On November 29, 2018, the SEC announced that it had settled charges with boxer Floyd Mayweather Jr. and music producer DJ Khaled for failing to disclose payments they received for promoting investments in Initial Coin Offerings (ICOs). In the following guest post, John Reed Stark, the President of John Reed Stark Consulting and former Chief of the SEC’s Office of Internet Enforcement, takes a look at the SEC’s actions against Mayweather and Khaled and identifies some important takeaways from the SEC’s orders. I would like to thank John for his willingness to allow me to publish his article on this site. I welcome guest post submissions from responsible authors on topics of interest to this site’s readers. Please contact me directly if you would like to submit a guest post. Here is John’s article.
Never in the history of securities regulation has there been more distortion, spin and deception than in the crazy, mixed-up world of initial coin offerings (ICOs).
Imagine an entire industry rising up where just about everything related to that industry is blatantly unlawful and often flat-out fraudulent. That is the nature of the ICO space and that is why it is critical to disregard much of the ICO noise and instead, focus on official government pronouncements relating to ICOs, especially enforcement actions taken by the U.S. Securities and Exchange Commission.
Consider last week’s announcement that professional boxer Floyd Mayweather and superstar music producer DJ Khaled pumped up ICOs without telling investors they were getting paid a promotional fee to do so.
The Enforcement actions themselves came as no surprise. In fact, I predicted the coming of SEC enforcement actions against Khaled and Mayweather over seven months ago in an article entitled, “Ten Crypto-Caveats Floyd Mayweather and DJ Khaled Should Have Heard From Their Lawyers,” published in The Harvard Law School Forum on Corporate Governance and Financial Regulation.
But what I did not predict was that the Khaled/Mayweather settled SEC enforcement administrative orders would provide such indispensable insight into the views of the SEC enforcement staff and the SEC commissioners regarding ICOs.
Specifically, within the Khaled and Mayweather SEC orders, the SEC offers five critical takeaways, which every purveyor of ICOs and every fintech legal practitioner should keep in mind:
- ICOs Constitute the Sale of Securities.Despite all the misguided hoopla, the preliminary injunction decision in the SEC Blockvest enforcement action does not portend a weakening or abating of the SEC’s view of ICOs. From the SEC’s perspective, every ICO falls into one of three categories: 1) registered; 2) exempt; or 3) unlawful — and every ICO the SEC has ever seen typically falls squarely into the third “unlawful” category. End of story.
- Promotion Bans are the New Thing.The Khaled and Mayweather enforcement actions evidence the genesis of a new SEC enforcement weapon, the “promotion bar,” which is not derived from on any statute and appears to be a new SEC “equitable” invention.
- Disgorgement Gets Some New Life.The Khaled and Mayweather enforcement actions have given new meaning to, and injected new life into, the traditional SEC enforcement remedy of disgorgement.
- Beware ICO “Finders.” The Khaled and Mayweather enforcement actions send a stern warning not only to ICO promoters but also to so-called “finders,” the international legion of ICO peddlers who receive transaction-based compensation for any generated ICO-related sales.
- YouTube ICO Promoters, the SEC Man Cometh.With the proliferation and hype surrounding the ICO marketplace, it is not surprising that ICO-related informercials have become programming staples on YouTube. These YouTube advertisements raise a range of SEC regulatory issues, from prohibited stock promotions and illegal stock sales to flat out fraud, deceit and chicanery. The purveyors of these YouTube videos are on the SEC’s radar and the SEC’s Khaled and Mayweather orders signal that the days of YouTube ICO and other crypto-financing promotions may be numbered.
This article discusses these five imperative takeaways gleaned from the Khaled/Mayweather SEC enforcement actions, harkening a grim future for the ICO marketplace and perhaps an end to the ongoing disinformation campaign by ICO promoters, affiliates and other interested parties. But first some background.
Section 17(b) of the Securities Act
The SEC charged Khaled and Mayweather with violations of Section 17(b) of the Securities Act of 1933 (Section 17(b)), a little-known and rarely used federal statute, enacted a year or so before the SEC was even created.
Section 17(b) addresses the aged old fraud scheme known as “touting,” which is when paid shills promote stocks with the appearance of being objective – when they are not objective at all. Section 17(b) mandates that if a person is paid to promote a security, then they must disclose the nature, source and amount of that compensation. Section 17(b) essentially prohibits the publication of paid for descriptions of securities without full disclosure of the compensation arrangement.
There is very little legislative history surrounding Section 17(b) except that it was “particularly designed to meet the evils of the tipster sheet, as articles in newspapers or periodicals that purport to give an unbiased opinion but which opinions in reality are bought and paid for.” But despite the lack of legislative history, ICO promotional efforts, whether conducted via social media outlets, YouTube videos or just a megaphone, all raise serious concerns about securities violations of section 17(b).
Unchanged since its enactment in 1933, with no rules or regulations ever promulgated thereunder, the SEC started out charging Section 17(b) to combat touting fraud in a variety of mediums, including brochures, newsletters, and radio talk shows – wherever touters attempted to disguise their paid promotions as independent, objective analysis.
