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E-MailRahul Mukhi is a partner and James Michael Blakemore is an associate at Cleary, Gottlieb, Steen & Hamilton LLP. This post is based on a Cleary Gottlieb publication by Mr. Mukhi and Mr. Blakemore.
On Monday, December 4, 2017, the U.S. Securities and Exchange Commission (SEC) obtained an emergency order from a U.S. District Court in New York to enjoin an allegedly fraudulent initial coin offering scheme. The SEC’s complaint alleges that Dominic Lacroix, a recidivist securities law violator, and his company PlexCorps violated the anti-fraud and registration provisions of the U.S. federal securities laws in collecting up to $15 million in investor funds purportedly in exchange for digital tokens and promised returns in excess of 1,000% in 29 days. The complaint also charges Lacroix’s partner Sabrina Paradis-Royer with securities fraud. Among other relief, the district court has granted the SEC’s request to freeze the defendants’ assets.
ICOs and the SEC
The charges, filed on Friday, December 1, 2017, mark the second time the SEC has taken action against a so-called initial coin offering, or ICO, and the first action taken by the SEC’s newly created Cyber Unit.
ICOs or token sales are a form of crowdfunding in which participants contribute funds to a blockchain-based project, often in the form of a cryptocurrency like bitcoin or ether, and in return receive cryptographic coins or tokens. Tokens currently in circulation aim to serve myriad functions, including as currency, betting or prediction mechanisms, and to capture advertising revenue. In some cases, tokens replace traditional securities, for example representing shares in a company. Tokens issued in token sales also typically trade on secondary cryptocurrency markets.
ICOs have flourished in 2017. When the SEC announced in September the creation of the Cyber Unit, which focuses on cyber-related misconduct, including involving blockchain and ICOs, token sales had already raised more than $1.3 billion for the year. As 2017 comes to a close, that number has risen to more than $3.6 billion.
The SEC’s first major pronouncement regarding digital tokens came in a July 25, 2017 Report of Investigation on The DAO, an organization whose tokens allowed investors to vote to invest in projects and to distribute investment earnings. The SEC found the tokens to be securities under the familiar Howey test, [1] and thus subject to the requirements of U.S. securities law, and took the opportunity to confirm the absence of a bright-line rule to determine whether a given token is a security. As with other transactions, the analysis in each case will turn on the specific characteristics of the token and the circumstances of its issuance. Along with the DAO report the SEC published an investor bulletin describing ICOs and warning of their potential use for fraud.
Two months later, on September 29, 2017, the SEC brought its first action to halt an allegedly fraudulent ICO against Maksim Zaslavskiy and two companies he controlled, REcoin Group and Diamond Reserve Club.
Lacroix, PlexCorps, and PlexCoin
According to the SEC’s complaint against Lacroix, Paradis-Royer, and PlexCorps, the defendants established a purported ICO in which they offered “PlexCoin” tokens and promised investors returns of up to 1,354% in less than a month. The defendants may have raised as much as $15 million in what the SEC alleges was a fraudulent and unregistered offering of securities.
Among the misstatements asserted in the complaint, the SEC alleges that the defendants falsely claimed that PlexCorps was run by teams of cryptocurrency experts across the world (rather than by Lacroix and his compatriots in Quebec), that invested funds would be used to maintain the price of PlexCoin and further develop the project (rather than to enrich the defendants), and that the identity of the project’s founders was kept secret for security reasons and to avoid headhunters (rather than to conceal Lacroix’s involvement in light of his history of fraud). The complaint seeks permanent injunctions, disgorgement, and civil penalties. As a preliminary matter, Judge Carol Bagley Amon of the Eastern District of New York has granted the SEC’s request to freeze the defendants’ assets to preserve the court’s ability to order, if necessary, disgorgement and the payment of civil penalties.
Implications
The SEC’s action is consistent with the approach it has taken with tokens and token sales thus far in two respects. First, the complaint reiterates that the securities laws cannot be avoided simply by soliciting investments in cryptocurrency in exchange for tokens. As with any other transaction, the facts and circumstances of a particular token and its issuance matter more to the SEC than its mechanism or label: a digital token is a security if it meets the Howey test.
Second, as with the SEC’s first ICO enforcement action, the Commission has taken aim at what, as least according to its allegations, is a traditional case of securities fraud. On the face of the complaint, PlexCorps does not present the hard case that would require the SEC to police the line between tokens governed by the securities laws and so-called utility tokens which arguably are not—a debate underway among legal commentators. [2] As a result the SEC’s action here does little to dispel lingering regulatory uncertainty.
What is clear, however, is that the SEC has made it a priority to target fraudulent exploitation of investor enthusiasm for ICOs.
Endnotes
1In SEC v. W.J. Howey Co., 328 U.S. 293 (1946), the Supreme Court set forth the foundational test for whether a transaction qualifies as a form of security known as an “investment contract.” Under Howey, an investment contract is (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived from the entrepreneurial or managerial efforts of others. See also SEC v. Edwards, 540 U.S. 389, 393 (2004).(go back)
2Broadly speaking, utility tokens are distinguished from security or investment tokens for, as the name suggests, having some utility apart from or in addition to their value as an investment. Because the value of utility tokens may depend more on market factors like demand for the token or its particular function or use than on the managerial efforts of others, it has been argued that functioning utility tokens may not qualify as securities under the Howey test.(go back)
