The SEC’s reminder: the wheels of justice grind slow, but exceedingly fineNovember 2018
by Jocelyn Roberts
Based on the SEC’s comments in its public statement, it intends for these enforcement actions to provide a model for other currently non-compliant ICO issuers to take action to bring themselves into compliance: it remains to be seen how much sympathy the SEC will show to any projects who fail to do so, whether through ignorance or misplaced optimism.
The actions taken against the ICO issuers seem to indicate a new phase of the SEC’s approach to ICOs: unlike previous actions, neither involved fraud so the SEC is clearly progressing beyond the so-called “low hanging fruit”. Having said that, both the Airfox and Paragon ICOs appear to fall pretty squarely within the SEC’s characterisation of a securities offering based on its previous guidance (including the speech by William Hinman in June 2018 https://www.sec.gov/news/speech/speech-hinman-061418).
Particular factors mentioned include:
(i) Functionality : the tokens were not functional at the point of ICO and there was an expectation that functionality would be built with the proceeds of the sale. In particular, the Airfox order reported that Airfox did not have any real users at the time of the ICO.
(ii) Expectation of profit : in both cases, promises were made to potential investors that created an expectation of profit, including through the creation of an “ecosystem”. These were not just implicit: for example, Paragon stated that the PRG token “is designed to appreciate in value”.
(iii) Exchanges : both projects had stated an intention to seek to create a secondary market through listing on exchanges, which is another step viewed as being in order to increase the value of the tokens.
(iv) Marketing of tokens : in the case of Airfox, it was noted that the tokens were marketed to investors rather than anticipated users. So although the sale documents had included a representation of purchasers that they were buying the tokens for their utility, and not as an investment or a security, given that they were marketed to investors and did not have the necessary functionality available for use, the SEC focused on substance over form.
(v) US publicity : both tokens were offered and sold in general solicitation that included potential investors in the US. Even if there was not a focus on marketing to US investors, no steps were taken by either of the projects to restrict the access of US investors to marketing materials or from acquiring tokens in the public sale.
Given that the tokens were clearly not utility tokens at the moment of the sale, the orders did not need to provide a nuanced argument around whether or not the ICOs were offerings of securities. They unfortunately do not, therefore, provide any further clarification on the SEC’s approach in determining in what circumstances a digital asset is not a security. Potentially, this will be provided by the SEC’s anticipated “plain English” guidance on token offerings (https://www.coindesk.com/sec-official-says-plain-english-guidance-on-icos-is-coming).
The orders provided for the payment of penalties of US$250,000 by Airfox and Paragon and also the requirement to register the tokens as securities and file periodic reports. In addition, the token issuers are required to offer to compensate investors who seek to make a claim. The intention here is to address the information asymmetries between the projects and the investors in order to enable investors to make an informed choice around whether to continue to hold the tokens or to claim reimbursement. This therefore places both an administrative burden on the projects and potentially a high financial cost.
In its statement, the SEC confirmed that these orders provide a model for companies that have issued tokens in ICOs and that seek to comply with federal securities laws. The message is clear: any ICO issuers who have sold tokens in the US other than in accordance with securities laws should seriously consider voluntary remedial action or risk the SEC taking enforcement action against them.
Following the example set in the orders would require an ICO issuer to offer to reimburse investors, which may be a difficult ask for some ICO issuers, especially those that have not fared well during the crypto winter. However, given that the SEC has expressly highlighted this as a path to compliance with federal securities laws, failure to take steps now could result in even more onerous enforcement penalties for projects that choose to ignore the SEC’s guidance.
This is an important step by the SEC in taking proactive measures to shepherd those parts of the market that have already carried out ICOs but have failed to comply with securities laws and the guidance provided by the SEC, whilst also providing US investors with means of remedy. It is also important to note that this does not seem to challenge the concept of a utility token or the general idea of a token sale. However, there remain significant outstanding ambiguities.
Further regulatory clarification would be welcomed, particularly on the possible factors that the SEC will consider in assessing whether an offering of a digital asset would be considered an investment contract and, therefore, a security. Without that, digital assets remain in a grey area which serves neither issuers, investors nor regulators.