Alert December 18, 2017

SEC Issues Warnings Regarding Celebrity-Promoted Coin Offerings and Moves Swiftly Against Unregistered ICOs

Summary

The Securities and Exchange Commission (SEC) recently issued two warnings about investments sold on the basis of celebrity endorsements, including one relating to initial coin offerings (ICOs), and followed up with enforcement actions against unregistered ICOs. 

Investors can be misled by biased promotions. Receipt of cash or other consideration in exchange for promoting a security can create an incentive to describe the security in an attractive light, regardless of associated risks, costs and fees. Promoters of ICOs that are securities must fully disclose any consideration received, including the type (i.e., cash or securities), amount and the identity of the party making the payment, in order to comply with federal securities laws.

The SEC’s Office of Investor Education and Advocacy (OIEA) recently issued an investor alert warning of the risks of basing investment decisions solely on celebrity endorsements. In a separate release, the SEC Division of Enforcement (Enforcement) and the Office of Compliance Inspections and Examinations (OCIE) issued a statement on potentially unlawful celebrity promotion of ICOs and other investments.

According to the SEC, a celebrity, or any other individual for that matter, who promotes an ICO that is a security must comply with certain disclosure requirements (e.g., the nature, scope and amount of compensation received in exchange for the promotion). Failure to do so could violate anti-touting and other provisions of the federal securities laws. In particular, Section 17(b) of the Securities Act of 1933 (Securities Act) generally requires a person who publicizes, advertises or otherwise promotes a security to fully disclose the receipt of any payments, directly or indirectly, from an issuer, underwriter, or dealer, including in the form of cash or securities. More broadly, Section 10(b) of the Securities Exchange Act of 1934 and corresponding Rule 10b-5 make it unlawful for any person, in connection with the purchase or sale of any security, to, among other things, employ any device, scheme, or artifice to defraud or to make an untrue statement of a material fact or omit a material fact necessary to make the statements made, in light of the circumstances under which they were made, not misleading.

As the SEC indicated in its report on the DAO token offering, certain features of an ICO could cause it to be a securities offering, thereby triggering registration requirements (absent an exemption) as well as registration requirements for platforms or systems that facilitate trading of tokens (i.e., as a national securities exchange or Alternative Trading System (ATS)). As we have since learned from two recent SEC enforcement actions and public statements from SEC Chairman Clayton, non-security ICOs (i.e., true “utility” ICOs) may be a rarity. It is clear that simply claiming that an ICO is issuing a “utility” token does not exempt the ICO from federal securities laws, even if the token does possess some functional characteristics.

Disclose! Disclose! Disclose!

Given the regulatory uncertainty and scrutiny surrounding the status of ICOs (i.e., security vs. utility), those involved in their promotion should consider taking a conservative approach to compliance by disclosing compensation received, even if there is a possibility that the offering ultimately is not subject to the federal securities laws. Rule 10b-5 applies generally to any person involved in a securities offering. Securities Act Section 17(b) does not directly apply to issuers. Nevertheless, persons, including issuers, who knowingly or recklessly provide substantial assistance to effect these violations could be deemed in violation for aiding and abetting.

Beyond the question of adequacy of disclosure, of course, there is also the risk that if the ICO is determined to be an offering of securities without registration or a good exemption, there could be liability (directly and indirectly) for violating the securities registration requirements of the Securities Act or, for intermediaries in the transaction, for acting as an unregistered broker. For example, the SEC recently issued a cease and desist order against a company developing a restaurant review app that halted its ICO this fall after being contacted by the SEC. The company returned ICO proceeds to token purchasers before delivering any tokens. According to the SEC, the tokens were unregistered securities that the company sold in violation of federal securities laws. At least in part, the company’s quick reaction to the SEC’s inquiry spared it from incurring a fine or other penalties. Interestingly, the SEC order mentions at least one promoter of the company’s tokens who, according to the SEC, touted in a YouTube video that “[p]retty much, if you get into it early enough, you’ll probably most likely get a return on it” and made claims of a $94,000 return on a mere $1,000 investment. The SEC did not elaborate on whether it would pursue action against this promoter or others who touted the ICO. See our recent client alert for more on various practical considerations relating to this matter.

In a separate recent matter, the SEC filed charges and obtained an emergency asset freeze halting an alleged fraudulent ICO that, according to the SEC, falsely promised a 1300% profit in less than a month. Through this action, which was the first brought by the SEC’s new Enforcement Cyber Unit, the SEC is seeking to impose numerous penalties in addition to the emergency asset freeze and ICO halt, including payment of civil money penalties, disgorgement of ill-gotten gains, a prohibition from participating in any offering of digital securities, and a permanent ban from serving as officers or directors of any public company. Tying the discussion back to potentially fraudulent promotion of securities, earlier this year the SEC charged 27 firms and individuals related to fraudulent stock promotion schemes that misled investors to think they were reading independent, unbiased stock research and analysis, when in reality the writers had been paid to tout the securities. 

Conclusion

The message is clear – the federal securities laws apply to offerings of securities, even where they exist only in a digital or virtual form. The practical reality is that the SEC considers few ICOs, if any, to be outside of its jurisdiction.[1] Promoters and other ICO market participants must be aware of and comply with applicable securities laws. 

The stage is set for additional SEC enforcement action against those who fail to heed the SEC’s warnings. ICO issuers and market participants, including promoters, should be mindful of the attendant regulatory risks and would be wise to conduct a pre-launch/pre-promotion analysis of their status under the U.S. federal securities laws and applicable SEC rules and regulations. 

Over the past several months, scores of clients from around the world have relied on Goodwin to execute their initial coin offerings, drawing from our expertise in regulatory compliance and enforcement, tax, and blockchain and emerging technology startups. Our experienced attorneys can guide you through the full lifecycle process of a token sale with a core team that includes experienced former U.S. federal prosecutors, corporate securities lawyers, specialists in financial transaction regulations and OFAC issues, and former in-house counsel for a regulated options exchange. Goodwin’s technical expertise, geographic footprint in key industry markets, and depth of experience allows us to offer unprecedented service to help our clients capitalize on opportunities and meet the challenges of this evolving industry. 

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[1] In his Statement on Cryptocurrencies and ICOs last week, SEC Chairman Clayton stated that, “[b]y and large, the structures of [ICOs] that I have seen promoted involve the offer and sale of securities and directly implicate the securities registration requirements and other investor protection provisions of our federal securities laws.”  Chairman Clayton also recently provided additional remarks on ICOs that underscore the regulator’s commitment to deterring, mitigating and eliminating misconduct related to ICOs.