By Grant P. Fondo, Mitzi Chang, Meghan Spillane, Stephen Fox, and Timothy Kistner
An initial coin offering (“ICO”) does not happen on its own. Rather, there are companies and individuals that assist in successful token sales. These can include ICO consultants, marketing firms, board members, partners at private equity and venture capital firms, and those that assisting in finding buyers for tokens. While there are benefits to those making ICO’s happen, there are also risks.
The Securities and Exchange Commission (“SEC”) Chief Commission recently stated “I have seen none of the [ICOs] that don’t have the hallmarks of securities” and that his office will start taking action against token coin offering issuers who fail to register with the agency or comply with federal laws. Thus, should the SEC find a token sale constitutes the sale of unregistered securities, it could subject the seller and those assisting the seller to an enforcement action by the SEC (or class action litigation). This article provides an overview of the kinds of activities that the SEC may deem sufficient “participation” to hold an individual liable under the federal securities laws. In light of these findings, this memorandum also includes some practical guidance for minimizing the risk of such liabilities.
SEC’s July 25, 2017, Guidance – “Participants” May be Liable. The SEC announced on July 25, 2017, that token sales, commonly referred to as ICOs, and other market “participants” offering digital assets by virtual organizations may be subject to the requirements of federal securities laws, but did not provide any further explanation for this term. The SEC uses the term “participant” in a variety of ways in different contexts. When assessing liability for individuals and outside entities involved with allegedly unregistered security offerings that did not comply with an available exemption under securities laws, as a matter of practice, the SEC appears to determine “participation” based upon the particular conduct of the individual or entity, rather than relying upon an individual’s or entity’s title or position.
Review of SEC related case law shows that liability may attach based upon an individual or company’s direct involvement in an offering. In particular, individuals or entities – including directors, officers, leading investors, public relations firms, and formally unaffiliated persons – who are directly involved with selling, issuing, or transferring shares, soliciting investors, or issuing investment materials for a particular unregistered security may be subject to the requirements of federal securities laws, and potentially held liable for violations of these laws in an SEC enforcement action.
I. ACTIVELY SOLICITING INVESTORS
Parties who actively solicit investors to buy or publicly promote the sale of unregistered offerings may be found to be necessary participants in the offering or sale of unregistered securities in violation of Section 5 of the Securities and Exchange Act of 1934 (the “Exchange Act”). Active solicitation may include publishing investment materials, such as a prospectus; contacting potential investors; serving as an intermediary between the issuer and the investor; or conducting other promotional activities on behalf of the issuer.
For example, in SEC v. StratoComm Corp., the CEO and sole director of StratoComm issued several press releases stating that the issuer had entered into multiple sales contracts worth more than $60 million – even though the releases described a product that did not exist and sales that never occurred. In addition, the issuer’s Director of Investor and Institutional Relations acted as the issuer’s designated contact for investors, relayed the terms of stock sales, handled paperwork related to stock sales, facilitated the issuance of shares, and actively sought investors using an Executive Informational Overview that contained the same misleading information as described above. The SEC found that these activities were intended to solicit investments in more than 62 million unregistered shares of stock that the company issued between 2007 and 2010. The SEC brought civil enforcement actions against both individuals and moved for summary judgment, contending in part that there was no dispute of material fact that the defendants sold millions of shares to over 100 investors, and that StratoComm’s stock offering was not registered as required by law. The court ruled in the SEC’s favor, finding that the defendants were necessary participants in the offering of unregistered securities.
In a second case, SEC v. Jones, Cheryl Jones was charged as a participant in the selling of unregistered securities based upon her active involvement in the solicitation of investments. According to the SEC, Jones’ brother created a bridge fund, which allegedly fraudulently offered unregistered securities. In 2007, Jones became one of the first investors in the bridge fund. Soon after investing with her brother, but while holding no official title in the bridge fund, Jones began to recruit investors to the fund. In this capacity, Jones sometimes served as a conduit for conveying information to investors, flew to Jamaica with potential investors to visit a real estate development project in which the funds were purportedly going to be invested, and served as an intermediary between her brother and investors after money was transferred to the fund. As part of her involvement, Jones received a commission of approximately 10% of the principal obtained from new investors, and received a legal retainer as high as $7,000. Although Ms. Jones held no formal title with the bridge fund, the SEC still asserted her liability as a participant in the selling of unregistered securities that did not comply with an exemption from registration based upon her active involvement in the solicitation of investments, charging her with violations of Section 5 of the Securities Act, and sought disgorgement of her gains, prejudgment interest, and a civil penalty. This case is one to watch as it remains pending.