But that all changed in the early 1990s, when the Internet grew into an important tool for investors and unlawful touting of securities began to spread in cyberspace, including websites, newsletters, spams (electronic junk mail), and then online message boards, discussion forums and now, social media. Since then, the SEC has dusted off Section 17(b) on a variety of occasions.
For instance, in the late 1990s, the SEC initiated a series of Section 17(b) Internet “sweeps,” the first in October 1998 and the next in February 1999. These coordinated anti-touting roundups, led then by the SEC’s Office of Internet Enforcement consisted of more than 25 separate enforcement actions against more than 50 individuals and companies, garnering tremendous publicity at the time, and virtually eliminating the unlawful online promotion practice entirely, while simultaneously stunting the growth of unlawful securities offerings as well.
What makes Section 17(b) such a powerful statutory weapon 17(b) is that Section 17(b) is a strict liability statute. Strict liability exists when a defendant is liable for committing an action regardless of what their intent or mental state was when committing the action. This means that a Section 17(b) violation does not require a finding of fault (such as negligence or tortious intent). The SEC need only prove that the ICO promotion occurred without the proper disclosure and that the defendant was responsible for the act of the publication.
In other words, even though Khaled and Mayweather (or apparently, their lawyers) likely never even heard of Section 17(b), Khaled and Mayweather could still be found guilty nonetheless.
The Khaled and Mayweather SEC Enforcement Actions
On November 29, 2018, the SEC enforcement staff charged Khaled and Mayweather with violations of Section 17(b). Specifically, the SEC alleged that Mayweather failed to disclose promotional payments from three ICO issuers, including $100,000 from Centra Tech, Inc.
With respect to Khaled, the SEC alleged that Khaled failed to disclose a $50,000 payment from Centra Tech, which he touted on his social media accounts as a “Game changer.” Mayweather’s promotions included a message to his Twitter followers that Centra’s ICO “starts in a few hours. Get yours before they sell out, I got mine…”
A post on Mayweather’s Instagram account predicted he would make a large amount of money on another ICO and a post to Twitter said: “You can call me Floyd Crypto Mayweather from now on.” The SEC order found that Mayweather failed to disclose that he was paid $200,000 to promote the other two ICOs.
Without admitting or denying the findings, Mayweather and Khaled agreed to pay disgorgement, penalties and interest. Mayweather agreed to pay $300,000 in disgorgement, a $300,000 penalty, and $14,775 in prejudgment interest. Khaled agreed to pay $50,000 in disgorgement, a $100,000 penalty, and $2,725 in prejudgment interest. In addition, Mayweather agreed not to promote any securities, digital or otherwise, for three years, and Khaled agreed to a similar ban for two years (more on these bans later). Mayweather also agreed to continue to cooperate with the investigation.
Mayweather and Khaled’s promotions came after the SEC issued its DAO Report in 2017 warning that coins sold in ICOs may be securities and that those who offer and sell securities in the U.S. must comply with federal securities laws. In April 2018, the Commission filed a civil action against Centra’s founders, alleging that the ICO was fraudulent. The U.S. Attorney’s Office for the Southern District of New York filed parallel criminal charges.
A New Era for Section 17(b)
These first-of-their-kind SEC actions ushered in a new era of Section 17(b) enforcement, this time targeting ICO promoters. SEC Enforcement Division Co-Director Stephanie Avakian stated about the Khaled and Mayweather enforcement actions:
“These cases highlight the importance of full disclosure to investors. With no disclosure about the payments, Mayweather and Khaled’s ICO promotions may have appeared to be unbiased, rather than paid endorsements.”
SEC Enforcement Division Co-Director Steven Peikin similarly warned:
“Investors should be skeptical of investment advice posted to social media platforms, and should not make decisions based on celebrity endorsements. Social media influencers are often paid promoters, not investment professionals, and the securities they’re touting, regardless of whether they are issued using traditional certificates or on the blockchain, could be frauds.”
The SEC’s investigation, which is continuing, was supervised by the Cyber Unit, a specialized group of enforcement staff dedicated to cyber-related frauds such as ICOs. This is not the first SEC specialized unit to manage cyber-crimes.
From 1998 – 2009, before being merged with the SEC’s Office of Market Intelligence, the SEC created the Office of Internet Enforcement (OIE), the SEC’s first specialized cyber group. OIE led a broad range of SEC enforcement actions, initiatives and investigations, many filed parallel to criminal prosecutions. The original cyber group faced a similar threat in the form of unlawful touting and unlawful offerings conducted via the Internet and came out swinging against those frauds, leading five Internet fraud sweeps in its first two years.
Clearly, ICOs and other cryptocurrency issues have become the primary focus of the SEC’s new cyber group, and if history is at all telling, should similar ICO promotions continue, charging crypto-related Section 17(b) cases will be prominent among the re-activated cyber group’s continuing prosecutorial maneuvers.
Given the SEC’s formation of its own specialized squadron, whose principle function is to investigate and prosecute cyber and crypto-related frauds, ICO purveyors should be sounding the alarm – and should also read carefully the Khaled and Mayweather orders, because there are five critical messages, albeit somewhat hidden and nuanced, contained therein.
Message #1: Blockvest Was Not a Harbinger of Any Kind: The Headlines Were “Fake News”
On November 27, 2018, in a matter involving an allegedly fraudulent ICO by a company called Blockvest, the Honorable Judge Gonzalo Curiel of the United States District Court for the Southern District of California denied the SEC’s motion for a preliminary injunction against the promoters of the Blockvest ICO.
