United States: Court Freezes Assets Of Defendants Who Offered Allegedly Fraudulent ICOs

On Sept. 29, 2017, the Securities and Exchange Commission (SEC) brought an emergency enforcement action against Maksim Zaslavskiy, REcoinGroup Foundation LLC (REcoin) and DRC World Inc. (also known as Diamond Reserve Club) (Diamond), alleging they defrauded investors in a pair of initial coin offerings (ICOs), in violation of the anti-fraud and registration provisions of the federal securities laws.

The SEC's complaint alleged that the defendants sold unregistered securities and that the digital tokens or coins being offered did not actually exist, though the defendants raised at least $300,000 from hundreds of investors between July 2017 and the date of the complaint. The SEC further alleged that the defendants touted the REcoin ICO as "The First Ever Cryptocurrency Backed by Real Estate" and told investors they could expect significant returns from their investments (between 10-15% in the case of Diamond) when neither company had any real operations, and made other false and misleading statements regarding the defendants' previous fundraisings and investment activities — representations that "recklessly disregarded" the reality. The SEC also alleged that Zaslavskiy attempted to circumvent the securities registration requirements by refashioning the sale of interests in Diamond as "memberships in a club" and the Diamond ICO as an "Initial Membership Offering."

The U.S. District Court for the Eastern District of New York granted the SEC's request to temporarily and preliminarily freeze the assets of the defendants. Its decision stated that Zaslavskiy remains a threat to cause "continued and additional harm to investors," as he is launching or has already launched as many as 18 different websites to promote the sale of the fraudulent coins and continues to send frequent e-mails to investors about purchasing "tokens." The SEC's complaint seeks permanent injunctions and disgorgement plus interest and penalties. For Zaslavskiy, the SEC also seeks an officer-and-director bar and a bar from participating in any offering of digital securities.

The enforcement action came after the SEC's Office of Investor Education and Advocacy issued an investor alert earlier in 2017 that noted the increasing prevalence of ICOs and the potential risks associated with the promises of high returns in the new investment space. Further, the SEC released an investigative report on July 25, 2017, in connection with DAO tokens, warning that "virtual" organizations' offers and sales of digital assets may be subject to the requirements of the Securities Act of 1933 and the Securities Exchange Act of 1934. While that report by the SEC does not indicate that all offerings by virtual organizations are securities, it puts the industry on notice that some virtual tokens may be securities. In finding that the DAO tokens were securities, the SEC applied the Howey test (from SEC v. W.J. Howey Co., 328 U.S. 293 1946) to conclude that the DAO tokens were investment contracts and, in turn, securities. Very simply, the Howey test requires that (1) there is an investment of money in a common enterprise, (2) the investors had a reasonable expectation of profit and (3) these profits are derived from the managerial efforts of others. Most recently, on Sep. 25, the SEC announced the creation of a new Cyber Unit that will focus on targeting cyber-related misconduct including those involving distributed ledger technology and initial coin offerings.

These public warnings and the establishment of a Cyber Unit, combined with this latest court action, demonstrate the SEC's ongoing focus on digital currencies and their associated offerings. They demonstrate a clear pattern that ICOs and virtual organizations are firmly on the SEC's radar and that, in the absence of a valid exemption, the regulator intends to exert its authority over such entities and hold them to the same regulatory standards as traditional securities transactions.

Industry participants can expect this trend to continue in the coming years as ICOs become increasingly common, and should ensure that their activities with respect to ICOs comply with all relevant securities laws in order to avoid similar regulatory attention.

Originally published November 1, 2017

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