A federal district court has—for the first time—agreed with the SEC that initial coin offerings (ICOs) could be considered securities offerings and has allowed a criminal case alleging violations of securities laws arising from an ICO to proceed to trial. The case, U.S. v. Zaslavskiy, 17 cr 0647, involves Maksim Zaslavskiy's offering of two purportedly asset-backed tokens, REcoin (backed by real estate) and Diamond tokens (backed by diamonds).
According to its white paper, REcoin was backed by domestic and international real estate investments and led by an experienced team of brokers, lawyers, and developers. Meanwhile, Diamond was promoted as a virtual ecosystem that offered members cryptocurrency tokens hedged by physical diamonds stored in secure locations and fully insured for their value.
Prosecutors alleged these were all misrepresentations, as Zaslavskiy did not purchase any real estate or diamonds, did not hire a team, and never developed any REcoin or Diamond tokens. These allegations, among other alleged misrepresentations, formed the basis for the indictment charging Zaslavskiy with conspiracy and securities fraud.
The heart of this case is the question of whether these investments are securities. The prosecution, citing the Howey test, argued that the purchases of REcoin and Diamond are investment contracts and, therefore, are subject to U.S. securities law. Zaslavskiy, in a motion to dismiss, took the position that the tokens are currencies, which by definition are not securities, and that even if they were not currencies, the tokens did not qualify as securities under the Howey test.
The court denied the defendant's motion, finding that the prosecution alleged sufficient facts that, if proved at trial, could lead a reasonable jury to find that REcoin and Diamond constituted investment contracts.
But what does this mean for ICOs generally? There are several key points to keep in mind.
First, this decision is not unexpected. The SEC has made clear its position that, under the facts and circumstances analysis of the Howey test, many ICOs likely involve securities offerings. A key factor in this analysis is the expectation of profits. Each of Zaslavskiy's offerings focused on the profit potential, and he allegedly forecasted minimum growth of 10% to 15% a year. We have previously discussed a number of similar SEC enforcement actions, which can be read about here, here, and here.
Second, and most importantly for the cryptocurrency ecosystem, the facts of this case, as alleged, do not provide any insight into the utility token distinction for ICOs. Many ICO proponents argue that a token's utility (i.e., the function or access to services that it provides) should weigh against a security classification. Here, the tokens were purportedly backed by real estate and diamonds. Zaslavskiy did not promote and investors did not invest based on the utility of the technology, but rather "cryptocurrency" was used as a buzzword to entice buyers. The case, therefore, cannot show how the utility token theory works under the Howey test.
Third, the court did not hold that Zaslavskiy's scheme was a security offering—it said that a jury could reach that conclusion. Notably, the court agreed with the SEC that the Howey test is the appropriate legal standard for determining whether an ICO is a security offering, but it said that the "question of whether the conspirators, in fact, offered a security, currency, or another financial instrument altogether, is best left to the [jury]."
While Zaslavskiy is novel in that it is the first criminal case brought under securities law for an ICO, its implications are, at this point, limited, leaving cryptocurrency developers waiting for clear guidance.