Shearman & Sterling | FinTech | SEC Order Shows Free Tokens Do Not Get a Free Pass From Securities Laws 
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  • SEC Order Shows Free Tokens Do Not Get a Free Pass From Securities Laws 

    The Securities and Exchange Commission cracked down on another initial coin offering, despite the fact that the parties were unable to raise any money.  The SEC found that the efforts to fund oil exploration and drilling in California through the issuance of digital tokens called “Tomahawkcoins” or “TOM,” by Tomahawk Exploration LLC and David T. Laurance constituted an illegal securities offering in which they made materially false claims about the exploration prospects, the firm and Mr. Laurance’s background. 
    Tomahawk and Mr. Laurance attempted to raise $5 million through the ICO.  In connection with the ICO, Tomahawk and Mr. Laurance initiated a “bounty program” that offered tokens in exchange for efforts to promote the ICO.

    The SEC found that TOM tokens constituted securities because TOM tokens were “investment contracts” and the TOM tokens were “an option, or privilege on any security” and “transferable shares” under the securities laws.  The SEC applied the standard investment contract analysis in SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946) to easily conclude that a purchase of TOM tokens was (a) an investment of money (b) in a common enterprise (c) with a reasonable expectation of profits (d) to be derived from the entrepreneurial or managerial efforts of others.  We note that the SEC considered it an investment of “money” under U.S. securities laws even when TOM tokens were exchanged for other digital assets.

    The SEC also found that TOM tokens were securities because they constituted “an option or privilege on any security” and “transferable shares.”  Tomahawk’s offering materials claimed that purchasers would have the ability to convert TOM tokens into equity shares, and TOM token holders had the right to transfer TOM tokens on a decentralized trading platform.  Therefore, the SEC found that TOM tokens were, in economic substance, analogous to ordinary shares of stock, thus were a “security” and therefore were subject to U.S. securities laws.

    Further, the SEC found that Tomahawk and Mr. Laurance made an “offer” of securities, even though they did not receive any monetary consideration for the TOM tokens that were issued.  The SEC stated that a lack of monetary consideration does not necessarily mean there has not been an offer for sale or a sale of securities for purposes of Section 5 of the Securities Act.  A “gift” of a security is considered a “sale” under U.S. securities laws when the donor receives some real benefit in return.  Here, Tomahawk and Mr. Laurance received a benefit from the recipients in the form of online marketing and promotion of the ICO on blogs and other online forums.  Tomahawk received value in exchange for these “gift distributions” of TOM tokens triggering a sale under the securities laws.

    Additionally, the SEC found that Tomahawk and Mr. Laurance committed fraud by, among other things, making materially false or misleading statements about Tomahawk’s rights to drilling sites, projections of oil production and Mr. Laurance’s “flawless background” while he had a prior criminal conviction for fraudulent securities offerings and also had personal bankruptcies.  In conjunction with the enforcement order, the SEC’s Office of Investor Education and Advocacy issued an alert warning investors to be wary of this type of language in an ICO’s promotional materials.  

    Without admitting or denying any wrongdoing, Tomahawk and Mr. Laurance agreed to a cease and desist order, and Mr. Laurance consented to an officer and director bar, penny stock bar and a $30,000 penalty.

    This order reflects the fact that an ICO may be subject to securities laws even if no funds are actually raised through the ICO.