effectively operated as high-tech Ponzi schemes.1 The two investment schemes, both run by the same New York businessman, Maksim Zaslavskiy, solicited money from investors in exchange for digital currency ("tokens" or "coins") which were purportedly tied to investments in real estate and diamonds that would appreciate in value over time. According to the SEC, both schemes were complete frauds with no investments or infrastructure behind them. However, the most significant takeaway is the SEC's position, confirming its prior guidance on the subject, that the digital tokens were themselves securities and not simply a form of virtual currency due to Zaslavskiy's claim that they were "backed" by investments. This action is a significant development for the SEC, which appears poised to allow ICOs to continue but increasingly willing to step in to prevent fraud in the space.

I.Existing SEC Guidance on Initial Coin Offerings

An ICO is a means of raising funds for a new company or enterprise, similar to an Initial Public Offering ("IPO"). However, unlike an IPO, which issues stock or other traditional securities to its investors, ICOs issue digital tokens to investors, often in the form of Bitcoin, Ethereum ("ETH"), or one of several other alternatives. Each of these relies on "Blockchain" technology which, among other uses, provides a platform for exchanging digital currency. Blockchain has been cited as having great potential for data security and reliability because it is decentralized – users can conduct transactions peer-to-peer without a financial intermediary between them, so there are no bank accounts to be hacked and no single storage database that could potentially fail. And, because of its open source nature, all users can see every transaction in digital currency in real time which means that transaction history cannot be fraudulently modified.

The open question has been how these ICOs would be viewed by the SEC, and whether the digital currency issued to investors would constitute securities subject to registration and the anti-fraud provisions contained in the federal securities laws. In July 2017, the SEC's Office of Investor Education and Advocacy issued guidance stating that while ICOs could be fair and lawful investment opportunities, the digital currency they offer or sell may be considered securities subject to registration (absent an exemption to registration, such as those for private placements under Regulation D and overseas offerings under Regulation S).2 The guidance cautioned investors against being enticed with the promise of high returns, particularly in a new and untested investment space.

At the same time, the SEC's Enforcement Division released details on its investigation of Slock.it UG, a German corporation, and The DAO, a "decentralized autonomous organization" designed to replace a traditional corporate structure with a user-driven collaborative.3 The concept of The DAO was described in a white paper issued by Slock.it with the purpose of creating and holding assets through the sale of DAO Tokens to investors in exchange for ETH. These assets would be used to fund "projects" from which the holders of DAO Tokens would share in anticipated earnings. DAO Token holders could monetize their investments by re-selling DAO Tokens using a web-based platform that supported secondary trading. By the close of its offering period, The DAO issued DAO Tokens in exchange for ETH valued at approximately $150 million.

The SEC set about to determine whether the DAO Tokens issued to investors constituted securities under Section 2(a)(1) of the Securities Act of 1933 and Section 3(a)(10) of the Securities Exchange Act of 1934 (the "Exchange Act"), which include an "investment contract." According to Supreme Court precedent in SEC v. W.J. Howey Co., an investment contract 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."4 In applying the factors from Howey to the facts underlying The DAO, the SEC found that:

  • Investors in The DAO Invested Money. The SEC determined that the investment of "money" is not limited to fiat currency (e., cash), but also can include goods, services, or some other exchange of value including digital currency. Investors in The DAO used ETH to receive DAO Tokens, and such investment is the type of contribution of value that can create an investment contract under Howey.
  • Investors in The DAO Had a Reasonable Expectation of Profits. The SEC found that investors who purchased DAO Tokens were investing in a common enterprise and reasonably expected to earn profits through that enterprise. In doing so, the SEC looked to the white paper describing The DAO, which characterized it as a for-profit entity who objective was to fund projects in exchange for a return on investment. As a result, a reasonable investor would have been motivated by the prospect of profit on their investment of ETH in The DAO.
  • Profits Were to be Derived from the Managerial Efforts of Others. Finally, the SEC found that investors' profits were to be derived from the managerial efforts of others – specifically, Slock.it and The DAO's curators, who were responsible for managing The DAO and putting forth project proposals. The individuals were responsible for safeguarding invested funds, and investors had limited direct input and control over decision-making of the enterprise.

As a result, the SEC determined that the DAO Tokens were securities and, therefore, The DAO was an issuer of securities under the Exchange Act. Because of this, The DAO was subject to registration, disclosure, and anti-fraud provisions despite its not taking the form of a traditional corporation and its solicitation of investments in the form of digital currency rather than in fiat currency. Since this determination regarding The DAO, companies contemplating ICOs have been awaiting the SEC's next regulatory move in this space.5

II. Enforcement Action Against RECoin and DRC World

Consistent with its finding in The DAO case, the SEC is asserting that the ICOs offered by Zaslavskiy were illegal offerings of securities.

