On September 29, 2017, the Securities and Exchange Commission (SEC) charged Maksim Zaslavskiy and two of his companies with defrauding investors in two initial coin offerings (ICOs), one of which was purportedly backed by investments in real estate and the other by investments in diamonds. The SEC also obtained an emergency court order to freeze the assets of Zaslavskiy and his companies.
The term ICO generally refers to a company offering digital assets, usually called coins or tokens, in exchange for cryptocurrencies (e.g., Bitcoin or Ethereum’s Ether). These digital assets are usually offered on a blockchain, a form of distributed ledger technology, and may represent anything—often membership in the offering company’s network, discounts on the company’s services or participation in the company’s profits—or even nothing at all. For example, Dogecoin was created in 2013 as merely a Bitcoin parody to highlight the worthlessness of some digital assets (and yet the total market value of Dogecoin remains above $110 million). Indeed, there are websites that allow users to generate an ICO in a matter of minutes, with no coding skill required. As such, many startups view ICOs as a holy grail for easy, unregulated fundraising. That is beginning to change, however, as ICOs and digital assets have recently become a primary focus of many federal, state and foreign regulators.
The SEC’s complaint against Zaslavskiy and his companies (Zaslavskiy Complaint) alleges that, starting in July 2017, Zaslavskiy, through his wholly-owned companies: (1) REcoin Group Foundation, LLC, a Nevada LLC, and (2) DRC World, Inc., a/k/a Diamond Reserve Club, a Puerto Rico corporation, fraudulently raised more than $300,000 from hundreds of investors through material representations and deceptive acts related to virtual coins offered during ICOs for these companies.
Zaslavskiy and his companies may have attempted to skirt the application of federal securities law by characterizing the purported interests being sold as, among other things, “memberships in a club;” however, the SEC has taken the position that these ICOs were illegal offerings of securities that were not registered, and for which no registration exemption was available. The SEC alleges Zaslavskiy’s case is particularly troubling because the coins offered during the ICOs do not, and never did, exist.
The SEC's complaint, filed in the Eastern District of New York, charges Zaslavskiy and his companies with violations of the anti-fraud and registration provisions of the federal securities laws. The complaint also seeks permanent injunctions and disgorgement plus interest and penalties. For Zaslavskiy, the SEC is also seeking an officer-and-director bar and a bar from participating in any offering of digital securities.
The Zaslavskiy Complaint was filed just two months after the SEC issued an investigative report (DAO Investigative Report) detailing its position that offers and sales of digital assets (e.g., coins, tokens, or memberships) by virtual organizations are subject to the requirements of federal securities laws. That report was the first indication by the SEC as to whether digital assets could be regulated as securities, and concluded that: “Whether . . . a particular [investment] transaction involves the offer or sale of a security – regardless of the terminology [or technology] used – will depend on the facts and circumstances, including the economic realities of the transaction.”
The Zaslavskiy Complaint, the DAO Investigative Report, a number of other SEC investor alerts and a recent speech by SEC Chief Accountant Wesley R. Bricker make clear that the SEC is keenly focused on ICOs and other novel capital-raising structures using distributed ledgers, blockchain and related technologies. However, the Zaslavskiy case may be the first opportunity for a court to weigh in on whether digital assets may be deemed to be securities.
Companies looking to raise capital should be aware that offering an interest under a novel name (e.g., a coin) or via a novel technology (e.g., blockchain) will not affect the SEC’s analysis of whether the interest being offered is in fact a security. Such companies should seek the advice of counsel before offering such interests to ensure that they are properly characterizing the interest being offered and, especially if they wish to offer securities via blockchain technology, that they are complying with the relevant laws and regulations that apply to such offerings, including federal securities laws. Conversely, investors presented with an opportunity to invest in digital assets should engage in careful due diligence regarding the investment.
The SEC is not the only regulator focused on ICOs and virtual currencies, coins and tokens. Companies considering offering or otherwise working with digital assets should educate themselves on the regulatory environment they may face under anti-money laundering, derivatives, securities and tax laws, among others.
For example, on July 26, 2017, the Financial Crimes Enforcement Network (FinCEN) of the US Department of the Treasury assessed a civil monetary penalty of more than $110 million against the cryptocurrency exchange commonly known as BTC-e, and a $12 million penalty against Alexander Vinnik, a Russian national who allegedly controlled BTC-e. On the same day, a 21-count criminal indictment against BTC-e and Mr. Vinnik was unsealed, and Mr. Vinnik was arrested in Greece, based on, among other things, charges that BTC-e was violating US Bank Secrecy Act (BSA) regulations. Additionally, the US Commodity Futures Trading Commission (CFTC) is currently investigating Coinbase, Inc., a popular digital-coin exchange, in relation to a June 21, 2017, flash crash in the cryptocurrency known as Ether. In that case, a single $12.5 million sale of Ether is alleged to have triggered a chain reaction of automated trades that caused the value of an Ether token to drop from $317.81 to around 10 cents in a matter of milliseconds, and then recover to around $300 per token within about 10 minutes.
Additionally, states have begun putting forth their own, sometimes conflicting, regulatory schemes with respect to digital assets, and it remains unclear to what extent the federal government will exercise preemptive power in this area. Meanwhile, foreign governments are also grappling with whether and how to regulate digital assets.
Despite these uncertainties, early adopters continue to forge ahead. In December 2016, Overstock.com became the first publicly traded company to issue shares of stock via blockchain. An Overstock subsidiary, tZERO, is also developing an exchange to facilitate the trading of blockchain-based assets, including securities. Additionally, Goldman Sachs is currently considering a trading operation dedicated to digital currencies. Although blockchain (and the virtual currencies, coins and tokens to which it has given rise) is a new legal and technological frontier, two things are certain: (1) blockchain technology and digital assets are not going away and (2) those looking take advantage of these technologies and the digital assets they allow for will need competent legal counsel to help them navigate and adapt to the regulatory requirements that may apply in this new and quickly evolving area of the law.