For ICO true believers, exuberance was in the air as news banners proclaimed that for the first time in history, a U.S. federal judge held that an ICO was not a security and therefore outside of SEC jurisdiction. Some examples of the headlines:
- “Judge to SEC: You Haven’t Shown This ICO Is a Security Offering” (The Recorder)
- “US Court Dismisses SEC’s Claims That Blockvest Sold Unregistered Securities,” (BTC Thereom.com)
- “Monumental: Federal Court Rules Case in Favor of Crypto ICO Against SEC” (CCN)
- “SEC Fails to Show Court Blockvest Tokens Are Securities” (Bitcoin.com)
- “Not So Fast: Court Rules Against SEC, Finding It Did Not Prove Blockvest Sold Tokens as Securities.” (Fenwick.com)
- “SEC Fails to Show Court Blockvest Tokens Are Securities.” (Dachcoin)
- “SEC Handed Setback on Whether Digital Tokens Are Securities” (Bloomberg)
The only problem with the above headlines and so many other headlines just like them: They are all dead wrong, and given especially the Khaled and Mayweather actions, sending an ill-advised and imprudent message about ICOs.
The SEC Blockvest TRO
News about the SEC’s Blockvest enforcement matter first came to light on October 11, 2018, when the SEC announced that it had obtained a temporary restraining order (TRO) halting a planned ICO of digital tokens called “BLVs.” The order also halted ongoing “pre-ICO” sales by the company, Blockvest LLC and its founder, Reginald Buddy Ringgold, III.
The unsealed SEC complaint alleged that Blockvest falsely claimed its ICO and its affiliates received regulatory approval from various agencies, including the SEC. According to the SEC’s complaint, Blockvest and Ringgold, who also goes by the name Rasool Abdul Rahim El, were using the SEC seal without permission, a violation of federal law, and falsely claiming their crypto fund was “licensed and regulated.”
The complaint also alleged that Ringgold promoted the ICO by creating a fictitious regulatory agency, the “Blockchain Exchange Commission,” or “BEC,” which he claimed “regulates” the “Blockchain Digital Asset Space,” supposedly to “protect” digital asset investors. But the SEC alleges that BEC is not a regulator at all. It falsely conjures similarities to the SEC: its logo is similar to the SEC’s; its mission statement is cribbed from the SEC’s own; and its offices share the same address as SEC headquarters. The Block.vest website allegedly linked directly from the BEC seal to the SEC’s website. Ringgold allegedly promoted the Blockvest offering and the BEC side-by-side, further conveying a false veneer of legitimacy to the Blockvest ICO.
Blockvest and Ringgold also allegedly misrepresented Blockvest’s connections to Deloitte, a well-known accounting firm, and continued their fraudulent conduct even after the National Futures Association (NFA) sent them a cease-and-desist letter to stop them from using the NFA’s seal and from making false claims about their status with that organization.
Judge Curiel issued the TRO, freezing the defendants’ assets and granting other emergency relief. A hearing was eventually scheduled for November 16th, 2018, to consider continuing the asset freeze and issuance of a preliminary injunction.
The SEC’s complaint charges Blockvest and Ringgold with violating the antifraud and securities registration provisions of the federal securities laws. The complaint seeks injunctions, return of ill-gotten gains plus interest and penalties, and a bar against Ringgold to prohibit him from participating in offering any securities, including digital securities, in the future or making misrepresentations about regulatory approval.
Judge Gonzalo Curiel Denies the SEC’s Preliminary Injunction Request
On Tuesday, November 27, 2018 Judge Gonzalo Curiel denied the SEC’s request to continue the TRO and extend that order into a preliminary injunction – and set the case for trial.
Judge Curiel held that, at this stage of the case, the SEC had not shown that the BLV tokens were securities under the Howey Test, a decades-old test established by the U.S. Supreme Court for determining whether certain transactions are investment contracts and thus securities.
The Howey Test
In a typical ICO, virtual coins or tokens are distributed by a company to the public in exchange for another cryptocurrency or fiat currency. These coins or tokens come with particular rights, such as: a right to access to a future service once the ICO is launched; a right to redeem the token for a currency or service; or a right to receive future profits from the company (like a dividend).
To determine how traditional securities regulation applies to ICOs, the four-pronged Howey Test, derived from the 1946 Supreme Court decision in SEC vs. W.J. Howey Co., states that a security is an investment contract in which a person 1) invests their money; 2) in a common enterprise; 3) with an expectation of profits; 4) based on the efforts of the promoter or a third party. In order to be considered a security, an offering must meet all four prongs.
Rather than prospectuses, token issuers put out so-called “white papers” describing the platform, software or product they are trying to build, and then investors buy those tokens typically using widely-accepted cryptocurrencies (like bitcoin and ethereum) or fiat currencies like the U.S. dollar. These issuers also often employ promoters and facilitators to generate interest, excitement and participation in the ICO.