According to the SEC, Zaslavskiy described his two companies, REcoin Group Foundation and DRC World Inc. (or the Diamond Reserve Club), as "managed, tracked and authenticated through blockchain technology." In promoting the first company, Zaslavskiy published a white paper on the Internet encouraging investors to invest in RECoin, which he described as "The First Ever Cryptocurrency Backed by Real Estate," and "an attractive investment opportunity" that "grows in value." The website provided investors with links to invest in RECoin, and later in the Diamond Reserve Club, using fiat currency (either with a credit card or via PayPal) or digital currency, in exchange for the promise of individualized digital "tokens" or "coins" that would be backed by investments in real estate and diamonds, respectively. According to Zaslavskiy, investors would receive returns based on the appreciation of the value of the investment which would, in turn, cause the value of and demand for the tokens to also appreciate. Over the course of several months, Zaslavskiy reportedly collected over $300,000 from investors in the two companies.

Ultimately, the SEC alleged that Zaslavskiy's entire ICO scheme was a fraud because he had in fact never invested any of the $300,000 he had received from investors, had no internal staff or infrastructure, never issued any digital tokens, and made material misstatements in the white paper and on the company website. In addition, the SEC argued that Zaslavskiy actively attempted to avoid securities registration requirements by refashioning the sale of interests in the Diamond Reserve Club as "memberships in a club" and an "Initial Membership Offering." In fact, the memberships promised in the Diamond Reserve Club were identical to the digital tokens promised to investors in RECoin.

III.Conclusion

The SEC's action against Zaslavskiy was likely an easy call. Few would argue with the conclusion that the offerings by RECoin and Diamond Reserve Club constituted securities under the Howey test here. In addition, Zaslavskiy's operation appears to be nothing more than a typical Ponzi scheme masquerading as an ICO. However, there are a few takeaways that should be considered by companies considering ICOs going forward.

The SEC does not appear interested at this point in asserting jurisdiction over ICO, generally. However, if advocates and asset managers hoped that the SEC's apparent hesitation meant that ICOs would remain unregulated, they should expect to be disappointed. The SEC has clearly responded and asserted its authority in the digital currency space. What remains to be seen is whether the SEC will bring actions related to ICOs that would require a much broader interpretation of securities definitions. Will the SEC extend Howey to a situation where the digital currency's value comes not from a direct promise of profit-sharing, but rather from the scarcity of the coin itself? How will the SEC view situations where a digital token has an articulable function, similar to a virtual product, and is less akin to an investment of money with the expectation of future profits? It seems like the SEC will take a measured approach – at least for now.

It also remains to be seen what steps the Commodity Futures Trading Commission ("CFTC") will likely take in this area. The CFTC has previously indicated that it considers Bitcoin and other digital currencies to be "commodities" as defined by the Commodity Exchange Act.6 As such, and particularly since the SEC has asserted itself in this area, it is likely the CFTC will follow suit. Therefore, a likely outcome is shared enforcement responsibility for ICOs between the SEC and the CFTC dependent on the facts and circumstances of each case.

Footnotes

1 Securities and Exchange Commission vs. REcoin Group Foundation, LLC et al., Case No. 1:17-cv-05725 (E.D.N.Y. Sep. 29, 2017), available at https://www.sec.gov/litigation/complaints/2017/comp-pr2017-185.pdf.

2 SEC Investor Bulletin: Initial Coin Offerings (Jul. 25, 2017), available at https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_coinofferings.

3 SEC Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Release No. 81207 (Jul. 25, 2017), available at https://www.sec.gov/litigation/investreport/34-81207.pdf.

4 See SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946); SEC v. Edwards, 540 U.S. 389, 393 (2004); see also United Housing Found., Inc. v. Forman, 421 U.S. 837, 852-53 (1975) (The "touchstone" of an investment contract "is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.").

5 See, e.g., Digital-Coin Companies Shrug Off SEC Scrutiny, The Wall Street Journal (Jul. 26, 2017), available at https://www.wsj.com/articles/digital-coin-companies-shrug-off-sec-scrutiny-1501110893.

6 See In the Matter of Coinflip, Inc. et al., CFTC Docket No. 15-29 (Sep. 17, 2015), available at http://www.cftc.gov/idc/groups/public/%40lrenforcementactions/documents/legalpleading/enfcoinfliprorder09172015.pdf.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions