SEC Offers Possible Path to Compliance for ICO Issuers
By Nicolas Morgan, David Hernand, Meagan Olsen & Vivian Tsai
On November 16, 2018, the Securities and Exchange Commission (“SEC”)
The defendants in the two cases were CarrierEQ Inc. (“Airfox”), which raised $15 million to build an “ecosystem” in emerging markets that would allow users to earn digital tokens for mobile data, and Paragon Coin Inc., which raised $12 million to implement blockchain technology in the cannabis industry. Both ICOs occurred after the SEC issued its
In each of the Airfox and Paragon settlements, the issuers and the SEC agreed that the company would issue a press release “informing all persons and entities that purchased tokens from Respondent . . . of their potential claims under Section 12(a) of the Securities Act, including the right to sue ‘to recover the consideration paid for such security with interest thereon, less the amount of any income received thereon, upon the tender of such security, or for damages if [the purchaser] no longer owns the security’ . . . .”
In the press release announcing the settlements, a Co-Director of the SEC’s Enforcement Division stated that the settlements “provide a model for companies that have issued tokens in ICOs and seek to comply with the federal securities laws.”
ICOs became an increasingly popular means of raising capital in 2017, with 875 ICOs bringing in an aggregate of $6.2 billion.
Beginning in late 2017, members of the SEC’s top brass publicly stated their views that most tokens sold in ICOs constitute securities and warned issuers and other market participants to comply with federal securities laws in connection with offers and sales of such tokens.
Historically, to cure an unregistered offering, companies would make a rescission offer, which is a process detailed in many states’ securities law statutes. Generally, offerees who reject a rescission offer lose the right of action to a refund under state securities laws. However, besides being time-consuming and costly, making a rescission offer can be a risky remedial measure because it may not eliminate an issuer’s liability under federal securities laws. After making a rescission offer, companies could still be liable to investors under federal securities laws or face penalty by the SEC.
Through no-action letters, the SEC has issued guidance indicating that a rescission offer does not eliminate an issuer’s liability to a purchaser who rejects the offer.
Adding to this conundrum is that the SEC historically has viewed a rescission offer as both an offer to buy the security issued in violation of applicable securities law and an offer to sell the same security.
The Airfox and Paragon settlements suggest SEC acceptance of a new roadmap for ICO issuers that are eager to remove the taint from past illegal offers and sales of securities. With this approach, ICO issuers can implement a “claims process” to give investors an opportunity to receive a refund without having to register the offer of such refund, which should enable a faster and more efficient process for removing the taint on a prior unlawful offering. The claims process approach also may provide more certainty regarding future liability under federal securities laws. Lastly, it may be possible for the claims process to satisfy the requirements for effecting rescission offers under applicable state securities laws, which would effectively cut off liability under state law.
Many ICO issuers may wish to consider whether to implement the claims process identified in the Airfox and Paragon settlements to address possible past defects in their offerings. Each issuer should evaluate with legal counsel the facts and circumstances applicable to its ICO, its appetite for registering its securities and becoming subject to periodic reporting requirements (similar to other public companies), and what steps would be necessary in jurisdictions applicable to such issuer.
The viability of this approach for many ICO issuers may hinge on the issuer’s resources and how “the amount due under Section 12(a) of the Securities Act” is calculated. The SEC orders do not specify whether repayment is to be made in the same currency as used by an investor for its original investment or the U.S. Dollar equivalent (and if the latter, whether it is calculated as of the time of investment or the payment of a claim). Both Airfox and Paragon accepted payment for tokens in cryptocurrencies like Bitcoin and Ether. Given the general volatility of the cryptocurrency market and the fact that the prices of many cryptocurrencies have declined significantly in the past year, the SEC’s position on this issue can decidedly affect whether ICO issuers would be able to take advantage of this new method for addressing unregistered, non-exempt offerings.
The new claims process approach identified by the SEC is not perfect, but represents an effort to create a lighter regulatory construct to remedy prior violations.