Historically, the courts and the SEC have taken an extremely broad view of whether any kind of investment is a security. Indeed, the definition of “security” under Section 2(a)(1) of the Securities Act of 1933 (and the nearly identical definition under Section 3(a)(10) of the Exchange Act of 1934) includes not only a number of specific types of financial instruments, such as notes, bonds, debentures and stock, but also broad categories of financial instruments, such as evidences of indebtedness and investment contracts. The definition of security was crafted to contemplate not only known securities arrangements at the time, but also to encompass any prospective instruments created by those who seek the use of the money of others on the promise of profits.
The DAO 21(a) Report
On July 25, 2017, the SEC provided important initial guidance on its views of whether ICOs are securities when it released a Section 21(a) Report of Investigation on its findings regarding the token sale by The DAO. The SEC’s Report of Investigation found that tokens offered and sold by a “virtual” organization known as “The DAO” were securities and therefore subject to the federal securities laws.
In making this determination, the SEC focused on whether the efforts of others were “the undeniably significant ones … that affect the failure or success of the enterprise.” The SEC found that the so-called curators of the DAO played the requisite role. The curators held themselves out as experts in, among other matters, the blockchain protocol, determined which projects would be voted on by DAO Token holders, addressed security issues and more generally held itself out in marketing materials as a group that investors could rely on for their managerial efforts.
The SEC also concluded that the voting rights of the DAO Token holders were limited, noting, “[e]ven if an investor’s efforts help to make an enterprise profitable, those efforts do not necessarily equate with a promoter’s significant managerial efforts or control over the enterprise.” The SEC concluded that the voting rights of DAO Token holders was largely “perfunctory.” Since they could only vote on projects approved by the curators, token holders did not receive sufficient information to vote in a meaningful way, and there were no means to obtain additional information.
Equally important, the SEC also noted: that the widely dispersed DAO Token holders could not identify and effectively communicate with each other; that there was a large number of them; and that they could not be deemed to be in a position to effectuate meaningful control.
The SEC message to the purveyors of ICOs was clear: ICOs are very likely selling plain-old shares of stock fancifully masquerading as tokens — and their offer and sale would need to be registered under the Securities Act or qualify for an exemption from registration.
If the token offering is exempt from registration, the offering must adhere to a range of important restrictions, including: that the sale be made to accredited investors; that the tokens be subject to limitations on resales or transfers; and that there be no general solicitation involved. Regardless of whether the offering is registered or exempt, careful consideration would also have to be given to ensuring that prospective investors receive sufficient disclosure about the offering, including associated risks.
Blockvest Fights Back
Blockvest asserted that its offering was not an ICO, but was rather a “Pre-ICO” for a group of 32 “test” investors, and the BLV tokens were only designed for testing its platform. Judge Curiel seemed to buy into this notion, stating:
“While defendants claim that they had an expectation in Blockvest’s future business, no evidence is provided to support the test investors’ expectation of profits.”
The SEC responded to Blockvest’s defense by noting that various individuals wrote “Blockvest” or “coins” on their checks and were provided with a Blockvest ICO white paper describing the project and the terms of the ICO. But Judge Curiel still found that, without further discovery, there remained disputed issues of fact which could only be properly determined at trial, stating:
“Plaintiff and Defendants provide Starkly different facts as to what the 32 test investors relied on, in terms of promotional materials, information, economic inducements or oral presentations at the seminars, before they purchased the test BLV tokens. Therefore, because there are disputed issues of fact, the Court cannot make a determination whether the test BLV tokens were securities” under the first prong of Howey. (emphasis in original) . . . As to the second prong of Howey, Plaintiff has not demonstrated that the test investors had an “expectation of profits.” While Defendants claim that they had an expectation in Blockvest’s future business, no evidence is provided to support the test investors’ expectation of profits. ‘By profits, the Court has meant either capital appreciation resulting from the development of the initial investment . . . or a participation in earnings resulting from the use of investors’ funds. . . . At this stage, without full discovery and disputed issues of material facts, the Court cannot make a determination whether the BLV token offered to the 32 test investors was a security. Thus, Plaintiff has not demonstrated that the BLV tokens purchased by the 32 test investors were “securities” as defined under the securities laws.”
What investors actually believed about Blockvest will undoubtedly be revealed during trial. Granted, if Blockvest’s assertions are true i.e. that the investors had no expectation of any profit, then ruling that the tokens are not securities might make sense. But given the hundreds of pages the SEC filed in a slew of declarations, websites, chat transcripts, videos and other SEC evidence set forth meticulously in the SEC complaint, this assertion not only defies common sense – it is laughable. Based on my experience, no one invests in an ICO without the expectation that they will make some sort of profit – why else invest? It would be like buying a company’s stock solely to receive a discount on its products, and not a very attractive investment principle.
Blockvest Essentially Consents to the Preliminary Injunction
What so many commentators have missed in their analysis of Blockvest is that Blockvest and Ringgold essentially consented to the preliminary injunction, leaving Judge Curiel with little reason to grant a motion mandating that the defendant do something that they have already agreed to do. Judge Curiel notes:
“While there is evidence that Ringgold made misrepresentations shortly after the complaint was filed and prior to having retained counsel, Ringgold, with counsel, now asserts he will not pursue the ICO and will provide SEC’s counsel with 30 days’ notice in the event they decide to proceed. By agreeing to stop any pursuit of the ICO, Plaintiff does not oppose the preliminary injunction concerning compliance with federal securities laws. Therefore, Plaintiff has not demonstrated a reasonable likelihood that the wrong will be repeated. Because Plaintiff has not demonstrated the two factor test to warrant a preliminary injunction, the Court DENIES Plaintiff’s motion for preliminary injunction” (emphasis in original)
What Does the Blockvest Ruling Actually Mean?
