John Reed Stark

On February 27, 2020, the SEC announced that it had settled charges against the actor Steven Seagal on charges that he had failed to disclose compensation he received for promoting an initial coin offering. In the following guest post, John Reed Stark, President of John Reed Stark Consulting and former Chief of the SEC’s Office of Internet Enforcement, takes a look at three important takeaways from the SEC’s order against Seagal. A version of this article originally appeared on Securities Docket. I would like to thank John allowing me to publish his article as a guest post on this site. I welcome guest post submissions from responsible authors on topics of interest to this blog’s readers. Please contact me directly if you would like to submit a guest post. Here is John’s article.

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“You guys think you’re above the law? Well, you ain’t above mine.” — Steven Seagal, as martial-arts expert and former CIA agent Nico Toscani in his 1988 breakout film, Above the Law.

“Celebrities are not allowed to use their social media influence to tout securities without appropriately disclosing their compensation.” — Kristina Littman, as newly appointed SEC Cyber Chief in her 2020 breakout enforcement action, SEC v. Seagal.

Last week, the U.S. Securities and Exchange Commission (SEC) announced that actor and famed martial artist Steven Seagal pumped up an initial coin offering (ICO) without telling investors he was getting paid a promotional fee to do so. Much like two prior 2018 SEC enforcement actions against Floyd Mayweather and  DJ Khaled, the SEC’s Seagal enforcement action came as no surprise.

However, the SEC’s Seagal case does offer a few important reminders concerning the SEC’s current cryptocurrency posture. Specifically, for legal practitioners, financial professionals, fintech consultants and the like, there are three important takeaways from the Seagal SEC order worthy of analysis:

  1. ICOs Constitute the Sale of Securities. The Seagal order reinforces the notion that, 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 within the third “unlawful” category;
  2. Promotion Bans are the New Thing. The SEC ordered a securities “promotions bar” against Steven Seagal (a three year ban), reinforcing the import of this nascent conduct-related enforcement weapon, which is not derived from any statute and appears to be a newly concocted SEC “equitable” invention (first ordered in the Khaled and Mayweather SEC actions); and
  3. The SEC Continues to Expand its Questionable Disgorgement Powers. Like the Khaled and Mayweather SEC enforcement actions, in its Seagal action, the SEC continues to broaden the traditional SEC remedy of disgorgement into somewhat unchartered territory, despite a judicial landscape less receptive of SEC disgorgement theory i.e. far more likely to restrict the SEC’s disgorgement arsenal than acquiesce to expanding it.

This article discusses the above SEC/Seagal takeaways and concludes with some guidance for looking ahead. But first some history and background.

 

Section 17(b) of the Securities Act

The SEC charged Seagal with violating 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 violations of Section 17(b).

Unchanged since its enactment in 1933, with no rules or regulations ever promulgated thereunder, the SEC began 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, 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 eliminated the unlawful online promotion practice entirely, while simultaneously stunting the growth of unlawful online securities offerings as well.

What makes Section 17(b) such a powerful statutory weapon 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 Seagal (or apparently, his lawyers) likely never even heard of Section 17(b), Seagal could still violate 17(b) nonetheless.

 

The Khaled and Mayweather SEC Enforcement Actions

On November 29, 2018, the SEC enforcement staff charged DJ Khaled and Floyd 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.”

Meanwhile, 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 also 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: 1) Mayweather agreed to pay $300,000 in disgorgement, a $300,000 penalty, and $14,775 in prejudgment interest; and 2) 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/bars below in Takeaway #2).

 

The Seagal Enforcement Action

On February 27, 2020, the SEC filed its third crypto-related 17(b) case, settling charges against famed action star Steven Seagal for failing to disclose payments he received for promoting an investment in an ICO conducted by Bitcoiin2Gen (B2G).

The SEC’s order found that Seagal failed to disclose he was promised $250,000 in cash and $750,000 worth of B2G tokens in exchange for his promotions, which included posts on his public social media accounts and a press release titled “Zen Master Steven Seagal Has Become the Brand Ambassador of Bitcoiin2Gen.” According to the SEC, a Bitcoiin2Gen press release also included a quotation from Seagal stating that he endorsed the ICO “wholeheartedly . . . excited about the management, and especially about the secure blockchain, underlying mining technology and safeguards.”

Specifically, within days of the bitcoiin press release, Seagal’s Twitter account, which had about 107,000 followers, began posting messages about the company and its imminent ICO. “Don’t miss out,” a Feb. 28, 2018, message on the Twitter account said, which was echoed the following day with “the same tout” on Seagal’s Facebook account, according to the SEC. The Facebook account had about 6.7 million followers.

Bitcoiin2Gen claimed that bitcoiin was a “superior or more advanced version” of the original bitcoin, however, after bitcoiin soared to a price of $0.76 per bitcoiin token in the midst of late 2017 cryptocurrency gold rush, the price crashed to almost zero last year. Specifically, at its peak bitcoiin had a total market value of almost $40 million. Today, the 52 million bitcoiin in circulation appear to be marked for death with a combined worth less than $10,000, according to CoinMarketCap data.

