Federal and state regulators aren’t the only ones taking a closer look at initial coin offerings: so is the plaintiffs’ bar.
In the last month alone, class actions have targeted five ICOs, alleging they were unlawful sales of unregistered securities, and securities lawyers say more are sure to follow.
“The possibility of these types of lawsuits shouldn’t be a surprise to anyone in the industry at this point. The SEC has been very vocal recently that it will deem most tokens or coins issued through ICOs to be securities under U.S. law,” Benjamin J.A. Sauter, a securities litigator at Kobre & Kim LLP told Bloomberg Law. “Companies selling new tokens or coins through ICOs to U.S. investors are taking a calculated risk.”
No federal court has addressed whether ICOs implicate securities laws and the question is still up for debate, Joshua Ashley Klayman, of counsel at Morrison Foerster LLP, told Bloomberg Law.
“Many people bringing suits may just assume that all tokens are securities, but you actually have to do an analysis on the particular token and token sale itself,” said Klayman, referring to the Howey test, which says a security exists where there’s a monetary investment in a common enterprise with most profits coming from others’ efforts. Klayman, cofounder of the firm’s Blockchain + Smart Contracts Group and chair of the Wall Street Blockchain Alliance Legal Working Group, cautioned against “jumping to conclusions” about which ICOs are sales of securities before courts have had a chance to weigh in.
An early test of how the courts will treat class actions targeting ICOs has already begun playing out in the U.S. District Court for the Northern District of California, Michael Dicke and Eric Young of Fenwick West LLP noted in a Jan. 3 client alert.
That’s where U.S. District Judge Richard Seeborg is considering a consolidated series of class actions against Dynamic Ledger Solutions, Inc., the owner of Tezos, which is alleged to have violated state and federal securities laws by marketing the sale of proposed tokens as charitable contributions. Seeborg Dec. 20 denied the plaintiffs’ motion for a temporary restraining order and asset freeze.
Seeborg has presided over 56 securities cases and the U.S. Court of Appeals for the Ninth Circuit has affirmed his securities decisions in two out of three appeals, according to Bloomberg Law’s Litigation Analytics.
The next day, investors filed a class action in the U.S. District Court for the Southern District of New York against ATBCOIN LLC, an ICO that raised over $20 million and billed itself as “the fastest blockchain-based cryptographic network in the Milky Way galaxy.”
A week earlier, other investors filed a class action in the U.S. District Court for the Southern District of Florida against Centra Tech, Inc., an ICO that raised $30 million and attracted an endorsement from boxer Floyd Mayweather.
Silver Miller, a four-attorney law firm behind the first of the Tezos suits, which markets itself as “the leading cryptocurrency investor law firm in the country,” filed class actions in late December in the U.S. District Court for the Southern District of Florida and the U.S. District Court for the Eastern District of Washington against two other proposed ICOs promoted by Monkey Capital and Giga Watt, respectively.
“2018 will be the year of ICO litigation,” David Silver, partner at Silver Miller, who previously practiced law at Patton Boggs for six years, told Bloomberg Law.
Are ICOs Securities?
To Silver, the question of whether ICOs qualify as securities is clear-cut.
“I have yet to see an ICO that did not fit the definition of the sale of a security,” Silver said.
Securities lawyers say the legal analysis of whether any individual ICO is a security is actually more complicated.
Much will depend on how any individual ICO is structured and how companies use the proceeds, Klayman said.
Some companies focus on getting purchasers to use the companies’ cryptocurrencies within their own ecosystems, Klayman said. Other companies might use ICOs as a way to raise capital without giving up company control as they would in a stock offering, she said, and encourage buyers to invest in order to sell later rather than simply to use the underlying product.
“When you do things like that as a token seller, you make your tokens look more like securities,” she said.
This ambiguity can make things difficult even for those who want to follow the law. Most people want their ICOs to comply, Klayman said. “Many people are trying to do it right, but because there hasn’t been any bright line guidance, it’s tough,” she added.
SEC and State Regulatory Action
The Securities and Exchange Commission has brought three enforcement actions concerning ICOs since the agency’s July 2017 investigative report into tokens from the DAO, a decentralized autonomous organization. The report, a first-of-its-kind SEC analysis of an ICO, found the DAO’s tokens were securities and subject to applicable U.S. laws, but didn’t file charges in the matter.
The agency then brought a lawsuit in September 2017 against a man and his two companies for allegedly defrauding investors in a scheme involving ICOs supposedly backed by investments in real estate and diamonds. The commission in December also secured an emergency asset freeze to halt an ICO that allegedly promised investors a 13-fold profit in less than a month.
The SEC later that month followed that case by reaching a settlement with the maker of a restaurant-review app to stop its ICO after the agency questioned whether the company was planning an unregistered securities offering.
State regulators are also showing interest in ICOs. Last week, the Texas State Securities Board filed an emergency cease-and-desist-order against U.K.-based BitConnect. The Jan. 4 order came the same day multiple state securities regulators advised the public to “go beyond the headlines and hype” of cryptocurrencies and fully understand the potential risks.
No matter its merits, the risk of litigation could nevertheless have a chilling effect on ICOs, Brian Knight, a senior research fellow at George Mason University’s Mercatus Center specializing in financial regulation, told Bloomberg Law.
“Suits like this, in addition to enhanced SEC and state enforcement, will likely chill the market to a degree,” said Knight. “There is a risk that the chill will disproportionately impact legitimate firms who are scared off of an innovative delivery method, rather than frauds who are looking to scam people anyway.”