Consistent with these cases, individuals who have actively solicited investors in the cryptocurrency context may also be subject to liability under the securities laws as “participants.” For example, the SEC brought charges against Erik T. Voorhees, who published prospectuses on the internet and actively solicited investors to buy shares, using Bitcoin, in “SatoshiDICE” (a gambling website that takes bets and pays out winnings in bitcoins) and “FeedZeBirds” (an entity that pays Twitter users a fee in bitcoins in exchange for forwarding sponsored text messages) on a website known as the Bitcoin Forum, as well as on Facebook. Voorhees ultimately settled with the SEC, which had claimed that “SatoshiDICE” and “FeedZeBirds” were unregistered securities that did not comply with an exemption under securities law. The profits ultimately earned by Voorhees through the unregistered offerings totaled more than $15,000. Voorhees agreed to pay full disgorgement of the profits plus a penalty of $35,000. Thus, any individual who is engaged in soliciting investors to purchase unregistered shares, including by publishing prospectuses, may be subject to an SEC enforcement action.
The SEC recently highlighted this risk when, on November 1, 2017, it issued guidance that individuals who promote investments into ICOs may be subject to an enforcement action. The SEC advised that “any celebrity or other individual who promotes a virtual token or coin that is a security must disclose the nature, scope, and amount of compensation received in exchange for the promotion. Failure to disclose this information is a violation of the anti-touting provisions of the federal securities laws.” The SEC also noted that individuals “making these endorsements may also be liable for potential violations of the anti-fraud provisions of the federal securities laws, for participating in an unregistered offer and sale of securities, and for acting as unregistered brokers.” Although the SEC guidance focuses on “celebrities,” the statement suggests that all individuals who are promoting ICOs need to be aware of the risk that the SEC may consider their activity to be unlawful.
II. TRANSFERRING AND SELLING SHARES
Significantly, even individuals who are not directly involved with the public-facing offering of unregistered securities that do not comply with an exemption may be subject to liability as a “participant” under the securities laws if they are involved in transferring the shares. For example, in SEC v. Platforms Wireless Intern. Corp., the SEC alleged and the district court found that because the defendant was CEO of Intermedia, an affiliate of the initial seller of unregistered securities, he was liable for selling unregistered securities in violation of Section 5 of the Securities Act. The court found liability because the CEO controlled the affiliate at the time of the transactions, did not take reasonable care to ensure that the affiliate was not an underwriter, and because the shares were unregistered. The court further held that the transaction could not qualify for a resale safe harbor under the securities laws and did not qualify for an exemption because of Platforms’ Executive Vice President – who received many of the shares from the affiliate before selling them to the public – qualified as an “underwriter”: “Intermedia’s affiliate status precludes any eligibility for the exemption. Because Intermedia was an ‘affiliate’ of Platforms at the time the transactions took place, by definition it necessarily also qualified as an ‘issuer’ for the limited purpose of defining underwriters… Having acquired the securities from an ‘issuer’ with an aim to distribute those securities to the public,” the Executive Vice President was rendered an underwriter and thus the transaction was ineligible for an exemption.
III. FACILITATING ISSUANCE/TRANSFER OF SHARES
Liability under the securities laws may also extend to individuals and entities that facilitate the issuance of certain unregistered securities through intermediaries. For example, in SEC v. Wyly the SEC brought a civil enforcement action against Samuel Wyly (Chairman of the Board of Directors of Michael Stores) and Charles Wyly (Michael Stores’ former Vice Chairman of the Board of Directors). Michael Stores sold two million shares of unregistered stock, and later sold two million options to purchase unregistered stock, to independent, offshore trusts of which Wyly family members were beneficiaries. Subsequently, those trusts sold the shares of unregistered stocks to the public at increased prices, without ever disclosing that the trusts were affiliates of Michaels Stores by virtue of being commonly controlled by the Wylys, or without properly registering the securities.
The SEC filed a complaint against both Wylys, each of whom was subsequently found liable by a federal jury for selling unregistered securities in violation of Section 5 (as well as other violations). The Wylys’ were ordered to disgorge all funds from the sale of these unregistered securities, plus prejudgment interest for the entire period of the violations.
