On April 3, 2019, the U.S. Securities and Exchange Commission issued new guidance for assessing whether an initial coin offering is a securities offering. It also issued its first no-action letter, confirming that it would not recommend an enforcement action if Turnkey Jet did not register its proposed TKJ token as a securities offering.
While these actions are meaningful, they do not alter the SEC’s previously-stated position that it is likely to view most, if not all, prior ICOs as unregistered securities offerings. As a result, existing ICO issuers still face difficult decisions on how to proceed.
The SEC has offered a path for unregistered ICOs to come clean. Three projects that conducted ICOs in late 2017 — CarrierEQ Inc. (Airfox), Paragon Coin and Gladius Networks — each recently settled with the SEC by agreeing to:
- Notify purchasers of their right to sue, provide a claim form and reimburse those who submit valid claims;
- Register the tokens as securities and comply with reporting obligations “until such time as Respondent is eligible to terminate its registration”; and
- Report to the SEC on claims made and paid.
Cooperating with the SEC led to reduced penalties of $250,000 for Airfox and Paragon Coin, and self-reporting led to no penalty at all for Gladius Networks. The SEC holds these settlements out as “a model for companies that have issued tokens in ICOs and seek to comply with the federal securities laws.”
Before proceeding, past ICO issuers should ask two key questions.
What Will Settlement Cost?
The ICO settlements may cost much less than it appears. Draft claim forms posted by Airfox and Paragon Coin provide that claims will be paid in dollars, valuing contributions at the time of purchase (fall 2017, when values were near their peak). That might appear prohibitively expensive, but in practice the cost will probably be low, particularly compared to what the SEC could have demanded.
SEC enforcement actions frequently seek disgorgement of any ill-gotten gains plus civil penalties that equal or exceed the amount of disgorgement. It is striking that these ICO settlements do not require disgorgement, and the penalties are far below the amounts raised in the ICOs. Issuers must reimburse only purchasers who submit valid claims.
To do so, claimants must provide real-world identities, identify token wallets and transactions, and provide bank account information and supporting documentation. Most purchasers may not bother. A 2015 report by the Consumer Finance Protection Bureau found that in “claims made” class action settlements, the claim rate was only 4%, and that rate dropped by 90% when documentary proof was required.
What Risks Remain?
Avoiding a fight with the SEC may seem too good to pass up, but substantial risks remain.
State Enforcement Actions
SEC settlements only resolve federal registration violations. Numerous states’ laws may also apply to any ICO, depending on where the offering was conducted, where purchasers reside and where relevant conduct occurred. State regulators can also seek penalties and disgorgement, so it would be unwise to assume that an issuer ultimately will be able to retain funds from an unregistered ICO.
ICO issuers should also anticipate private lawsuits and many, including Paragon Coin, already face such lawsuits. Plaintiffs may seek rescission or damages, and typically seek to do so on behalf of all purchasers. Issuers can limit their exposure to private suits by conducting a rescission offer, but the ICO settlements may not qualify.
Even a valid rescission offer may not protect against federal claims. Federal securities laws prohibit waivers of compliance, and the SEC has taken the position that a rescission offer does not cure a violation of registration requirements. On the other hand, at least two federal appellate courts concluded that rejecting a rescission offer did waive rights under federal laws, leaving the impact on federal claims uncertain.
Rescission offers can bar state-law claims for failure to register, but to do so an offer must meet several requirements, and investors or state authorities may take the position that the ICO settlements do not satisfy those requirements. For example, state laws typically require that an offer be approved by state authorities, but the ICO settlements do not appear to contemplate state approval. It is also not clear they would obtain state approval, as there is no precedent for doing so in the cryptocurrency context.
State rescission statutes also typically require that “equivalent” offers be made to all investors who have a claim, and that the offers equal the damages available under the statute or place the parties back in the same position as before the transaction. Past ICO purchasers contributed Ethereum (or bitcoin) during a period of intense volatility, and ICOs handled conversion rates in different ways. Purchasers may argue that the dollar payments contemplated by the SEC are not equivalent for all investors, that they are entitled to higher damages and/or that tax consequences of reimbursement would put them in a worse position than before the transaction. Until there is more legal certainty around such questions, ICO settlements lack the clear preclusive power of a standard rescission offer.
Fraud and Other Misconduct
The ICO settlements provide no protection against fraud or misrepresentation claims. Even companies that act in good faith frequently find themselves defending such claims, and as limitation periods for registration claims expire, fraud and other such claims (which have a longer limitations period) may become more prevalent. It would be wise to assess that exposure through a careful review of conduct surrounding an ICO before determining how to proceed.
The Bottom Line
The SEC’s ICO settlement model is attractive, but it is not a panacea. There is no substitute for evaluating each case with experienced securities litigation and enforcement counsel, and periodically reevaluating as the law comes into focus.
Originally published on Law360 (Subscription required)
 https://files.consumerfinance.gov/f/201503_cfpb_arbitration-study-report-to-congress-2015.pdf (at page 31).
 In the Matter of Google Inc. and David C. Drummond, Securities Act of 1933 Release No. 8523 (Jan. 13, 2005), Admin. Proc. File No. 3-11795. See also Stoiber v. Securities and Exchange Commission , 161 F.3d 745 (D.C. Cir. 1998), cert. denied, 119 S.Ct. 1464, 143 L.Ed.2d 549 (1999).
 Topalian v. Ehrman , 954 F.2d 1125 (5th Cir. 1992); Meyers v. C & M Petroleum Producers Inc. , 476 F.2d 427 (5th Cir. 1973).