Seagal’s touts came six months after the SEC’s 2017 DAO Report warning that coins sold in ICOs may be securities. The SEC has also advised that, in accordance with Section 17(b), any celebrity or other individual who promotes a virtual token or coin that is a security must disclose the nature, scope, and amount of compensation received in exchange for the promotion.

The SEC’s order found that Seagal violated the anti-touting provisions of the federal securities laws. Without admitting or denying the SEC’s findings, Seagal agreed to pay $157,000 in disgorgement, which represents his actual promotional payments, plus $16,448.76 of prejudgment interest, and a $157,000 penalty. In addition, Seagal agreed not to promote any securities, digital or otherwise, for three years (more on his bar/ban discussed in Takeaway #2).

Kristina Littman, Chief of the SEC Enforcement Division’s Cyber Unit, clearly out for justice, stated after the settlement:

“These investors were entitled to know about payments Seagal received or was promised to endorse this investment so they could decide whether he may be biased.” 

 

Takeaway #1: ICOs are Securities.

The Seagal SEC enforcement action is the latest in a long-running crypto-crackdown by the SEC on unregistered sales of digital assets such as tokens, including a roundup of ICO promoters and facilitators paid to generate ICO interest, excitement and participation.

During the course of all of the SEC’s crypto-related litigation, the SEC has repeatedly argued that ICOs and other types of digital token offerings easily meet the so-called Howey Test and are therefore subject to the same rules around disclosure and marketing as ordinary securities.

In opposition, some outspoken members of the fintech bar, together with the SEC’s own Commissioner Hester Pierce (dubbed the “crypto-mom”), have argued that digital token offerings:

  • Are unfairly under siege;
  • Do not necessarily meet the archaic parameters of the Howey Test; and
  • Can fall outside the SEC’s jurisdiction.

The crypto-Howey clash has evolved into quite the blockbuster battle both inside and outside of the SEC, leading to much academic debate as well as an oddly rebellious and provocative rule proposal independently published by the now notoriously rogue libertarian Commissioner Hester Pierce. Along these lines, two active SEC prosecutions, SEC v. Telegram Group, Inc. and Ton Issuer, Inc  and SEC v. Kik Interactive, are on deadly ground and primed to address the crypto-Howey issue in the coming months.

Yet, despite all of the fintech hoopla, the SEC’s Seagal order (just like the SEC’s  Khaled and Mayweather orders), does not include any discussion of the Howey Test — not even a mention or reference. That the promoted ICOs are securities is presumed and axiomatic.

If the SEC was at all concerned about whether ICOs met the Howey Test, the SEC would have included a discussion of Howey’s multiple prongs in the Seagal order. Instead, the SEC opted to state in a conclusory and authoritative manner that the ICOs were securities – no ifs, ands or buts.

“ICOs that are securities offerings, we should regulate them like we regulate securities offerings, end of story,” SEC Chairman Jay Clayton said back in early 2018, testifying before the Senate Banking, Housing and Urban Affairs Committee. Clearly, Chairman Clayton has made an executive decision about the illegalities of ICOs and the like, and when drafting SEC judicial pleadings, his view requires no explication.

 

Takeaway #2: The SEC Likes its New Enforcement Weapon — The Promotions Bar.

Perhaps never before seen in an SEC enforcement action, at the tail end of each of the Khaled, Mayweather and Seagal 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 and Seagal’s are for three years. These “promotion bars” have no statutory basis, but the SEC imposed them upon Khaled, Mayweather and Seagal nonetheless.

Specifically, Khaled, Mayweather and Seagal undertook to:

“ . . . for a period of  [two (2) years for Khaled; three (3) years for Mayweather and Seagal] 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. For the first 50 years of its history, the SEC relied on courts’ broad equitable powers to obtain bars and initially used the remedy sparingly.

After the financial crisis, however, the SEC began crafting conduct-based bars with increasing creativity and seeking them more often in settlements. Conduct-based bars are hard to kill, falling outside of the purview and analytical framework of any judicial scrutiny.

By their very nature, conduct-based bars seek to enjoin conduct that is not itself a violation of securities laws. Moreover, 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, the SEC began to stray from its statutory roots, and has obtained orders barring individuals from:

Indeed, as recently as 2018, the SEC secured a conduct-based injunction in its settlement with Billy McFarland, who, according to the SEC’s complaint, fraudulently induced more than 100 investors to put over $27 million into his companies, including Fyre Festival LLC. In addition to ordering that McFarland and his companies were liable for full disgorgement, the final judgment in the SEC’s matter against McFarland included a conduct-based injunction, enjoining McFarland from directly or indirectly participating in the issuance, purchase, offer, or sale of any security, except for his own personal account.

