In 2017, the Securities and Exchange Commission announced in the Report of Investigation on The DAO its view that digital tokens (or coins or certain cryptocurrencies) can be securities, subject to regulation by the SEC under the federal securities laws. Last month, it flexed its regulatory muscle. For the first time, the SEC imposed civil penalties—of $250,000 each—on two companies solely for selling digital tokens through unregistered securities offerings.
The first company, Airfox, which aims to create an ecosystem in which its “AirToken” can be exchanged for digital air time in developing countries, raised $15 million in its ICO. The second, Paragon Coin, which touts the potential for blockchain technology to stabilize the growing cannabis industry, raised more than $12 million. Neither company had registered its digital token offering with the SEC, and neither qualified for a registration exemption.
The fines were but one of the requirements of the respective settlements reached with the SEC. Much bigger financial exposure comes in the form of a requirement that both companies offer to buy back their tokens from investors at the ICO offering price, and to pay damages to any investor who purchased the tokens and later sold them at a loss. Airfox and Paragon Coin will also have to register their tokens as securities, with all the regulatory filings that registration entails.
The SEC found that both companies’ tokens were marketed and sold to investors based on representations that the companies would undertake various activities aimed at increasing the tokens’ value. This potential for token holders to profit solely through the efforts of others is what brings these tokens within the definition of a security. Airfox, it seems, tried to avoid such a determination by requiring that investors “agree” that they were buying the tokens as a medium of exchange for digital airtime. The SEC was unpersuaded. It noted that at the time of the ICO, the exchange functionality of Airfox’s promised app was not yet available.
It’s too soon to say how much the agreements with the SEC will ultimately cost Airfox or Paragon. Neither company was accused of fraud or of making false statements, and most investors may choose to hang onto their coins in the hope of seeing a profit rather than take up the offer of reimbursement. Airfox CEO Victor Santos was certainly trying to nudge investors in that direction last month. He wrote in an email that registration would “lead to additional clarity and transparency for token holders.” He also wrote that registration was becoming “more normal.” Nonetheless, AirToken transfers were “temporarily paused until we finalize the claims process,” Santos said.
One thing that is clear after the SEC’s announcement is that the SEC is just beginning to exercise its authority over cryptocurrencies, digital tokens, and ICOs. Stephanie Avakian, Co-director of the SEC’s Enforcement Division, said that the settlements “made it clear that companies that issue securities through ICOs are required to comply with existing statutes and rules governing the registration of securities.” She also warned that the penalties imposed on Airfox and Paragon “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.”
The settlements are also intended as guidance to other ICO sponsors. “By providing investors who purchased securities in these ICOs with the opportunity to be reimbursed and having the issuers register their tokens with the SEC, these orders provide a model for companies that have issued tokens in ICOs and seek to comply with the federal securities laws,” said Steven Peikin, another Co-Director of the SEC’s Enforcement Division. Peikin’s comments suggest that companies that have already undertaken ICOs can minimize or even avoid fines if they voluntarily take the same steps that the SEC required of Airfox and Paragon Coin. But if that is the message that Peikin wanted to send, it’s not entirely clear who the intended audience is. Both Airfox and Paragon Coin offered their tokens to the general public and sold to investors in the United States. ICOs conducted under different conditions might get different treatment from the SEC, and companies involved in those ICO’s might need to take different sorts of corrective action to bring themselves into compliance.
Whatever the route to compliance, companies that have already raised funds through ICOs can be sure the SEC has its eyes on them. Companies thinking about a future offering need to take compliance seriously – and start out on the right side of federal securities laws.
Article by Gretchen Helfrich