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With the SEC, Cooperation is Key

As an expensive “slap on the wrist,” the Securities and Exchange Commission (“SEC” or the “Commission”) recently concluded that approximately $12.7 million worth of funds raised in a 2017 Initial Coin Offering (“ICO”) by Gladius Network LLC (“Gladius”) were part of an unregistered securities offering, and all proceeds must be returned to investors. However, the penalty to Gladius for their regulatory violations was zero.

In recent years, the SEC has brought a number of actions involving offerings of digital asset securities including ICOs. These actions have principally focused on two important questions. First, the SEC examines when is a digital asset a “security” for purposes of the federal securities laws, and if the digital asset is a “security,” the SEC examines what registration requirements apply, if any. After the Commission warned in its Decentralized Autonomous Organization (DAO) Report of Investigation that ICOs can be securities offerings, Gladius raised approximately $12.7 million in digital assets. Gladius did not register its ICO under the federal securities laws. Moreover, the ICO did not qualify for an exemption from registration requirements. However, in the summer of 2018, Gladius proactively elected to self-report to the SEC’s enforcement staff and expressed an interest in taking prompt remedial steps, then cooperated with the SEC investigation. Unlike a number of other unregistered ICO enforcement actions, the SEC imposed no penalties because Gladius self-reported its conduct, agreed to compensate investors and agreed to register the tokens as a class of securities.

In other cases where proactive measures or cooperation with regulators were absent, the SEC enforced much harsher penalties. For example, two former executives behind the AriseCoin ICO were stopped by the SEC in 2018 and ordered in federal court to pay fines of nearly $2.7 million. Moreover, the then-CEO and then-COO responsible for the AriseCoin ICO were both prohibited from serving as officers or directors of public companies or participating in any future offerings of digital securities. The harsh penalties came after an SEC investigation, wherein there was little cooperation by AriseCoin. In fact, the SEC sought emergency relief to prevent investors from being victimized by the many misrepresentations throughout the AriseCoin ICO, and halted hundreds of millions in investment.

The SEC will impose penalties, even in ICOs where fraudulent misrepresentation is absent. Last year, the SEC imposed large civil penalties solely for ICO securities offering registration violations against two companies, CarrierEQ Inc. (Airfox) and Paragon Coin Inc. Both conducted ICOs, like Gladius, after the SEC warned that ICOs can be securities offerings. Airfox, a Boston-based startup, raised approximately $15 million worth of digital assets. Paragon, an online entity, raised approximately $12 million worth of digital assets. Neither Airfox nor Paragon registered their ICOs pursuant to the federal securities laws, nor did they qualify for an exemption to the registration requirements. The SEC imposed $250,000 penalties against each company and required actions to compensate and reimburse harmed investors who purchased tokens in the illegal offerings.

Since 2017, the number of new ICOs has steadily increased through 2018. However, as one might expect with the increasing competition, the amount of capital raised by each ICO has, on average, decreased. In 2018, the average amount of funds collected by a single ICO was $11.52 million. This is a sharp decrease from the average amount of funds collected by a single ICO in 2017, which was $24.35 million. Even after a dramatical downsizing, the crypto market is still larger than at the beginning of the upward trend in 2017, and many are focusing on alternative ways to finance the crypto industry in light of the fact that the SEC has not published new rules regarding digital securities or security tokens to address gray areas in this time of uncertainty.

The trend in leading crypto market exchanges is backing Security Token Offerings (STOs). Unlike an ICO, a security token denotes an investment contract into an underlying investment asset, such as stocks, bonds, funds or real estate investment trusts. When one invests in traditional stocks, ownership information is written on a document and a digital certificate is issued. For STOs, the process remains the same, except the transaction is recorded on a blockchain and a security token is issued. STOs offer the advantage of regulatory predictability to both traditional and crypto investors because security tokens are straightforwardly classified and fit into exhibiting regulatory frameworks in place for traditional securities. With STOs, all parties have an increased likelihood of avoiding regulatory purgatory, making STOs more attractive to most investors and issuers.

The era of mega ICOs is coming to a slow halt. Companies which have successfully conducted an ICO in the past would be wise to proactively correct any regulatory missteps, including the failure to register, make proper disclosures or any other litany of violations. Careful corrections to past ICOs may be necessary to avoid potentially enormous regulatory fines, as exemplified by the relative leniency the SEC showed with respect to Gladius based on its self-reporting and cooperative actions with the SEC enforcement staff.

Copyright © 2020, Sheppard Mullin Richter & Hampton LLP.


About this Author

Andrea Cataneo, Sheppard Mullin, corporate attorney

Andrea Cataneo is a partner in the Corporate Practice Group in the firm's New York office.

Areas of Practice

Ms. Cataneo focuses on structuring secured and unsecured private equity financing transactions for microcap companies, and taking companies public via self-registration statements and reverse merger transactions. Additionally, through her extensive relationships in the investment banking community, Ms. Cataneo offers her clients targeted sources of capital. She also represents publicly-held companies with their 1934 Act reporting...

Winnie Weil, Corporate lawyer Sheppard Mullin

Winnie Weil is an associate in the Corporate Practice Group in the firm's San Diego (Del Mar) office. She is a member of the firm’s Energy, Infrastructure and Project Finance industry team, as well as the Healthcare industry team.

Areas of Practice

Winnie advises on mergers & acquisitions, renewable energy project finance, healthcare transactions, emerging company transactions, technology transactions, corporate governance, and other general corporate transactional matters.

Prior to joining Sheppard Mullin, Winnie was a management consultant specializing in the energy sector.