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SEC Obtains Emergency Court Order Against Canadian Firm for Allegedly Violating Federal Securities Law; Halts Initial Coin Offering
On December 4, the SEC announced it had obtained an emergency court order to freeze the assets of a Canadian company and the company’s founders (Defendants) and block Defendants’ ability to continue to raise funds through an initial coin offering (ICO). At the time the order was issued, the ICO had raised $15 million since August by “promising investors returns of 1,354% in under 29 days.” This is the first enforcement action taken by the SEC’s recently established Cyber Unit, whose focus includes distributed ledger technology and initial coin offering violations. (See previous InfoBytes Cyber Unit coverage here.)
According to a complaint filed December 1 in the U.S. District Court for the Eastern District of New York, Defendants allegedly violated the anti-fraud and registration provisions of U.S. federal securities laws by making a series of materially false and misleading statements when marketing and selling securities as digital tokens/cryptocurrencies to obtain investor funds. From August to the present, Defendants purportedly raised $15 million through the ICO, and made false representations including, among other things, that: (i) the firm consisted of large teams of experts across the globe, and (ii) investors would receive certain promised returns (1,354% in less than a month) on investments if all tokens were sold. Further, Defendants allegedly failed to disclose (i) that a portion of the proceeds from the ICO funds would pay personal expenses, and (ii) that the company’s principal executive was “a known recidivist securities law violator in Canada.” The SEC seeks relief in the form of permanent injunctions, monetary penalties and interest, and an “officer-and-director bar and a bar from offering digital securities” against the company’s founders.
SEC Chairman Discusses Corporate Governance, States Enhanced Transparency Can Help Prevent Fraud, and Reveals First-Ever National Database of Barred Brokers and Advisors
On November 8, the Chairman of the SEC, Jay Clayton, spoke before the Practising Law Institute’s annual institute on securities regulation to discuss the role of corporate governance and how enhanced transparency can help prevent fraud. Clayton stated that the SEC would be streamlining and shortening its near-term agenda in an effort to increase transparency and accountability, and that the SEC also would apply this approach to its longer-term strategic plans as well.
Clayton also commented on approaches to mitigate “misconduct” before an enforcement action would be required. Specifically, Clayton noted, “[l]ooking back at enforcement actions, a common theme emerges – where opacity exists, bad behavior tends to follow.” Clayton highlighted the following areas in which opacity may exist: (i) disclosures involving “hidden or inappropriate fees”; (ii) poor recordkeeping and lack of reliable information related to penny stocks; (iii) transaction processing related to unregistered securities; (iv) online platforms that manage initial coin offerings (ICOs); and (v) investor education.
Concerning ICOs, Clayton commented that because “[t]here is a distinct lack of information about many online platforms that list and trade virtual coins or tokens offered and sold in . . . ICOs . . ., [t]rading of tokens on these platforms is susceptible to price manipulation and other fraudulent trading practices.” The SEC proposed enhanced clarity when listing tokens on these types of platforms, assigning value to tokens, and examining measures designed to protect investors and market integrity.
Clayton further revealed that the SEC was creating a website that would publish, among other things, a searchable database of those individuals who have been barred or suspended as a result of federal securities law violations. Clayton noted that this database would be “intended to make the prior actions of repeat offenders and fraudsters more visible to investors” and could be “particularly valuable when bad actors have shifted from the registered space for investment advisers and broker-dealers to the unregistered space.”
CFTC Issues Primer on Virtual Currencies, Claims Certain Virtual Tokens Fall Under Its Oversight
On October 17, the U.S. Commodity Futures Trading Commission (CFTC) announced the release of “A CFTC Primer on Virtual Currencies” (Primer) issued by its LabCFTC division. As previously discussed in Infobytes, the LabCFTC initiative rolled out in May of this year to engage innovators in the financial technology industry to promote responsible fintech innovation within regulated CFTC markets. In this Primer—a first in a series—the CFTC discusses potential use-cases for virtual currencies and outlines the agency’s role and oversight of virtual currencies. The Primer also highlights the risks associated with virtual currencies, such as (i) the susceptibility of “digital wallets” to cybersecurity hacks; (ii) inadequate safeguards and other customer protection related systems on virtual currency exchanges; and (iii) the susceptibility of virtual currencies to Ponzi schemes and other types of frauds.
The CFTC noted that there’s no inconsistency between the SEC’s analysis that Initial Coin Offerings or Token Sales may be subject to federal securities law (see previous InfoBytes coverage here) and CFTC’s determination that virtual currencies are commodities and virtual tokens “may be commodities or derivatives contracts, depending on the particular facts and circumstances.” Last month, as discussed in InfoBytes, the CFTC also filed its first-ever antifraud enforcement action for activities involving Bitcoin investment solicitations.