While the SEC may use an individual’s or entity’s participation in the transferring of shares as a basis for this “participation,” the title of “transfer agent,” without more, will not necessarily provide a basis for liability under the securities laws. In SEC v. CMKM Diamonds, Inc., 729 F.3d 1248 (9th Cir. 2013), the Ninth Circuit considered the case of a transfer agent, Helen Bagley, and the corporation she owned, Global Stock Transfer Agency, LLC (“Global”), who had been found liable at summary judgment by the district court for serving as CMKM’s transfer agent in the course of issuing 622 billion shares of unrestricted CMKM stock (A court will grant summary judgment where there is no genuine dispute as to any material fact, and the party moving for summary judgment is entitled to judgment as a matter of law. Here, the court found that the SEC was entitled to summary judgment against Bagley and Global). Bagley and Global argued that they relied upon opinion letters written by co-defendants which caused them to understand that the stock was to be issued without a restrictive legend because payment for the stock had been made, or the stock split had occurred, at least two years earlier. Bagley also testified that Global is “only the transfer agency. That’s all we do. If we get proper paperwork, we do what needs to be done.”
The Ninth Circuit ruled that the SEC had failed to show as undisputed fact that Global and Bagley were “substantial participants” in the distribution. “A participant’s title, standing alone, cannot determine liability [for selling unregistered securities], because the mere fact that a defendant is labeled as an issuer, a broker, a transfer agent, a CEO, a purchaser, or an attorney, does not adequately explain what role the defendant actually played in the scheme at issue. Instead, whether a defendant is a necessary participant and substantial factor in the distribution of unregistered securities that do not qualify for an exemption from registration under securities laws is a question of fact requiring a case-by-case analysis of the nature of the securities scheme and the defendant’s participation in it.” CMKM at 1255, 1258 (emphasis added). Thus, once again it is not the title or position that is crucial in determining whether the SEC may be able to bring a successful enforcement action – instead, an individual’s or entity’s specific role in the offering itself is the determining factor.
IV. OVERSEEING A SCHEME TO CONVERT LOANS INTO UNREGISTERED SECURITIES
Notably, liability under the securities laws may also extend to contexts beyond the sale of traditional equities. For instance, in SEC v. E-Smart Tech, defendant Mary Grace (E-Smart’s President, CEO, CFO, and Director) sought investor capital by selling unregistered free-trading e-Smart shares. The sale, which Grace conceived of and executed, consisted of a convertible loan scheme, in which investors would make short-term loans to two intermediary corporations which Grace controlled, who would then offer up their restricted e-Smart shares as collateral for the loans. When the loans inevitably defaulted, the lender-investors would be given the option to convert their notes into e-Smart stock at $0.10 / share. As a result, millions of dollars in loans were exchanged for unregistered e-Smart shares. Grace was ultimately held liable for selling unregistered securities, making false statements in a 2008 press release, and failing to manage her business in accordance with SEC regulations.
V. CLASS ACTION LITIGATION
Separately, outside the realm of SEC enforcement, the scope of potential liability for participating in the alleged unregistered security sale not in compliance with securities laws may also be informed by the positions taken by private plaintiffs in civil litigation. In the recent class action lawsuit of Baker v. DLS, plaintiffs set forth allegations against a variety of individuals in executive level positions for allegedly selling unregistered securities, and even extended potential liability to a public relations firm that helped to promote the allegedly unregistered ICO by making allegedly false statements to the public about the offering. Plaintiffs’ position arguably is similar to the SEC’s apparent focus on individual “participants” who are actively involved in the solicitation and promotion of unregistered securities, but also expands the scope of potential liability to individuals wholly outside of the subject organization. While there has been no findings in that case, nor does it appear the SEC has taken “participant” liability that far, this case is worth watching to see how the court responds to these issues raised by the allegations.
In light of the SEC’s treatment of “participants” in these other contexts, we offer the following practical guidance that may assist an individual or entity in preventing or limiting liability when providing services to organizations in connection with an ICO, in the event that the token sale may be determined to be governed by the federal securities laws:
1. Do Not Be a Leader in the Decision to Do the ICO or in Executing It.
2. Perform Due Diligence on the ICO and Understand the Legal Status of the Token: It is important for potential participants to under understand the mechanics of the ICO in an effort to appreciate whether the sale is likely to be deemed a securities offering, and to possibly minimize securities-like activities the company may be engaging in when selling the token.