Nothing in Judge Curiel’s ruling prohibits the SEC from taking Blockvest and Ringgold to trial. Rather it just means that the SEC did not meet the high burden required to receive a preliminary injunction of proving (1) a prima facie case of previous violations of federal securities laws, and (2) a reasonable likelihood that the wrong will be repeated.
Judge Curiel simply determined that, at this stage, without full discovery regarding the disputed issues of material facts, he could not decide whether the BLV token were securities. Moreover, since Blockvest and Ringgold agreed to stop the ICO and provide 30 days’ prior notice to the SEC if they ever intended to move forward with their ICO, Judge Curiel decided no reasonable likelihood that the wrong would be repeated. As a result, Judge Curiel denied the SEC’s motion for a preliminary injunction.
Despite what many of the Blockvest-related headlines imply, this was not a victory for the ICO industry or a setback for the SEC. Judge Curiel’s ruling does not mean that the SEC is going to reconsider its current ICO enforcement posture. In fact, a close reading of the Khaled and Mayweather orders reveals that the SEC is not concerned in the least about the Blockvest preliminary injunction decision, and that the SEC continues to view ICOs as securities.
In the Khaled and Mayweather orders, there is no discussion of Howey, not even a mention or reference. That the promoted ICOs are securities is presumed. If the SEC was concerned about ICOs and the Howey test, the SEC would have made sure the Khaled and Mayweather orders contained a discussion of Howey’s multiple prongs. The SEC, instead, opted to state in a conclusory manner that the ICOs were securities. Period. End of story.
Message #2: The SEC Has a New Enforcement Weapon — The Promotion Bar
Perhaps never before seen in an SEC enforcement action, at the tail end of each of the Khaled and Mayweather consent orders is an equitable remedy, framed as an undertaking, where each defendant promises for a fixed period of time never to promote any sort of investment. Khaled’s promise is for two years and Mayweather’s is for three years. This “promotion bar” has no statutory basis, but the SEC has imposed it upon Khaled and Mayweather nonetheless.
Specifically, Khaled undertook to:
“ . . . for a period of two (2) years from the date of this Order, forgo receiving or agreeing to receive any form of compensation or consideration, directly or indirectly, from any issuer, underwriter, or dealer, for directly or indirectly publishing, giving publicity to, or circulating any notice, circular, advertisement, newspaper, article, letter, investment service, or communication which, though not purporting to offer a security, digital or otherwise, for sale, describes such security.”
Mayweather similarly undertook to:
“ . . . for a period of three (3) years from the date of this Order, forgo receiving or agreeing to receive any form of compensation or consideration, directly or indirectly, from any issuer, underwriter, or dealer, for directly or indirectly publishing, giving publicity to, or circulating any notice, circular, advertisement, newspaper, article, letter, investment service, or communication which, though not purporting to offer a security, digital or otherwise, for sale, describes such security.”
The explicit authorization to bar an individual from otherwise legal conduct was first given to the SEC by Congress in the Securities Enforcement Remedies and Penny Stock Reform Act of 1990 (Remedies Act). For the first 50 years of its history, the SEC relied on courts’ broad equitable powers to obtain bars and, as a group of securities lawyers at Clyde Snow & Sessions noted after studying the issue, initially used the remedy sparingly.
After the financial crisis, however, the SEC began crafting conduct-based bars with increasing creativity and demanding them with accelerating frequency. These bars provide greater flexibility for the SEC to target specific areas of misconduct. Generally, the SEC has used conduct-based bars largely in settled resolutions outside of the analytical framework established by judges.
By their very nature, conduct-based bars seek to enjoin conduct that is not itself a violation of securities laws. Yet, conduct-based bars do not enjoy the same clear statutory basis as officer-and-director, securities industry bars or penny stock bars. Along these lines, per the team at Clyde Snow & Sessions, the SEC began to stray from its statutory roots, and obtained orders barring individuals from:
- Offering mortgage-backed securities;
- Soliciting investors to purchase or sell securities;
- Conducting classes, workshops, or seminars about securities trading; and
- Offering or selling securities from any entity controlled by the defendant.
The SEC has also been creative concerning the curbing of day-trading abuses in the early 2000s, goings far as to impose (via consent) a five year bar against an individual, curtailing his so-called day-trading practices.
But the Khaled and Mayweather promotion bars have taken the use of conduct-based bars to a new level. The remedy of a promotion bar, which encumbers upon the First Amendment right of free speech, is a leap forward by the SEC and a clear signal of the gravity of ICO related misconduct.
Even during the SEC’s Section 17(b) sweeps and SEC microcap fraud sweeps of the late 1990s, the SEC never sought or obtained stock promotions bars for the miscreants involved (including for those prosecuted criminally in parallel prosecutions by the U.S. Department of Justice).