SEC Announces Two Enforcement Initiatives Designed to Combat Cyber Threats
On September 25, the SEC announced the expansion of its Enforcement Division’s focus on cyber-related misconduct with the creation of a Cyber Unit and a Retail Strategy Task Force. The Cyber Unit will focus on areas such as (i) market manipulation schemes involving electronically-transferred false information; (ii) data breaches intended to obtain nonpublic information; (iii) distributed ledger technology and initial coin offering violations; (iv) misconduct through the use of the dark web; (v) retail brokerage account intrusions; and (vi) cyber-related threats targeting trading platforms and other critical market infrastructures. The Cyber Unit will complement the SEC’s internal assessment of its cybersecurity risk profile. (See previous InfoBytes coverage here.) The goal of the Retail Strategy Task Force will be to “develop proactive, targeted initiatives to identify misconduct impacting retail investors [and] apply the lessons learned from those cases and leverage data analytics and technology to identify large-scale misconduct affecting retail investors.”
China Bans Commercial Trading of Initial Coin Offerings
On September 4, the People’s Bank of China and several Chinese regulators reportedly jointly announced plans to ban the commercial trading of bitcoin and other cryptocurrencies. This measure, announced in a statement issued by the Ministry of Industry and Information Technology of the People’s Republic of China, will outlaw all fundraising Initial Coin Offerings (ICOs), and declares ICOs and the sale of virtual currency as unauthorized illegal financing behavior, suspected of illegal sale tokens, illegal securities issuance, and illegal fund-raising, including financial fraud, pyramid schemes and other criminal activities. The statement reportedly stresses that virtual currency in China will not be recognized as a legal form of currency and must not be circulated as currency when financing activities. Furthermore, going forward, all cryptocurrency trading platforms are prohibited in China from acting as central counterparties to facilitate the exchange of tokens for virtual currencies. Additionally, one of China’s bitcoin exchanges reportedly published an announcement on its website saying it will close its bitcoin currency trading platform in the country on September 30.
The SEC recently released an investor bulletin about ICO investment risks and offered fraud prevention guidance. (See previous InfoBytes summary here.) ICO sales are often used to raise capital, and the SEC is monitoring companies who use this method for fraudulent purposes.
SEC Issues Investor Bulletin Concerning Fraud Related to Initial Coin Offerings
On August 28, the SEC Office of Investor Education and Advocacy (OIEA) released an Investor Bulletin about the risks associated with investing in companies that claim to be related to, or assert that they are engaged in, Initial Coin Offerings (ICOs). ICOs are also known as coin or token launches, and sales are often used to raise capital. However, the OIEA warns investors that while some companies employ ICOs for lawful opportunities, the agency is cracking down on companies who use emerging technologies like ICOs for fraudulent purposes, such as announcing ICOs in order to affect the price of their common stock. The OIEA issued guidance, including (but not limited to) the following, to help investors spot potential fraud:
- Investors should consider past trading suspensions as warning signs of possible microcap fraud when considering whether to invest, especially if there is a lack of current, reliable information about the company and its stock offerings.
- Investors should be cautious about “pump-and-dump” schemes where companies manipulate the price of a stock to urge investors to buy quickly through false and misleading statements, and then unload shares of those stocks at artificially inflated prices, causing investors to lose money.
- Investors should understand the risks of investing with companies that are not required to file reports with the SEC (“non-reporting companies”);
- Investors should be very cautious of stock promotions offered by companies that do not provide details on whether the ICOs are compliant with securities law.
The bulletin also includes links to additional investor resources, including an Investor Bulletin on ICOs.
SEC Issues Investigative Report: Federal Securities Laws Apply to Virtual Organizations
On July 25, the SEC issued an investigative report stating that federal securities laws apply to anyone who offers and sells securities in the U.S., regardless of the manner of distribution or whether dollars or virtual currencies are used to purchase the securities. The SEC’s Report of Investigation (Report) advises users to make sure they are compliant with federal securities laws when raising capital through Decentralized Autonomous Organizations (DAO) or other forms of distributed ledgers or blockchain technology. These offering are often referred to as “Initial Coin Offerings” (ICOs) or “Token Sales.”
The Report originates from an Enforcement Division inquiry into whether the DAO—and affiliated entities—“violated federal securities laws with unregistered offers and sales of DAO Tokens in exchange for ‘Ether,’ a virtual currency.” According to the SEC, the DAO, which has been described as a “crowdfunding contract,” has not met any of the specific Regulation Crowdfunding exemption requirements issued earlier this year by the agency. These regulations were previously discussed in InfoBytes. In its Report, the SEC stated that the individuals involved in a 2016 virtual currency offering that was later hacked will not face charges, but will rather serve as a warning to the industry that people who offer and sell securities in the U.S. must follow the law. In light of this discussion, the SEC’s Office of Investor Education and Advocacy issued an Investor Bulletin to educate investors about the benefits and risks of ICOs, which promoters have begun to use to sell virtual currencies.
“Investors need the essential facts behind any investment opportunity so they can make fully informed decisions, and today's Report confirms that sponsors of offerings conducted through the use of distributed ledger or blockchain technology must comply with the securities laws,” said William Hinman, SEC Director of the Division of Corporation Finance.
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