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August 23, 2018

Enforcement Trends in the Cryptocurrency Industry – Week in Review (August 13-19, 2018)

Another ICO Becomes the Subject of a Class Action Lawsuit and a New SEC Order Calls Into Question the Practice of Airdrops

By Robert L. Lindholm, Matthew G. Lindenbaum

Our latest recap of enforcement news centers on a lawsuit filed last week in Washington state court alleging that an ICO conducted by a Seattle-based e-sports betting start up violated securities laws by not registering with the SEC and on the SEC’s recently released cease and desist order against Tomahawk Exploration LLC that concluded that tokens issued in a bounty program were securities that needed to be registered with the SEC.  Below is a summary of the most interesting enforcement stories from the past week.

New Civil Lawsuit Filed in Washington Against Unikrn.  On August 13, 2018, an investor filed a purported class action lawsuit in Washington state court against a Seattle-based e-sports betting startup, Unikrn, alleging that it violated U.S. securities laws in a recent ICO.  The lawsuit alleges that Unikrn and its founders Rahul Sood and Karl Flores sold unregistered securities to the public through an ICO for its blockchain-based UnikoinGold tokens (UKG).  Plaintiff, who invested 10 Ethereum in the UnikoinGold ICO, purports to represent a class of investors who purchased the UKG tokens from the defendants during the UnikoinGold ICO, which lasted from September 22, 2017 through October 22, 2017, or any time after.

The complaint alleges defendants conducted the UnikoinGold ICO over a one-month period and raised approximately $30 million.  After the ICO ended, defendants continued to sell UKG tokens to the public through cryptocurrency exchanges.  The complaint refers to various statements from the SEC that the SEC believes that most tokens are securities.  Plaintiff also states that although defendants characterized the tokens as “utility tokens”, courts have looked beyond the form of the transaction to the substance and economic reality of the transaction and that the utility tokens had no functionality at the time of the ICO.  Plaintiff asserts that the tokens were investment contracts under the Howey test and thus were securities that should have been registered and spends much of the complaint pointing to various statements and actions to support the conclusion that the elements of the Howey test have been met.  Plaintiff also states that defendants knew the tokens were securities because they filed a Reg D notice with the SEC for a previous private placement of securities that first took place days before the ICO began and raised approximately $16 million.

Plaintiff asserts that defendants violated Sections 5, 12(a)(1) and 15 of the Securities Act by offering and selling UKG tokens to the general public without filing a registration statement with the SEC.  Plaintiff specifically notes it is not alleging any fraudulent behavior on behalf of defendants.  Plaintiff claims that he and the purported class are entitled to rescission of their transactions, receiving back their Ethereum, with any corresponding appreciation in value of invested assets or the equivalent in monetary damages, as restitution.

As we noted in previous posts in May and July, although civil lawsuits in the cryptocurrency industry have only been sporadically filed up until now, they may begin to gain popularity among private plaintiffs and plaintiff firms as regulators continue to crack down on the industry and cryptocurrency prices continue to decline. 

SEC Order Calls Into Question Airdrops.  On August 14, 2018, the SEC published a cease and desist order against Tomahawk Exploration LLC (“Tomahawk”) and David Thompson Laurance (“Laurance”), banning Laurance from participating in the securities industry as a director or officer and from participating in any offering of a penny stock, in addition to ordering him to pay a civil penalty of $30,000.  However, it’s the SEC’s attention to Tomahawk’s bounty program that has those in the crypto industry paying close attention. 

Tomahawk is an oil and gas exploration company founded by Laurance.  Beginning in 2014, Laurance sought to raise money for an oil exploration project targeting a 400 acre property in California.  After multiple failed attempts to raise money for the project, Laurance and another person decided in June 2017 to fund the project through the issuance of Tomahawkcoins.  Laurance put up a website in June 2017 touting an ICO that he hoped would raise $5 million that would be open from July 30, 2017 to August 30, 2017.  To promote the ICO, the website touted the low risk and high potential of the investment, a business plan that claimed 5 million barrels of oil were recoverable, and that the odds of finding oil were almost a “mute-point” [sic].  The website claimed that the TOM tokens could be traded on a decentralized platform from day one and that owners of Tomahawkcoin would be eligible to exchange Tomahawkcoin for the equivalent value of shares of the public company.  The website also touted the principals’ as “refined successful citizens with flawless backgrounds”, failing to mention Laurance had a prior criminal conviction for mail fraud. 