The closest analogy to the SEC’s new promotions bars dates back to January 5, 2000, when the SEC filed civil charges against Yun Soo Oh Park (popularly known as “Tokyo Joe”), a stock touting websites which had garnered an almost fanatical following during an era when stock-picking websites were too often criminally entangled with microcap stock companies and had emerged as a serious threat to main street investors. “Tokyo Joe” allegedly charged investors up to $200 a month for a daily diet of stock touts and trading advice, and took in $1.1 million in the twelve-month period ending June, 1999.
Without admitting or denying wrongdoing, Park eventually settled with the SEC, paying $324,934 in ill-gotten gains and $429,696 in civil penalties, and via consent decree, agreed to a court order that permanently enjoined him from violating federal securities laws. Park also consented to a virtual Scarlett Letter, promising to post a link from his website to the court order against him for 30 days.
At the time, the Tokyo Joe the SEC’s mandated posting that the SEC imposed upon Park seemed more like an aberration rather than the start of something new. But now, given the Khaled and Mayweather SEC orders, perhaps not so much. The SEC views ICO abuses as a plague – the same way the SEC viewed bogus stock-picking websites as a plague back in the 1990s. Along those lines, it appears that the SEC is once again ticked off and getting resourceful.
Message #3: The SEC Has Broadened its Powers of Disgorgement
Disgorgement is the repayment of ill-gotten gains that is imposed on wrongdoers by the courts. Funds that were received through illegal or unethical business transactions are disgorged, or paid back, with interest to those affected by the action.
Disgorgement is not a remedy typically associated with stand-alone Section 17(b) violations because there exists no impacted investor or other victim to “pay back” the disgorgement. For example, in the SEC’s Section 17(b) sweeps and SEC microcap fraud sweeps of the late 1990s, the SEC never sought disgorgement of the moneys paid to promoters for touting. Rather, the SEC only sought disgorgement awards where there were actual victims, such as when a defendant unlawfully profited from stock trading, where the seller of the stock was considered the victim of the scheme.
However, in the settled orders against Khaled and Mayweather, each undertook to pay disgorgement of the compensation they received from the ICO issuers (Khaled agreed to pay $300,000 and Mayweather agreed to pay $50,000). So who did the SEC decide should receive the $300,000 Khaled earned and the $50,000 Mayweather earned? Not the ICO issuers – but rather, the U.S. Treasury.
By remitting Khaled and Mayweather’s disgorgement to the U.S. Treasury, which is remedial rather than punitive, the SEC turns the notion of disgorgement on its head. This is a sea-change for disgorgement and yet another aggressive and innovative effort by the SEC to enhance its ICO crackdown, while sending a strong message to the ICO marketplace.
Message #4: Beware ICO “Finders” – You’re Next
The Khaled and Mayweather enforcement actions were not only a shot across the bow against ICO promoters but also against co-called ICO “finders,” the international legion of ICO peddlers who are conducting unlicensed broker-dealer activity relating to ICO-related sales. I typically receive a few of these pitches each week, sometimes via email and sometimes via LinkedIn. Here are two of them:
I am not rendering any sort of opinion on the actual investment pitched in these emails, but these kinds of solicitations are troubling.
For starters, the sales team behind these emails might think of themselves as “finders” and not required to register with any federal agency. However, what they are likely missing is that the existence of a “finder’s exemption” from the SEC’s broker-dealer registration requirements has always been more fiction than fact.
The confusion all dates back to 1991, when the SEC Staff issued a no-action letter stating that singer Paul Anka was not required to register as a broker-dealer despite his assistance with a distribution of limited partnership interests in a Canadian hockey team (the Senators). In return for his referrals, Mr. Anka was entitled to receive a ten percent commission on sales to any person whom he recommended.
SEC no-action letters involve situations where an individual or entity is not certain whether a particular product, service, or action would constitute a violation of the federal securities law – and then requests a “no-action” letter from the SEC staff. Most no-action letters describe the request, analyze the particular facts and circumstances involved, discuss applicable laws and rules, and, if the staff grants the request for no action, concludes that the SEC staff would not recommend that the Commission take enforcement action against the requester based on the facts and representations described in the individual’s or entity’s request.
The no-action relief is provided to the requester based on the specific facts and circumstances set forth in the request. In some cases, the SEC staff may permit parties other than the requestor to rely on the no-action relief to the extent that the third party’s facts and circumstances are substantially similar to those described in the underlying request. In addition, the SEC staff reserves the right to change the positions reflected in prior no-action letters.
With respect to the Anka no-action letter, the no-action position were not only narrowly tailored to allow Anka only to provide a list of names and telephone numbers of possible investors and to have no further contact or involvement in the transaction. But, as Latham and Watkins has noted in their client advisories, the SEC has since indicated that they would not issue the Anka letter today.
“Finder” Registration Requirements
One of the more critical federal and state regulatory registration requirements relating to an ICO is that of broker-dealer activity. Specifically, Section 15(a)(1) of the Securities Exchange Act of 1934 makes it unlawful for a person to “effect a transaction in securities” or “attempt to induce the purchase or sale of, any security” unless they are registered as a broker or dealer under the rules and regulations of FINRA, the regulatory organization designated by the SEC to license and regulate broker-dealers.
