In 2017-2018, a wave of “initial coin offerings” (ICOs) swept the global markets, as companies looked for innovative ways to raise capital.  The United States regulatory authorities, particularly the Securities and Exchange Commission, took a dim view of these capital raises, however, and cracked down on such unregistered coin offerings. 

For those companies that joined the ICO wave, the SEC’s crackdown leaves difficult strategic questions:  Should a company come forward to the SEC and try to atone for its past sins?  What is the cost of doing so?

The SEC has provided some guidance on these questions through three different settlements:  Paragon Coin, Inc. and CarrierEQ, Inc. (d/b/a AirFox), whose settlements with the SEC were announced on November 16, 2018, and Gladius Network LLC (“Gladius”), whose settlement was announced on February 20, 2019. Taken together, these settlements are designed to encourage ICO issuers whose only sin was an unregistered coin offering to come forward and make amends.

The blueprints for these settlements were roughly similar to one another:  offer refunds to investors, get the tokens registered as securities, and if you come forward voluntarily, you may even avoid paying a penalty. 

The SEC appears to have a kind of taxonomy of ICOs.  First, the SEC has targeted the outright frauds, where there was never any coin, token, or underlying business project.  Second, the SEC tackled frauds in the offering, where purchasers received a token that was tied to a bona fide business project, but the token was sold with fraudulent statements or omissions.

Third, the SEC had been watching ICOs that were bona fide token offerings for a bona fide business idea, and were offered without fraudulent promotion, but where the ICOs were sales of securities done without registration or exemption, in violation of Section 5 of the Securities Act of 1933.

While the SEC has brought a slew of cases in federal court on the first two categories, the SEC’s settlements with Paragon and AirFox were the first where there was no allegation of fraud.  The only issue addressed in the settlement orders is failure to register the ICO as a securities offering.  

On that point, the SEC’s legal analysis and remedies are almost exactly identical.  In the settlements with Paragon Coin and AirFox, the SEC issued cease-and-desist orders under the Securities Act, on the grounds that each company issued tokens that were not registered with the SEC, or within one of the available exemptions to registration.

 The companies’ businesses were quite different. AirFox, which reportedly raised approximately $15 million, ‘‘sold technology to mobile telecommunications companies’’ in which customers could watch ads to earn free air time.  Paragon, which reportedly raised $12 million, develops blockchain products for the cannabis industry.

However, both companies stated that their tokens would be ‘‘utility tokens,’’ forming part of an ‘‘ecosystem’’ in which the tokens could be publicly traded on a token exchange, or used for some value within the company’s structure.  In each case, the SEC rejected the ‘‘utility token’’ categorization.  The SEC stated that these tokens were securities, and they were offered without being registered and without having met an available registration exemption.

In both cases, the issuer: (i) was charged a civil penalty of $250,000, (ii) was directed to register the tokens as securities under Section 12(g) of the Exchange Act, and (iii) is required to send investors a notice that they have the right to recover their investments.’

The SEC then explicitly encouraged companies to come forward and follow this model.  Steven Peikin, the Co-Director of the SEC’s Division of Enforcement, stated that “these orders provide a model for companies that have issued tokens in ICOs and seek to comply with federal securities laws.” 

The first ICO issuer to do so voluntarily was Gladius, which had raised approximately $12.7 million in its ICO.  On February 20, the SEC announced its cease-and-desist order against Gladius, finding that — like Paragon and AirFox — the Gladius ICO was an unregistered securities offering.  Gladius was also required to register its tokens and offer to return any investors’ money.  However, because Gladius self-reported, the SEC did not assess any civil penalty.

The settlements leave many questions unanswered.  Will the SEC allow every company that self-reports to avoid a penalty?  Will the SEC continue to charge $250,000 as a “standard” penalty for those who do not self-report?  What if issuers who have seen the value of their tokens plummet cannot afford to offer a refund, making any similar settlement a corporate death penalty?  Will investors be entitled to receive U.S. dollars back from the companies?  What if the consideration paid was not cash, but rather a different cryptocurrency?  What if that cryptocurrency fluctuated in value, giving either the investor or the company a huge windfall?  All of these questions will affect which companies decide to settle, and which decide to hide or fight.  

Despite the questions, companies that take the SEC’s new roadmap as a ‘‘hint’’ can put themselves on a more compliant path, and companies who can afford to get compliant may find it easier and cheaper to do so voluntarily than wait for the SEC to bring a much more costly enforcement action.