SEC Provides Guidance on Initial Coin Offerings

Over the last few months, the Securities and Exchange Commission (SEC) announced settled charges against a few different companies that sold security tokens in initial coin offerings (ICOs). Since the ICO tokens were not registered or unregistered offerings, the companies violated section 5 of the Securities Exchange Act of 1934 (“Exchange Act”).

SEC Settles Unregistered Securities Charges with Gladius Network

On February 20, 2019, the SEC settled its charges with Gladius Network LLC regarding its unregistered ICO that was completed in late 2017.  Gladius raised approximately $12.7 million in security tokens for its plan to develop a network for leasing spare computer bandwidth to combat cyberattacks and increase network speed.

Gladius did not register, nor qualify for an exemption from registering its ICO under federal securities laws.  Gladius self-reported to the SEC’s Enforcement staff of the lack registration in the summer of 2018 in which the SEC did not impose a penalty “because the company self-reported the conduct, agreed to compensate investors, and will register the tokens as a class of securities.”

The SEC issued a statement regarding settled charges: “The SEC has been clear that companies must comply with the securities laws when issuing digital tokens that are securities… Today’s case shows the benefit of self-reporting and taking proactive steps to remediate unregistered offerings.” Following the SEC order, Gladius will return funds to investors who purchased tokens in the ICO and properly register its tokens as securities and begin filing periodic reports with the Commission.

SEC Charges EtherDelta Over Initial Coin Offering

Notably, EtherDelta a trading platform specializing in the cryptocurrency known as Ether and ERC20 was not operated like a traditional Exchange with a centralized operations as there was no active management of the platform’s order taking and execution. Instead, EtherDelta was “decentralized” which means that it connects buyers and sellers through an initially established smart contract protocol upon which all operational decisions were carried out.

According to the SEC, EtherDelta met the Exchange Act Rule 3b-16(a) definition of an exchange notwithstanding the lack of an ongoing centralized management of order taking and execution. Robert Cohen, the chief of the SEC’s cyber unit within the Division of Enforcement stated after the release of the order “The focus is not on the label you put on something…. The focus is on the function of whether it is decentralized or not, whether it’s on a smart contract or not, what matters is that it’s an exchange “. Under section 5 of the Exchange Act, no broker-dealer or “exchange” may directly or indirectly operate in interstate commerce to use the facility of an exchange to ”effect any transaction in a security” unless that exchange is registered with the SEC as a national securities exchange or operates subject to an exemption. The SEC while conducting it’s extensive evaluation of EtherDelta, looked into the functional test according to Rule 3b-16(a), which prescribes that an organization, association, or group of persons will be viewed to be operating as an “Exchange” if it:

  • Brings together the orders of securities of multiple buyers and sellers and
  • Uses established, non-discretionary method under such orders interact with each other and the buyers and sellers entering such orders agree to the terms of trade. The SEC considered a number of operation characteristics of EtherDelta to see if it satisfies the test.

EtherDelta order taking and execution systems were conducted by a smart contract capable of executing transactions across any Ether/ERC20 and trade execution only occurred where orders were acted upon by a “taker” and EtherDelta had no discretion as to order receipt or execution procedures:

When a match was found, trades were executed automatically by the smart contract. Both parties cryptographically-signed orders were validated and confirmed as “open” and the funds and assets in each user’s account were verified for sufficiency. If all conditions were met, the trade was executed promptly in exchange for a fee imposed on takers of 0.3% of the transactions trade volume. For a period of 18-months EtherDelta smart contract executed more than 3.6 million orders for users in this manner.

As a result of these, the SEC found that EtherDelta brought orders for securities tokens together by receiving and storing them in its order book and publicly displaying all bid and offer details. EtherDelta also utilized Coburn’s smart trading protocol as established, non-discretionary methods to facilitate order entry and execution. Thus, EtherDelta fit the parameters of Rule 3b-16(a) and was subject to the registration requirement under Exchange Act section 5.

SEC Releases A Statement on Unregistered Platforms

On March 7, 2018 the SEC released a statement saying “if a platform offers trading of cryptocurrencies that are securities and operates as an ‘exchange’ as defined by the federal securities law, then the platform must register with the SEC as a national securities exchange or be exempt from registration”. The federal regulatory framework governing registered national securities is designed to protect investors and prevent against fraudulent and manipulate trading practices.

According to the SEC’s orders, both CarrierEQ Inc. (Airfox) and Paragon Coin Inc. conducted ICOs in 2017 after the Commission warned that ICOs can be securities offerings in its DAO report of investigation. Airfox raised approximately $15 million worth of digital assets to finance its development of a token-denominated “ecosystem” starting with a mobile application that would allow users in emerging markets to earn token and exchange them for data by interacting with advertisement. Paragon raised approximately $12 million worth of digital assets and implement its business plan to add blockchain technology to the cannabis industry and work hard towards legalization of cannabis. Neither Airfox nor Paragon registered their ICOs pursuant to the federal securities law nor did they qualify for an exemption to the registration requirement.

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Dan Carter
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