On April 2, 2018, the U.S. Department of Justice (“DOJ”) and Securities Exchange Commission (“SEC”) announced criminal and civil charges against two startup co-founders for allegedly defrauding and conspiring to defraud investors through the offer and sale of unregistered securities in an initial coin offering (“ICO”). In separate complaints filed in federal court in the United States District Court for the Southern District of New York, both the DOJ and the SEC alleged that the company’s co-founders orchestrated an elaborate marketing campaign to solicit over $25 million in investments for their digital technology company, Centra Tech. Complaint, SEC v. Sharma et al., No. 1:18-cv-02909 (S.D.N.Y. Apr. 2, 2018); Complaint, U.S. v. Sharma et al., 18-MAG-2695. The two men each face four criminal charges of commission and conspiracy to commit securities and wire fraud, as well as permanent injunctions and civil penalties for violating various anti-fraud and registration provisions of the Securities Act of 1933 and Securities Exchange Act of 1934.
According to the SEC and DOJ complaints, defendants represented that they would use the investors’ funds to build a suite of financial products, including a debit card service, by which users could instantly convert cryptocurrencies into spendable cash at any location that accepted the debit cards. To lend credibility to their venture, the founders allegedly published written materials in which they claimed to hold the required financial servicing licenses in 38 states, and to have created a partnership with Bancorp to issue Centra Tech debit cards licensed by Visa and MasterCard. The two enforcement agencies alleged that in fact, Centra Tech had no relationship with Bancorp, Visa, or MasterCard, and did not have the claimed licenses in all 38 states.
The SEC complaint focused additionally on the fact that no registration statement had been filed with the SEC in connection with the ICO. Instead, the ICO was conducted in reliance on a white paper distributed to investors that purported to describe certain aspects of the underlying tokens and which was revised over time. The complaint stated that the ICO was thus an unregistered offering of securities for which no exemption applied, given that funds for the ICO were raised through a general solicitation and extensive promotion to the general public.
The actions are another sign of the U.S. government’s increasing focus on the cryptocurrency space and ICOs in particular. Similar to an initial public offering (“IPO”) of securities, an ICO is a type of fundraising event in which an ICO issuer will offer a unique “coin” or “token” to participants in exchange for consideration. Token holders can access their tokens via the blockchain and may be entitled to certain rights related to their tokens’ underlying venture, including profits or shares of assets. A holder can also digitally trade their tokens on online platforms known as virtual currency exchanges.
Enforcement authorities, in this action among others, have argued that securities and antifraud laws apply to ICOs and cryptocurrencies as they would to any other type of securities. See, e.g., Memorandum of Law in Opposition to Defendant’s Motion to Dismiss, U.S. v. Zaslavskiy, No. 1:17-cr-00647 (E.D.N.Y. Mar. 19, 2018). Indeed, the DOJ press release in this case made clear that “[w]hile the cryptocurrency industry may be a new frontier, it is subject to the same laws against investor fraud as any other type of company.” U.S. Department of Justice, Two Co-Founders of Cryptocurrency Company Charge in Manhattan Federal Court with Scheme to Defraud Investors (Apr. 3, 2018), https://www.justice.gov/usao-sdny/pr/two-co-founders-cryptocurrency-company-charged-manhattan-federal-court-scheme-defraud. Further, it cautions that while trading in cryptocurrencies is legal, investors must “exercise the same degree of due diligence” as they would when investing in traditional securities. Id.