Initial Coin Offerings: The New Frontier

The Securities and Exchange Commission (SEC) Cyber Unit has filed its first case, freezing an initial coin offering which, according to the SEC, is a $15 million investor fraud. The SEC’s newest enforcement arm was established in September of this year to address cyber-based threats such as market manipulation schemes involving false information spread through electronic and social media, violations involving distributed ledger technology and initial coin offerings, and misconduct perpetrated using the dark web.

The ever-increasing value of Bitcoin has led to a massive growth in the cryptocurrency market. There are currently over 900 different cryptocurrencies in circulation with a market cap around half a trillion dollars. Developers of these new cryptocurrencies are increasingly using initial coin offerings (ICOs), also referred to as token sales, as a way to raise capital in order to develop a digital platform, create the software, or support other projects associated with running the new virtual currency. This can be done either using fiat currency or virtual currency. ICOs are similar to initial public offerings (IPOs) for businesses, though they are generally viewed to operate without all of the traditional IPO regulations. The cryptocurrency Ethereum, for example, which has the second highest market cap behind Bitcoin, was created in 2014 through an $18 million ICO funded with Bitcoin.

The lack of regulation surrounding ICOs has led to the SEC’s recent involvement and application of securities laws in the ICO arena. Depending on the facts and circumstances of each ICO, the coins offered and sold by virtual organizations are securities and therefore subject to the federal securities laws – meaning they need register unless a valid exemption applies. The SEC’s Office of Investor Education and Advocacy issued an Investor Bulletin in July 2017, warning investors of the potential risks of participating in ICOs.

This statement comes on the heals of the SEC’s report regarding the DAO, a virtual organization that raised more than $100 million before a hacker was able to steal more than a third of the funds, leading to its collapse. The SEC determined that virtual organizations’ use of blockchain technology to raise capital constitute investor contracts puts them within the purview of the federal securities laws.

The first criminal action brought by the SEC’s Cyber Unit was against PlexCorps, a Canadian company that allegedly told potential investors its virtual currency would yield a 1,354 percent profit in less than 29 days. The SEC obtained an emergency asset freeze for the $15 million raised by PlexCorps from thousands of investors since August. The complaint charged violations of the anti-fraud provisions and the registration provision of the federal securities laws.

Also, in November 2017, the SEC issued a statement on the potentially unlawful promotion of initial coin offerings and other investments by celebrities. There is a recent celebrity trend involving the use of social media to promote new ICO investment opportunities. In pointing to its report on the DAO indicating that some ICOs will be deemed securities and therefore subject to the federal securities laws, the SEC has posited that this also impacts the information celebrities may provide when promoting new ICOs. Any celebrity who promotes a virtual coin that is a security must disclose the nature, scope, and amount of compensation received in exchange for the promotion. A failure to do so is a violation of the anti-touting provisions of the federal securities laws.

We will continue to track the progression of this issue and update you accordingly.

 

 

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