3. Test the Veracity of All Promotional Materials: Where “participant” liability may attach under the securities laws for any individual involved in the solicitation of purchasers in the context of an ICO, potential participants should be on the alert for information used in the solicitation of purchasers or investors – or the promotion of a company issuing tokens – that is not fully truthful and accurate. Forward looking statements should avoid promises of future profits or an increase in the value of the token, and be couched in language stating that such statements are only speculative.
4. Refrain from Marketing the Token. “Participant” liability may attach under the securities laws for any entity or individual involved in the solicitation of purchasers in the context of an ICO. Therefore, to the extent possible, it is best to avoid marketing the token in any way and, in particular to investors (which are distinguishable from likely users of the tokens), nor should you seek compensation for doing so.
5. Refrain from Transferring Tokens: In light of liability that might attach from the transferring of unregistered securities not in compliance with securities laws, if you have received or purchased tokens, you should carefully evaluate transfers and sales, particularly on a public exchange.
6. Indemnification and Insurance. Evaluate whether your insurance covers governmental investigations/actions or civil litigation in the context of an ICO, and assess whether the seller will indemnify you for any legal fees and expenses or a judgment as a result of the ICO.
7. Stay off the Board. If you are not on the Board, stay off it – at least through the ICO.
8. Keep Track of Tokens: If the SEC were to find an individual liable as a “participant” in an unregistered securities offering not exempt from registration, tokens received as a result of services provided may be subject to disgorgement. As such, it may be advisable to keep track of how tokens were acquired, and to whom they were transferred.
9. Avoid Cap Table Allocations and Carefully Consider Pre-Sale Purchases: Private equity and venture firms and other investors may further limit their risk of potential liability as a “participant” in an unregistered securities offering by avoiding the granting of tokens through a cap table allocation provided to current equity holders only. Further, any purchase of pre-sale tokens should be done in a manner that complies with an available exemption from registration under the securities laws.
10. After the Sale. Potential participants, to the extent possible, should help ensure that companies, after the sale, do not spend the money raised foolishly or do anything inconsistent with the company’s representations in its white paper and sale agreements. For example, companies should not use funds raised to support lavish expenses, the enrichment of founders and employees or, unless explicitly disclosed, to invest in other token sales.
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Grant Fondo, an experienced federal prosecutor and former Assistant U.S. Attorney in the Northern District of California, is a partner in Goodwin’s Securities Litigation & White Collar Defense Group, its Privacy & Cybersecurity Practice and Chair of its Digital Currency & Blockchain Technology Practice. He represents technology, FinTech, blockchain, digital currency, life sciences, private equity and venture capital clients in a wide range of contested matters, as well as digital currency and blockchain companies in token sales and other matters.
Mitzi Chang, a partner in Goodwin’s Technology Companies & Life Sciences Group, focuses her practice on corporate and securities law, representing public and private companies, venture capital and private equity firms and investment banks in capital markets transactions, mergers and acquisitions, venture capital financings, SEC reporting and other general corporate and securities matters. Ms. Chang advises companies through every stage of the corporate life cycle – from initial financing through successful initial public offering or acquisition.
Meghan Spillane is a partner in Goodwin’s Securities, White Collar Defense & Business Litigation Group. She focuses her practice on white-collar criminal defense, including conducting internal investigations on behalf of corporate entities and representing companies and individuals in connection with government investigations and prosecutions. She also maintains an active civil practice, representing companies in complex business and financial litigation matters.
Stephen Fox is an associate in Goodwin’s Business Law Department. His practice focuses on advising emerging companies and investors throughout the corporate life cycle, including pre-incorporation planning and formation, venture capital financings, mergers and acquisitions, and general corporate representation and counseling. Mr. Fox represents clients in a variety of life sciences, technology, blockchain, digital currency, private equity and venture capital clients.
Timothy Kistner, an associate in the firm’s Securities Litigation & White Collar Defense group, concentrates his practice on government and internal investigations, corporate governance and securities litigation, white-collar criminal defense, and complex commercial litigation. Mr. Kistner has represented clients in federal government investigations related to national security, health care fraud, False Claims Act violations, Anti-Kickback Statute violations, immigration and visa issues, contract fraud, and export control violations.
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