The ramifications for failure to register as a broker-dealer are severe, even criminal. Section 29(b) of the Exchange Act provides that every contract made in violation of any provision of the broker-dealer registration requirements “shall be void” as to rights of persons who made or engaged in the performance of such contract. It results in the underlying purchase of securities becoming a voidable transaction that gives the investor a right of rescission, so for purchasers losing money on the investment, there is an instantaneous and simple claim to get a refund of their investment.
Moreover, Section 20(e) of the Exchange Act, under which the SEC may impose aiding-and-abetting liability on any person that knowingly or recklessly provides substantial assistance in a violation of the Exchange Act, creates additional potential liability. Finally, merely retaining and permitting an unlicensed intermediary to help facilitate or effect a securities transaction (such as an ICO) may be a violation of federal and many state laws and may subject the issuer to possible civil and criminal penalties.
In accordance with these fairly stringent requirements, when a person is at all engaged in facilitating or helping conduct an ICO (like a sending me an ICO solicitation), the person may be required to register as a broker-dealer with the SEC. For instance, many ICO promoters and affiliates negotiate payment of “success fees” upon completion of an ICO-related transaction or arrange for some other iteration of transaction-based compensation. Even if the arrangement conceals the true intent of the relationship, payment of transaction-based compensation i.e., a commission or some form of compensation that varies with the size or type of the resulting investment, is treated by the SEC as a nearly-conclusive indication that a person is engaged in the securities business and should be registered as a broker-dealer.
The Venable law firm analyzed the issue of finders intensely, and notes that there is very little that a finder may do without crossing the line into activities that may trigger the requirement to register as a broker-dealer. While the SEC has consistently viewed transaction-based compensation as the “hallmark” of broker dealer activity, the Venable law firm cites the following other factors as typical of broker activity, where the person involved may need to be a registered broker-dealer. This extensive list, based on prior SEC regulatory pronouncements, speeches, no-action letters, etc., demonstrates the wide breadth of Section 15(a) and includes:
- Participates in discussions and negotiations between the issuer and the potential investors;
- Assists in structuring transactions;
- Engages in “pre-screening” potential investors to determine their eligibility to purchase securities;
- Engages in “pre-selling” the issuance to gauge the level of interest;
- Conducts or assists with the sale of securities;
- Provides advice regarding the value of securities;
- Locates issuers on behalf of investors;
- Solicits new clients;
- Disseminates quotes for securities or other pricing information;
- Actively (rather than passively) finds investors;
- Sends private placement memoranda, subscription documents, and due diligence materials to potential investors;
- Advises on portfolio allocations to accommodate an investment;
- Provides analyses of potential investments; and
- Provides potential investors with confidential information identifying other investors and their capital commitments.
Thus, when pitching an ICO, even as simple as a LinkedIn email solicitation, the ICO could become immediately and irrevocably tainted.
Broker-dealers are supposed to serve as gatekeepers to protect investors in the marketplace and are required to “observe high standards of commercial honor and just and equitable principles of trade” in the conduct of its business, including determining if an investment is “suitable” for its customer and maintaining meticulous records of communications, representations, transactions and other important information. Broker-dealers also are subject to SEC and FINRA examination together with a broad range of regulations and rules of conduct.
One final note: the SEC considers the principle of gatekeeper registration sacrosanct, broadly construing the broker-dealer laws while narrowly construing the few permitted exceptions. So-called ICO finders will find little sympathy from SEC staff, no matter how well-intentioned or poorly advised.
Message #5: YouTube ICO/Crypto Promoters, You’re Days May be Numbered
With the proliferation of, and the hype surrounding, the ICO/crypto marketplace, it is not surprising that ICO-related informercials have been sprouting up all over YouTube. With respect to ICO-related YouTube promotions and advertising, the SEC can assert their jurisdiction anytime – and take enforcement action when appropriate.
In fact, the SEC has historically policed aggressively securities violations occurring over YouTube, whether relating to stock promotions; Ponzi schemes, pyramid schemes or any other get rich quick video pitch. The SEC has even gone so far as suspending trading in the stock of companies who touted their stock over infomercial like promotional videos on YouTube.
For instance, on March 20, 2008, the SEC suspended trading in the securities of three companies that had not adequately disclosed information to investors and have been the subject of spam e-mail campaigns and promotional videos on the Internet site YouTube.
The videos often repeated information in the companies’ press releases and are posted to coincide with traditional spam e-mail campaigns. The SEC issued an order finding that each of the companies subject to the trading suspension — NeoTactix Corporation (NTCX), Graystone Park Enterprises, Inc. (GPKE), and Younger America, Inc. (YNGR) — had inadequately disclosed its assets, business operations, and current financial condition. The SEC still maintains an archive of these YouTube infomercials – which can be viewed here.
A Side Note on Settled SEC Administrative Orders
It is important to note that the Khaled/Mayweather SEC enforcement actions are not actual federal cases, but are instead, settled SEC administrative actions. This means that with respect to both the Khaled and Mayweather matters:
- No Article III Judge approved the SEC settlements, or ever even considered either matter;
- The SEC Office of the Secretary actually signed the orders (Brent Fields, who is appointed by the SEC Chairman);
- Neither matter was adjudicated in any way by an SEC administrative law judge, which means no discovery, no court rulings, no trial, etc.; and
- The SEC enforcement staff drafted the order, which the Secretary then signed, perhaps with a few edits or perhaps with no edits at all.
