The Securities and Exchange Commission (SEC) has ordered refunds for two initial coin offerings (ICOs) after concluding that they sold unregistered securities. Paragon and Airfox have promised to return investors’ money, pay penalties, and register their tokens as securities after receiving cease-and-desist proceedings pursuant to Section 8A of the Securities Act of 1933. According to the most recent SEC press release, these are the Commission’s first cases imposing civil penalties solely for ICO securities offering registration violations. Some speculate that this could be indicative of an impending legal pursuit against more companies that closed utility token-based offerings and such fears seem warranted given statements like these:
“We have made it clear that companies that issue securities through ICOs are required to comply with existing statutes and rules governing the registration of securities,” said Stephanie Avakian, Co-Director of the SEC’s Enforcement Division. “These cases tell those who are considering taking similar actions that we continue to be on the lookout for violations of the federal securities laws with respect to digital assets.”
— SEC Press Release, Washington D.C., November 2018
For readers who are unfamiliar with these projects, Airfox raised US$15 million to develop a mobile app that allows customers of certain prepaid mobile telecommunications operators to earn free or discounted airtime and data by interacting with advertisements on their smartphones. Strangely, AirToken — the native ERC-20 token that facilitates the transfer of mobile airtime and data on the Airfox app — witnessed a dramatic increase in its market capitalization shortly after news of the proceedings surfaced. It could be that individuals traded these tokens are attempting to buy them back to receive the refund.
After raising US$12 million dollars in their ICO in October, 2017, Paragon — like other cannabis based projects — struggled to gain adoption and fell short of their promise to develop a blockchain ecosystem for the industry and promote the legalization of cannabis. At the time of this article, Paragon’s total market capitalization is just over US$3 million.
The orders impose US$250,000 in penalties against each company and include undertakings to compensate investors who purchased tokens in the offerings. The companies will also register their tokens as securities pursuant to the Securities Exchange Act and file periodic reports with the Commission for at least one year. Airfox and Paragon consented to the orders without admitting or denying the findings.
Fears of receiving cease-and-desist letters or encountering the SEC’s Enforcement Division have been long-standing in the cryptocurrency industry. However, this sentiment did seemingly little to deter the onslaught of utility token-based projects and ICOs in 2017. The majority of companies and projects that launched at this time stated something similar to what Airfox and Paragon promised participants of their offerings, that the tokens being offered would increase in value through the companies’ efforts.
These offerings should have been registered as securities as participants had a reasonable expectation of obtaining a future profit from the efforts of the promoter or third party, and the exchange of money for tokens would therefore be deemed an investment contract under the Howey Test, a simple test created by the Supreme Court for determining whether certain transactions qualify as investment contracts.
Here are some key takeaways from the SEC Proceedings:
- It has generally been assumed that if a company created an offering in which the token’s functionality and proposed utility were fully established at the closing of their ICO, they were more likely to be exempt from SEC proceedings. The fact that the proceedings against Airfox referenced how such functionality was not available and their prototype was designed to demonstrate how the application might work despite not having any real users suggests that this assumption might hold some validity.
- Similarly, while Paragon told potential purchasers that they would be able to use PRG tokens to buy goods or services in the future after Paragon created an “ecosystem,” no one was able to buy any good or service with PRG before or during the offering other than pre-ordering Paragon merchandise. The fact that the SEC directly referenced this in the proceeding suggests that companies need to have a functioning ecosystem or prototype before the closing of their offering, the tokens being offered must have an actual case for utility.
- Both proceedings directly reference the many statements made on behalf of Paragon and Airfox in respects to how their token offerings were an opportunity to profit. The SEC clearly did a thorough examination of the companies’ collateral, referencing statements from white papers, emails, blogs, and social media accounts that created expectations of obtaining a future profit for purchasers.
- Paragon violated SEC regulations by raising capital through the promotion of celebrities who did not understand what the platform was.
- In the “Undertakings” section of both proceedings, it clearly states that “[f]or any claims not paid, [the] Respondent will provide the claimant with a written explanation of the reason for non-payment.” This would suggest that while these companies are being ordered to refund purchases, if they are unable they may escape their obligation to do so by simply writing letters.
Paragon and Airfox have 90 days to register their tokens as securities, at which point they will be granted 60 days to inform all the persons who participated in their ICOs of their potential claims and right to sue to recover. Those who purchased these tokens will be required to submit written claims to Airfox and Paragon; at that time the companies will have three months to make all payments. For any claims not paid, Airfox and Paragon will provide the claimants with written explanations of the reason for non-payment. The companies will then have to report monthly on claims paid to the SEC. Additional details about this process and the fines that Paragon and Airfox must pay are available in the cease-and-desist proceedings at SEC.gov.
Today, the SEC released another press release that referenced Airfox and Paragon but emphasized that there is a path to compliance with the federal securities laws, even where issuers have illegally conducted an unregistered offering of digital asset securities. The release further outlines details and criteria for exchange registration and broker dealer registration, stating that “[t]he registration undertakings are designed to ensure that investors receive the type of information they would have received had these issuers complied with the registration provisions of the Securities Act of 1933.”
Will the SEC start widely pursuing companies that they believe offered unregistered securities?
Is this the first nail in the ICO proverbial coffin?
Might we interpret this as a sign or further justification for the burgeoning of the security token market?
Cease-and-desist proceedings for Airfox:
Cease-and-desist proceedings for Paragon:
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