But by ordering the Khaled, Mayweather and Seagal promotion bars, the SEC takes 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 crypto-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 website 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 mandated posting that the SEC imposed upon Park seemed more an aberration than the start of something new. But now, given the Khaled, Mayweather and Seagal SEC orders, perhaps not so much. Clearly, the SEC views ICO abuses as a plague – akin to the way the SEC viewed bogus stock-picking websites as a plague back in the 1990s.

Hence, the SEC marches on, leveraging their asymmetrical bargaining power in settlements, despite the untested legality and questionable nature of statutorily baseless conduct-based bars. In other words, drastic times call for drastic measures.

 

Takeaway #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 historically a remedy 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 and the seller of the stock was considered the victim of the scheme.

However, in the settled orders against Khaled, Mayweather and Seagal, each undertook to pay disgorgement of the compensation they received from the ICO issuers (Khaled agreed to pay $300,000; Mayweather agreed to pay $50,000; and Seagal agreed to $157K).  So who did the SEC decide should receive the $300,000 Khaled earned; the $50,000 Mayweather earned and the $157,000 Seagal earned? Not the ICO issuers – but rather, the U.S. Treasury.

By remitting Khaled, Mayweather and Seagal’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 crypto-enforcement efforts, while also sending a powerful message to the ICO marketplace.

 

Looking Ahead

While the SEC Seagal enforcement action might at first glance appear identical to the Khaled and Mayweather SEC enforcement actions, the Seagal SEC case actually offers a few important insights to consider for the future.

First, in an interesting twist, the SEC’s Seagal order comes within only a few days of a critical Supreme Court argument in Liu v. SEC (see March 2nd, 2020 Transcript of Liu Supreme Court oral argument here), which addresses the SEC’s overall ability to collect disgorgement.

The Liu Supreme Court case stems from a 2016 SEC enforcement action ordering a couple to give back, or disgorge, $26 million that was to be invested in a proposed cancer-treatment center. The SEC found that Charles Liu and Xin Wang defrauded the investors, pocketing millions for themselves and never building the facility. They also were ordered to pay $8.2 million in penalties.

The SEC argues that courts’ authority to require disgorgement stems from their power to order corrective measures that restore the status quo and undo the effects of misconduct. The defendants (and many SEC critics) counter that because Congress does not specifically grant the SEC the power to collect disgorgement, the SEC does not have it. Notably, the SEC’s disgorgement powers were already curbed by the court in the 2017 decision, Kokesh v. SEC, which held that regulators have only five years to get money back for harmed investors.

Yet, while the SEC might believe that its use of disgorgement post-Kokesh has been “more disciplined and less aggressive,” the Khaled, Mayweather and Seagal SEC disgorgement collections seem in stark contrast to that contention. Indeed, the Khaled, Mayweather and Seagal SEC disgorgement orders add fuel to the fire of the anti-disgorgement arguments in Liu, demonstrating that:

  • The scope of SEC disgorgement has grown over time entirely because it was not grounded in statutory text;
  • Congress has never taken steps in statutory language to allow for disgorged funds designated for particular victims to be repurposed for whistleblowers or other measures that ensure investor safety;
  • While SEC disgorgement might function in theory to help damaged investors, SEC disgorgement functions in practice to funnel payments to the U.S. Treasury Department; and
  • If not stopped, the SEC will continue to expand its use of disgorgement quietly usurping the role of Congress to legislate SEC remedies.

Having obtained $9.9 billion in court ordered disgorgement from 2010-2018 (though forging an estimated $1 billion post-Kokesh), the SEC clearly has a lot at stake. To me, it seems almost reckless for the SEC to expand questionable disgorgement powers which are already in dark territory and the subject of a Supreme Court challenge.

Second, the SEC has sent a strong signal regarding celebrities and ICOs: Securities offerings are not like Rolex watches or Nike sneakers and do not lend themselves to glitzy brand ambassadorships and global social media campaigns. 

Indeed, like the Section 17(b) sweeps of the 1990s, which in one fell swoop stopped most of the online unlawful stock touting of that time, the Khaled, Mayweather and Seagal actions could do the same for celebrity use of vast social media resources to promote ICOs.

Finally, the Seagal order evidences that despite the SEC’s bravado and bluster, the storied agency still has some sympathy for aging film stars who might have a few exit wounds and might not have saved enough for retirement. Seagal evidently could not afford an immediate payment to the SEC of his disgorgement and penalty. Instead, he promised to pay off his $330,448.76 of penalties, disgorgement and prejudgment interest in five installments made within 330 days of the SEC order.

But while Seagal cannot promote securities in the next three years, if he needs some cash to make his SEC payments, the SEC order does not prohibit Seagal from earning compensation by making movies. This could be good news for diehard Steven Seagal fans like myself, who have been wishing for an Above the Law sequel for over 30 years. Now, my favorite martial artist/action hero might actually become financially motivated to make it happen.

So thanks SEC, Above the Law 2 is going to be epic.

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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 currently teaches a cyber-law course as a Senior Lecturing Fellow at Duke Law School. 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.”