Ready or Not, Here They Come, You Can’t Hide, Gonna Find You and Make You Register & Refund
First and foremost, today’s expansive press release was made with the following disclaimer: “This statement . . . is not a rule, regulation, or statement of the Securities and Exchange Commission (“Commission”).The Commission has neither approved nor disapproved its content.”Essentially, until someone takes on the epic court battle, no true regulations are promulgated by the plethora of SEC press releases we’ve seen. However, the ever-growing number of Initial Coin Offering’s (“ICO”) surrendering to the enforcement actions has now created a David and Goliath power struggle should an ICO issuer ever decide to fight in court.
In a short summary, the notice today stated that, (1) ICO’s issued after the July 25, 2017 DAO warning, who meet the Howey Test definition of an Investment Contract should register now, and offer Investors a claim form to refund their investment, should the investors choose, after becoming more more knowledgeable on the investment by reading the detailed disclosure statements that should have been provided before the investment was made; (2) Hedge funds investing in ICO securities should have registered as Investment Companies; and (3) Exchanges are never going to be considered decentralized, and should be registered as National Securities Exchanges or Alternative Trading Systems.
Regardless of HOW securities are issued, the same old securities laws apply. AirFox and Paragon both received: (1) cease and desist orders to stop violating the Securities Laws by registering with the SEC, (2) were fined $250K, and (3) were ordered to give investors an opportunity for a refund by publishing a claim form. Both companies went down without a fight.
The SEC says registration is “designed to ensure that investors receive the type of information they would have received had these issuers complied with the registration provisions of the Securities Act of 1933 (“Securities Act”) prior to the offer and sale of tokens in their respective ICOs.”
AirFox raised $15 Million from over 2,500 investors between August and October 2017 in an ICO involving prepaid mobile phone airtime, interacting with ads, peer-to-peer lending, credit scoring, and use of the tokens to buy and sell services other than mobile data. They assured investors high returns, promised they would be listed on exchanges, and ran a robust promotional bounty program consisting of more than 400 shills, they aimed their promotional efforts to known ICO investors and not the anticipated AirToken users.
Paragon Coin had a mission to “Deploy a suite of blockchain enabled products to organize, systematize and bring verification and stability to the cannabis industry.” (Well, aint that a mouth full!) They used celebrity promoters including Miss Iowa, Jessica VerSteeg, and Compton rapper, the Game to raise $12 million from 8,323 investors between August and October 2017. 
Under Section 2(a)(1) of the Securities Act, a security includes “an investment contract.” See 15 U.S.C. § 77b. An investment contract is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. See SEC v. Edwards, 540 U.S. 389, 393 (2004); SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946); see also United Housing Found., Inc. v. Forman, 421 U.S. 837, 852–53 (1975) (The “touchstone” of an investment contract “is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”). This definition embodies a “flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” Howey, 328 U.S. at 299 (emphasis added). The test “permits the fulfillment of the statutory purpose of compelling full and fair disclosure relative to the issuance of ‘the many types of instruments that in our commercial world fall within the ordinary concept of a security.’” Id. In analyzing whether something is a security, “form should be disregarded for substance,” Tcherepnin v. Knight, 389 U.S. 332, 336 (1967), “and the emphasis should be on economic realities underlying a transaction, and not on the name appended thereto.” Forman, 421 U.S. at 849.
· Within 14 days of the Nov 16 Order, both companies must issue a press release notifying the public of the order and provide a link to a claim form, which must also get published on their website;
· Within 90 days of the Nov 16 Order, both companies must file Form 10 to register under Section 12(g) of the 1934 Act Registration — and publish the link on their website;
· No later than 60 days after the Form 10 filing, they must send electronic notification of the claim form to all investors who participated in the ICO. People have 3 months to submit the claim;
· Maintain 1934 Act Registration & Filing of all reports required by Section 13(a) of the Securities Exchange Act until Registration is terminated pursuant to Rule 12g-4;
· Pay the amount due under 12(a) to any person or entity that purchased Tokens before Oct 5, 2017;
· Submit to SEC a monthly report of the claims received and paid
· Cease and desist from committing any further and future violations of Securities Act
· Pay $250,000 fine to SEC
Path to Compliance for ICOs:
“These two matters demonstrate that there is a path to compliance with the federal securities laws going forward, even where issuers have conducted an illegal unregistered offering of digital asset securities.”
Investment Vehicles Investing in Digital Asset Securities
The next section of the statement enlightens readers that the 1940 Investment Company Act establishes a regulatory framework for when pooled investment vehicles need to register with the SEC.
The September 11, 2018 Crypto Asset Management Order showed that a hedge fund manager failed to register as an investment company and invested more than 40% of the fund’s assets in ICOs. The SEC said he was acting as an Investment Advisor and violated Anti-fraud provisions of the Investment Advisor Act by making misleading statements to the investors in the fund.
Trading of Digital Asset Securities
The statement essentially said any Exchanges offering tokens that were issued with an ICOs after they published their DAO Notice on July 25, 2017 need to register as National Securities Exchanges or as a broker dealer.
SEC’s thoughts about Decentralization:
The SEC also noted that even if a trading platform calls itself “decentralized,” it should still register. The SEC explained this sentiment with the following words:
“Any entity that provides a marketplace for bringing together buyers and sellers of securities, regardless of the applied technology, must determine whether its activities meet the definition of an exchange under the federal securities laws.”
Exchanges must register as a national securities exchange or be exempt from registration by complying with the Regulations governing alternative trading systems.
An entity that facilitates the issuance and secondary trading of ICOs is required to register as a Broker Dealer through FINRA.
While it is stated that the government supports innovation and the application of beneficial technologies in the American securities markets, they are clearly cracking down on the issuance and secondary trading of ICOs. The SEC created a new FinHub page encouraging inquiries, but unlike FinCEN, there is no way to ask questions anonymously.
It has come to light that the ICO market is/was crawling with fraud, misleading statements, celebrity endorsements, pump and dumps and exit scams. Perhaps only accredited investors are capable of navigating this sea of confusion.
It certainly appears that today’s notice will cause some ICOs to register, and offer refunds, likely hoping only a small percentage of their community will take action by submitting the claim form. While other, less “honorable” ICO issuers may see this notice as a signal to procure a fake passport and head to Panama.
While back-reaching enforcement seems harsh, what else can the SEC do to enforce its power? They‘ve been issuing notices and taking selective enforcement action for over a year now, and yet people are still choosing to ignore them, or trying to create something that’s supposedly outside their broad Howey Test.
It will be interesting to see how many of the 2017 ICOs still have enough money to refund their investors over a year later, especially considering much of the ETH value has evaporated into thin air. Perhaps grandfathering in the existing ICOs and making it a firm rule to register with the SEC on a going-forward basis might have been an easier and softer approach. Or, just leave our tiny crypto market alone and if people want to bet it all on black, so be it. Natural selection, survival of the fittest. But alas, we don’t live in some kind of libertarian utopia. The reality is, American investors are going to be protected by the SEC, like it or not.
 For a discussion of some questions that are relevant to registered investment companies that invest in certain digital assets, see Staff Letter to ICI and SIFMA AMG: Engaging on Fund Innovation and Crypto-related Holdings, available at https://www.sec.gov/investment/fund-innovation-cryptocurrency-related-holdings.