On November 16, 2018, the Securities and Exchange Commission (SEC) Division of Corporate Finance, Division of Investment Management and Division of Trading and Markets (the Divisions) issued a joint public statement to address the SEC’s recent activity relating to digital asset securities issuance and trading. In the statement, the Divisions reiterated the applicability of federal securities laws to digital asset securities and claimed that recent actions represent a path to compliance with federal securities laws for issuers of digital asset securities. They articulated that market participants under all facets of the SEC’s jurisdiction must adhere to federal securities laws whether the securities in which they are dealing are issued using new technology such as blockchain or otherwise.
The Divisions noted that issues relating to digital asset securities fell into three primary categories: (1) initial offers and sales of digital asset securities (including those issued in initial coin offerings (ICOs)); (2) investment vehicles investing in digital asset securities and those who advise others about investing in these securities; and (3) secondary market trading of digital asset securities. For all of these issues, the SEC has relied on the DAO Report1 issued on July 25, 2017 that applied the Supreme Court’s definition of investment contract in SEC v. W.J. Howey Co.2 to certain tokens to determine whether digital assets are securities.
The Divisions’ public statement was issued shortly after the first SEC enforcement action based on the finding that a token trading platform was an unregistered national securities exchange,3 and on the same day as the SEC announced in a press release that it had settled charges in what are the first non-fraud sanctions from the SEC in connection with the failure to register an ICO as a securities offering.
CarrierEQ, Inc. (d/b/a AirFox) and Paragon Coin, Inc. consented to settlement orders without admitting or denying registration violations of Section 5 of the Securities Act of 1933 (Securities Act), for which each company will pay $250,000 in penalties against and compensate harmed investors who had purchased tokens in the unregistered offerings. AirFox and Paragon will also have to register their tokens as securities pursuant to the Securities Act and file periodic reports with the SEC for at least one year.
AirFox had raised approximately $15 million worth of digital assets to finance its development of a token-denominated “ecosystem” starting with a mobile application that would allow users in emerging markets to earn tokens and exchange them for data by interacting with advertisements. Paragon had raised approximately $12 million worth of digital assets to develop and implement its business plan to add blockchain technology to the cannabis industry and work toward legalization of cannabis.
Stephanie Avakian, Co-Director of the SEC’s Division of Enforcement, stated that “[t]hese cases tell those who are considering taking similar actions that we continue to be on the lookout for violations of the federal securities laws with respect to digital assets.”
Although the Divisions stated that AirFox and Paragon demonstrate a path to compliance with federal securities laws for issuers of digital asset securities, even where they have conducted an illegal unregistered offering, prospective issuers should note that these are remedial actions accompanied by adverse regulatory consequences. In other words, this is a path for issuers that previously issued security tokens in an unregistered offering, but it is not a path that new issuers should follow. Additionally, the path set out for AirFox and Paragon may lead to retroactive compliance with federal securities laws, but issuers of security tokens in unregistered offerings may also be in violation of state securities laws.
The Divisions recommended that those employing new technologies consult with legal counsel concerning the application of the federal securities laws. If you have any questions about when dealing with certain digital assets could run afoul of applicable securities laws, rules or regulations, please speak with your S&K contact attorney or any member of our Blockchain and Cryptocurrency Group.
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1 See Seward & Kissel Client Alert, “SEC Speaks Out on ICOs, Cautions That Some May Involve Offering of Unregistered Securities,” July 27, 2017.
2 SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
3 See Seward & Kissel Client Alert, “SEC Charges EtherDelta Founder with Operating an Unregistered Securities Exchange,” November 9, 2018.
