Shearman & Sterling | FinTech | SEC Settles Charges Against Two Companies that Sold Digital Tokens in ICOs
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  • SEC Settles Charges Against Two Companies that Sold Digital Tokens in ICOs

    For the first time, on November 16, 2018, the Securities and Exchange Commission (SEC) sanctioned two companies with civil penalties for violating the securities laws in connection with issuing digital tokens in an initial coin offering (ICO). Interestingly, the Division of Corporation Finance, Investment Management and Trading & Markets issued a joint statement in support of the Division of Enforcement’s actions. Without admitting or denying the findings, the two companies consented to the SEC orders finding that they violated Section 5(a) and 5(c) of the Securities Act of 1933 for failing to register the tokens as securities. The companies agreed to $250,000 penalties and to cease and desist from future violations.

    The orders provided that the companies will register their tokens as securities pursuant to Section 12(g) of the Securities Exchange Act of 1934 (Exchange Act) and file periodic reports with the SEC for at least one year, as well as compensate investors who purchased tokens in the illegal offerings if an investor elects to make a claim.

    According to the SEC, these two matters demonstrate that “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.”  The SEC explained that with the benefits of ongoing disclosure provided by registration under the Exchange Act, investors who purchased the tokens from illegal offerings should be able to make a more informed decision as to whether to seek reimbursement or continue to hold their tokens.

    The SEC’s sanctions will significantly affect these two companies. They will now be required to file annual reports with audited financial statements, quarterly reports with financial statements and current reports on material events. They will also be required to prepare a proxy statement that complies with the proxy rules for an annual shareholder meeting. These two companies will only be able to terminate these reporting obligations after one year, but only if they have fewer than 300 holders of the tokens, which, if their digital currency platforms are successful, seems unlikely.  Additionally, perhaps more significantly, these two companies will be considered “bad actors” under the securities laws, which would prevent them from using Regulation D and Regulation A+ to raise capital in the private markets. To make things even worse, the orders gave investors who purchased the tokens from the companies the right to get their money back, plus interest. These sanctions apply even though the companies together raised only around $27 million.

    Being a public company is expensive and the potential liability to repurchase tokens could be crippling for companies that likely sold the tokens to raise funds to develop and operate their platforms. This does not even take into account the time, cost and expense of the investigation and settlement with the SEC.

    Companies and individuals seeking to raise funds through token offerings should carefully consider the potential implications if the SEC claims they run afoul of the federal securities laws. Although the SEC has indicated an openness to help those that are interested in finding a path within the securities law framework for an offering of a digital token, the Enforcement Division has been relentless in its focus on rooting out, and making an example of, those players who ignore or are indifferent to key requirements for conducting a securities offering in compliance with existing laws.