Initial Coin Offerings and SEC Enforcement: Protecting Investors (Part I)

May 30, 2018


scam-alert-picture-id918521002.jpgBy Dan Portnov

The SEC’s Office of Investor Education and Advocacy (“OIEA”) came in hot last week with its HoweyCoin initial coin offering pre-sale – a mock ICO designed to teach cryptocurrency-hungry investors the lesson that some ICOs may be scams. It’s quite clever, actually. Complete with countdown clock, tiers of discounts and a white paper (chock full of white paper confidence), the site also features Easter Eggs for securities lawyers, like the coin’s name and that its celebrity promoters feature a generic boxing champ.

(The SEC’s first foray into contemporary public service advertising was to warn March Madness fans about investment adviser fraud. It was catchy, though not as clever.)

The HoweyCoin page attempts to combine all the ways in which cryptocurrency scammers have duped investors. ICO schemes, unfortunately, have proven successful at separating investors from their money in large part due to people eager to catch the cryptocurrency wave while not knowing exactly what a cryptocurrency is.

Over the past year, the SEC, DOJ, CFTC and IRS have each flexed their enforcement muscles within the cryptocurrency realm in significant ways:

RECoin and Diamond Reserve Coin. Founded by “real estate leader and global philanthropist” Maksim Zaslavskiy and allegedly backed by real estate and diamonds, these respective ICOs raised three hundred thousand dollars before being shut down by the US Attorney’s Office for the Eastern District of New York and the SEC. Though Zaslavskiy’s motion to dismiss is currently pending, earlier this month Judge Dearie hinted that a jury would get to decide whether the purported coins were a currency or security.

Coin Drop Markets. Two months earlier in the same courthouse where Zaslavskiy’s case remains pending, Judge Weinstein ruled that the Commodity Futures Trading Commission had standing to sue Coin Drop Markets and its principal Patrick McDonnell for fraudulent cryptocurrency trading advice and investment services. McDonnell allegedly raised money from investors for customized advice and discretionary trading in their accounts before cutting off all communications. The judge was careful to note in his order, however, that regulation of cryptocurrencies was not the exclusive province of the CFTC.

Coinbase. In 2014, the IRS first released guidance on the tax treatment of “virtual currency,” e.g. Bitcoin, that “may be used to pay for goods or services, or held for investment.” In sum, virtual currencies may be treated as capital assets in certain instances and the taxpayer may realize corresponding capital gains or losses upon their sale.

By 2016, the IRS (rightly) suspected that thousands of US taxpayers were underreporting or failing to report gains from Bitcoin trades and, with help from DOJ, filed a request to serve “John Doe” subpoenas on all customers of Coinbase, a San Francisco-based digital currency exchange. Coinbase and some of its customers fought to quash the subpoenas but, in late 2017, a judge in the Northern District of California granted in part the IRS’ request: Coinbase would have to turn over information on approximately 13,000 accounts, including names, taxpayer identification numbers and account activity during the relevant period (2013-2015).

CentraTech. In perhaps the largest ICO-based fraud to date, CentraTech raised over $32 million from thousands of investors in September 2017, boasting a crypto-debit card “backed by an actual bank” and plugged by celebrities Floyd Mayweather Jr. and DJ Khaled (neither of whom disclosed that they were paid to make the endorsement). Despite issuing investors a “Centra Card,” the operation soon ran into trouble. Investors sued the company and its founders in December 2017, with the SEC and DOJ bringing civil and criminal charges, respectively, in April 2018. Among the allegations that CentraTech’s operations were bogus: the company’s website featured fictional executive biographies with fake pictures, and debit card “partners” Visa and MasterCard disclaimed any relationship with CentraTech.

In addition to the regulators in these actions, the North American Securities Administrators Association (NASAA) has made fraudulent ICOs a priority, launching “Operation Cryptosweep”. This joint effort among 44 jurisdictions throughout the United States and Canada is responsible for almost “70 inquiries and investigations and 35 pending or completed enforcement actions related to ICOs or cryptocurrencies since the beginning of May.”[1]

It is now the SEC’s unofficial official position that ICOs can be securities offerings that may need to be registered – especially ICOs that are securities; these will “most likely need to be registered with the SEC… or fall under an exemption to registration.” Crystal clear!

Reading between the lines of recent enforcement actions, OIEA’s informational pages and Chairman Jay Clayton’s statements and remarks, it appears that the SEC views cryptocurrency offerings as securities unless a truly compelling argument or exception exists. Chairman Clayton even reminded securities lawyers – already risk-averse by nature – that providing negligent or “‘it depends’ equivocal advice” in connection with ICOs in order to dodge SEC registration requirements will draw the scrutiny of the Commission’s enforcement division.

Still, all of this is cold comfort to existing and potential cryptocurrency investors – especially those who found themselves holding Centra Cards or RECoins – as enforcement actions typically take months or years, only to return pennies on the dollar to those defrauded.

The most valuable information for cryptocurrency investors is actually appended to Chairman Clayton’s December 2017 public statement: Sample Questions for Investors Considering a Cryptocurrency or ICO Investment Opportunity. This non-exhaustive list forms the basis of a due diligence checklist for cryptocurrency investors. Having every investor demand and scrutinize responses to these questions will do more to reduce the number and audacity of ICO fraud than any crafty website or primetime TV spot.

In the upcoming Part II of our look into protecting investors from ICO fraud, we will unpack the due diligence checklist and how investors can best utilize it.

[1] (Editor’s note: an enforcement action completed in under one month? Color us impressed.)

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