Tomahawk also initiated a “Bounty Program” to promote the ICO in which it dedicated 200,000 TOM to pay to third parties in exchange for the third parties marketing efforts.  Tomahawk offered between 10 and 4,000 TOM for activities such as making requests to list TOM on token trading platforms, promoting TOM on blogs and other online forums, and creating professional picture file designs.  Between July and September 2017, Tomahawk issued more than 80,000 TOM as bounties to approximately 40 wallet holders on a decentralized platform.  Ultimately Tomahawk did not raise any money through the ICO and in October 2017 the ICO was abandoned.

The SEC concluded that TOM constituted investment contracts under the Howey test and thus constituted securities.  The SEC also concluded that TOM constituted securities because they constituted “an option, or privilege on any security” and “transferrable shares” under Section 2(a)(1) of the Securities Act and Section 3(a)(10) of the Exchange Act because purchasers had the option to convert TOM tokens into equity shares and investors would hold that privilege as long as they own Tomahawkcoins.  The SEC found that Laurance didn’t register the offerings nor were any exemptions from registration available.  In addition to the failure to register the securities, the SEC found that the ICO website contained numerous false and misleading statements in violation of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, including statements about risk, acquisition of a lease, and the principals’ backgrounds.     

Probably most significantly, the SEC concluded:  “Tomahawk’s issuance of tokens under the Bounty Program constituted an offer and sale of securities because the Company provided TOM to investors in exchange for services designed to advance Tomahawk’s economic interests and foster a trading market for its securities.  Tomahawk and Laurance violated Sections 5(a) and 5(c) of the Securities Act by offering and selling TOM without having a registration statement filed or in effect with the Commission or qualifying for an exemption from registration with the Commission.”  The SEC explained that it constituted an offer of securities under Section 2(a)(3) of the Securities Act because it involved “an attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value.”  “The lack of monetary consideration for ‘free’ shares does not mean there was not a sale or offer for sale for purposes of Section 5 of the Securities Act.  Rather, a ‘gift’ of a security is a ‘sale’ within the meaning of the Securities Act when the donor receives some real benefit.”  The SEC concluded that Tomahawk received real value in exchange for the bounty distributions, in the form of online marketing including the promotion of the ICO on blogs and other online forums.  The SEC also found that Tomahawk received value in the creation of a public trading market for its securities.  “Distribution of tokens that are securities in exchange for promotional services to advance the issuer’s economic objectives or create a public market for the securities constitutes sales for purposes of Section 5 of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.”

The ruling that the issuance of tokens under the Bounty Program was a security is likely to reverberate in the crypto industry.  Many companies have resorted to token “airdrops” or free tokens in exchange for marketing efforts to get around potential ICO securities law problems.  One website, airdrops.io, lists thousands of airdrops and bounty programs.

Airdrops are when a crypto company distributes free coins to their communities to do things like increase project visibility, increase circulating supply, and stimulate trading.  Within the term “airdrops”, you can have “bounty” drops or “holder” drops.  Bounty airdrops were what was at issue in Tomahawk and occur when a crypto company distributes coins as a reward for completing relatively simple social media tasks.  Holder airdrops reward people for simply holding a specific coin and there is no expectation of any reciprocal consideration.  While the SEC’s order is clear that with respect to Tomahawk the issuance of tokens under the Bounty Program was a security, it is not clear how the SEC would treat a holder airdrop where the recipient of the tokens provides no services in exchange for the tokens.  Under the Howey test, an investment contract is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.  In the case of a holder airdrop, there is no investment of money or immediate contribution of value by the person who receives the token.  This was a critical part of the SEC’s decision as it concluded that “a ‘gift’ of a security is a ‘sale’ within the meaning of the Securities Act when the donor receives some real benefit.” (emphasis added).  The question becomes whether the SEC will view a crypto company as receiving “some real benefit” by the holder holding the coin.  The Tomahawk order does not provide an answer to that question. 

Those crypto companies planning to do any type of airdrop should be aware of this order from the SEC and should consult with counsel before making any airdrops.     

Nelson Mullins can help companies and investors navigate the evolving ICO, cryptocurrency, and blockchain regulatory and legal environment.  The White Collar Defense and Government Investigations Group has extensive experience responding to regulator inquiries and other government investigations, as well as representing clients in related civil litigation, including class action lawsuits.  The firm’s Blockchain and Digital Currency Group and Securities and Enforcement Practice are also available to advise ICO issuers, exchanges, investors, and institutional investors on how to comply with SEC and other governmental agency registration requirements and regulations.

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