But having said the above, the Khaled /Mayweather orders offer an official SEC enforcement division pronouncement relating to the future of ICOs. Moreover, most seasoned SEC lawyers would agree that settled SEC administrative actions have important precedential value – and typically command careful and thoughtful analysis and consideration.
The SEC formally launched its cryptocurrency regulatory efforts with a July 25, 2017 Investor Bulletin warning investors about ICOs and, issued that same day the 21(a) Report of Investigation explaining how ICOs are unlawful.
During the ensuing months, SEC Chairman Clayton launched his own crypto-tour asserting over and over again that cryptocurrency tokens looked like securities and were susceptible to fraud and chicanery by insiders, management and better-informed traders and market participants. Over and over again, Chairman Clayton explained to everyone who asked, including Congress, “I believe every ICO I have ever seen is a security . . . ICOs should be regulated like securities offerings. End of Story.”
But the most telling of all of Chairman Clayton’s ICO-related proclamations came when he and none other than Senator Elizabeth Warren metaphorically joined hands. (Yes, that Senator Warren, the one who opposed Chairman Clayton’s nomination and who pretty much combats most everything any Republican in Washington, D.C. has ever wanted to do.) Witness this awkward exchange during a February, 2018 hearing on cryptocurrencies:
Senator Warren: “In 2017, companies raised more than $4 billion in ICOs. How many of those ICOs registered with the SEC?”
Chairman Clayton: “Not one.”
Senator Warren: “As of today, how many companies have registered for upcoming ICOs?”
Chairman Clayton: “Not one.”
Senator Warren: “Why?”
Chairman Clayton: “I don’t think the gatekeepers that we rely on to assist us to ensure our securities laws are followed have done their job. . . . What ICOs do is they take the disclosure-like benefits of a private placement and then add to it the public general solicitation and retail investor promise of a secondary market without registering with us. And folks somehow got comfortable that this was new, and it was OK and it was not a security and just some other way to raise money. Well, I disagree.”
Senator Warren: “So it is new, but it’s not OK, and it’s not another way to raise money?’
Chairman Clayton: “Correct.”
The Khaled and Mayweather actions not only reinforce the Chairman’s concerns and viewpoints exponentially, but the matters also roll out a new arsenal of ICO-fighting weaponry, like the promotions bar and the launching of disgorgement 2.0. Despite the headlines and continuing ICO euphoria, the SEC has not stymied or otherwise adjusted its ICO dragnet because of the Blockvest decision. Quite to the contrary,
Moreover, like the Section 17(b) sweeps of the 1990s, which in one fell swoop put an end to most of the unlawful touting perpetrated over the Internet, the Khaled and Mayweather actions could do the same for using social media to promote ICOs and stop the practice dead in its tracks.
As for the future, my take is that the SEC will soon set its sights on the global mass of: 1) so-called finders who are receiving transaction-based compensation to peddle ICOs and other crypto-related related investments; and 2) crypto-touting YouTubers, whose shameless infomercials, masquerading as CNBC-esque news shows, are emerging as a genuine threat to retail investors.
Just like charging promoters with Section 17(b), charging finders with Section 15(a) (failure to register as a broker-dealer) is a strict liability statute — and, for the SEC, enforcing strict liability statutes is like shooting fish in a barrel.
In addition to being so easily prosecuted, ICO finders and YouTubers are also easy to catch. By opting to exploit YouTube and other social media platform’s for their financial gain, ICO sponsors, promoters and affiliates actually provide enforcement staff with a cost-free, readily available and extraordinarily resplendent view into ICOs as they unfold, enabling, in many cases, the enforcement division to arrest violations before investors savings are lost.
Indeed, unlike bitcoin users such ransomware attackers, dark web drug dealers and terrorists, cryptocurrency financiers want to be found. They require a wide audience to review their information, invest in their offering or participate in their transactions. Culprits are easier to surveil, easier to track, and ultimately, easier to catch. This may yet prove to be the most profound change brought by social media on the field of securities regulation. Far from tying regulators hands, social media in particular has evolved into the virtual rope that many cyber wrongdoers use to hang themselves.
In the meantime, perhaps ICO promoters, operators and other crypto-related supporters will take heed from the Khaled and Mayweather SEC enforcement actions and clean up their acts. But then again, given their hysteria, fanaticism and worldwide misinformation campaign, I am not betting on it.
John Reed Stark is president of John Reed Stark Consulting LLC, a data breach response and digital compliance firm. Formerly, Mr. Stark served for almost 20 years in the Enforcement Division of the U.S. Securities and Exchange Commission, the last 11 of which as Chief of its Office of Internet Enforcement. He has taught most recently as Senior Lecturing Fellow at Duke University Law School Winter Sessions and will be teaching a cyber-law course at Duke Law in the Spring of 2019. Mr. Stark also worked for 15 years as an Adjunct Professor of Law at the Georgetown University Law Center, where he taught several courses on the juxtaposition of law, technology and crime, and for five years as managing director of global data breach response firm, Stroz Friedberg, including three years heading its Washington, D.C. office. Mr. Stark is the author of, “The Cybersecurity Due Diligence Handbook.”