The SEC and the US Attorney yesterday announced parallel actions alleging fraud and registration violations relating to an initial coin offering (ICO) promoted by Centra Tech, Inc. – identified as a CTR or CTR Token. The allegations in the complaint included serious allegations of a false connection to VISA, MasterCard and The Bancorp, through an alleged fictional wallet debit card to exchange, withdraw or spend cryptocurrenices. The SEC alleges the offering was widely promoted through the company's website and social media, including marketing of the program by certain unnamed celebrity endorsers. The SEC alleges that the offering was listed on 8 to 10 exchanges, where the price multiplied from the initial sale price to more than 25 times its initial value. The SEC alleges the ICO offering was a security, no registration statement was in effect with respect to the offering, nor exemption from registration available and the defendants violated the antifraud and registration provisions of the federal securities laws.

The SEC complaint raises two interesting questions:

  • What were the exchanges where the CTR offering was listed, and what, if any, are the due diligence obligations of those exchanges before listing them. Query – what is the liability of the exchanges for listing and trading these CTRs
  • What is the liability, if any, of the celebrity endorsers for promoting this offering?

As to exchanges

The most recent SEC pronouncement on digital exchanges was issued in March 2018 by the SEC Division of Trading and Markets. This follows on the Commission's earlier DAO Section 21(a) report issued in 2017 on the potential liability of persons operating unregistered digital trading platforms. The latest staff release emphasizes that an exchange must be registered with the SEC or exempt from registration under Regulation ATS. The release highlights the standards that an registered exchange must have in place, including standards for selecting digital assets for trading, and protocols relating to the trading of those assets. Regulation ATS requires an exemption to be based on the exchange being a registered broker-dealer, with all the associated protections and disclosure standards associated with such registration. Potential liability of persons who violate these standards, is similar to that of any broker-dealer which violates its public duties to comply with the strict regulatory requirements for such persons imposed by state and federal law. Broker-dealers retain law enforcement exposure and private liability.

As to celebrities

The celebrities have potential exposure as aiders and abettors of the offering. The law of aiding and abetting is well settled: This requires proof of knowing and substantial assistance to the persons executing the fraud. But the SEC position is that recklessness satisfies the knowing and substantial assistance element. And willful blindness is the equivalent of knowing misconduct. Thus the liability of the celebrities will turn on what if anything they knew about the offering, and what if any due diligence they did before promoting it.

Alternatively, there is the potential that even if the celebrities are not charged with aiding and abetting the fraud, they could be liable to return any fees paid for their endorsements as relief defendants. While the law is clear that a relief defendant is not liable to the extent they gave value in exchange for their promotional activity, whether the SEC will view their endorsement services as value is problematic and if so their overall conduct as a whole is deserving of disgorgement.

Potential for criminal exposure

Promoters and other persons associated with an ICO offering also face potential criminal exposure for misrepresentations in connection with an ICO. In particular, the US Attorney's offices for the Southern and Eastern Districts of New York have obtained indictments against ICO promotors for conspiring to commit securities fraud, engaging in securities fraud, and wire fraud. This should alert all persons associated with such offerings that the risk is not only SEC exposure, but the additional risk of criminal exposure. The addition of the wire fraud claim forecloses any issue of whether the criminal authorities will be reticent to charge fraud associated with these offerings because of any remaining questions as to whether the underlying transactions involved the sale of securities. That being said, to date at least, the US Attorney’s offices have adopted the SEC's application of the Howey test in the context of ICOs.