by Stephan Schlegelmilch, Ezra Newman, and Cameron Wolfe

The recent wave of bankruptcies in the crypto industry, culminating in the collapses of Celsius, BlockFi, and FTX, has spurred financial regulators to adopt a more aggressive tone when discussing their enforcement priorities.[1]  For instance, when announcing charges against FTX Founder Sam Bankman-Fried (“SBF”) for allegedly orchestrating a scheme to defraud FTX’s equity investors,[2] Securities and Exchange Commission (“SEC”) Chair Gary Gensler trumpeted that the charges were a “clarion call to crypto platforms that they need to come into compliance with our laws.”[3] Chair Gensler went on to threaten platforms that do not comply with the SEC’s interpretation of the securities laws, stating that “the SEC’s Enforcement Division is ready to take action.”[4]

Arguing that the law is clear and that additional, crypto-specific regulation is unnecessary, the SEC has been content to push what many in the industry refer to as “regulation by enforcement.”  But by advancing a one-at-a-time approach to conduct that the agency contends is both widespread and clearly illegal, the SEC appears to have ignored thousands of Initial Coin Offering (“ICO”) issuers during what has been referred to as the “ICO bubble.” 

There was a frenzied escalation of unregistered ICOs between 2017 and 2018, followed by a sudden and dramatic decline.[5] In the years since, the SEC has expressed its view, in court filings and public statements, that “[o]f the nearly 10,000 tokens in the crypto market, . . . the vast majority are securities.”[6]  However, the SEC has not engaged in enforcement actions against more than a handful of these issuers, and for many it has run out of time to do so. Enforcement actions seeking financial penalties and disgorgement are barred by the 5-year statutes of limitations for such remedies.[7] By allowing the statute of limitations to lapse on claims against ICOs occurring during the 2017-2018 bubble, the SEC is once again sending mixed messages to investors, exchanges and issuers about its view on the question of which cryptocurrencies are and are not securities. 

I. The ICO Bubble

Analogous to an initial public offering, ICOs emerged in 2013 as a largely unregulated mechanism to raise capital for new crypto projects.[8] ICOs raise funds by issuing and selling cryptocurrency tokens to public and private investors.[9] These tokens can represent either an ownership stake in the entity that launched the digital asset or, more commonly, can be exchanged for current or anticipated products and services.[10] Many investors hope to profit by reselling their tokens to future investors at an increased value.[11]

ICOs began to attract major investor attention in 2017.[12] While estimates vary regarding the total size of the ICO market, it is clear that thousands of ICOs raised billions of dollars between 2017 and 2018.[13] The volume of ICO activity began to fall dramatically in late 2018 due to a variety of factors.[14] During the ICO bubble, startups were able to raise large amounts of capital very quickly, often with little more than a white paper and a website.[15] Some ICOs raised extremely large sums, including one that raised over $1.7 billion in early 2018 and another raising $4.1 billion in a year-long ICO that ended in June 2018.[16]

Despite significant investor interest, the vast majority of the ICOs occurring during the 2017-2018 bubble either failed or turned out to be fraudulent. According to an analysis by Ernst and Young, by October 2018, 86% of the 141 largest ICOs of 2017 were trading below their listing price, and 30% had lost their value entirely.[17] By some estimates, almost 80% of the ICOs issued in 2017 were fraudulent.[18]

II. SEC Enforcement

A. Section 5

Section 5 of the Securities Act of 1933 (“Section 5”) requires issuers of securities to make certain mandatory disclosures and to file a registration statement prior to initiating a public sale.[19] The purpose of these regulations is to ensure that the investing public has the information necessary to make informed investment decisions.

Section 5(a) states that it is unlawful to sell securities unless the issuer has filed a registration statement or an exemption from registration applies.[20] Section 5(a) applies to a “distribution of securities,” which includes the “entire process by which, in a public offering, a block of securities is dispersed and ultimately comes to rest in the hands of the investing public.”[21] Accordingly, where a cryptocurrency token is classified as a security and offered to the general public, the issuer of that token may be required to file a registration statement with the SEC, just as an issuer of a more traditional security would be required to do.[22]  The key, then, is determining which tokens are and are not “securities” within the meaning of the Securities Act.

B. Inconsistent Enforcement

The SEC has been inconsistent in its enforcement of Section 5(a) against ICO issuers; its tough talk and relative inaction are difficult to reconcile. In July 2017, the SEC issued an investigative report “cautioning market participants that offers and sales of digital assets by ‘virtual’ organizations are subject to the requirements of the federal securities laws.”[23]  The report – while still not defining or explaining when the SEC would view something as a “security” or not – stated that:

• “Issuers of distributed ledger or blockchain technology-based securities must register offers and sales of such securities unless a valid exemption applies.”[24]
• “Those participating in unregistered offerings may be liable for violations of the securities laws.”[25]
• “Securities exchanges providing for trading in securities must register unless they are exempt.”[26]

The operative question remained as to whether or when a token constitutes a security, or sale of a token a securities offering. In 2018, the SEC’s Division of Corporation Finance, Division of Investment Management, and Division of Trading and Markets issued a “Statement on Digital Asset Securities Issuance and Trading.”[27] That statement, while not made on behalf of the SEC as a whole, reiterated that “market participants must…adhere to our well-established and well-functioning federal securities law framework when dealing with technological innovations, regardless of whether the securities are issued in certificated form or using new technologies, such as blockchain.”[28]

Following that guidance, the SEC brought several dozen enforcement actions against unregistered token offerings that were a part of the 2017-2018 ICO bubble.[29] For example, in 2020, the SEC obtained court approval for its settlement with Telegram Group Inc. to resolve charges that Telegram’s unregistered offering of “Gram” digital tokens violated Section 5(a).[30] The defendants agreed to return more than $1.2 billion to investors and to pay an $18.5 million civil penalty.[31] More recently, in August 2022, the SEC announced charges against Bloom Protocol, LLC for “conducting an unregistered initial coin offering of crypto asset securities” between November 2017 and January 2018 in violation of Section 5(a).[32] To settle the charges against it, Bloom agreed to pay a $300,000 penalty, register the coins, and compensate harmed investors or pay a springing penalty of up to $30.9 million.[33]  While the SEC has prevailed in the cases it has brought to date, each of these enforcement actions has demonstrated that every token must be considered on its own, individualized merits as an economic arrangement. 

Nevertheless, the SEC continues to make blanket claims that a wide variety of cryptocurrency tokens are securities for purposes of Section 5(a), albeit without taking any action against the hundreds—perhaps thousands—of remaining tokens issued during the ICO bubble.[34] In SEC v. Wahi, the SEC alleged that a former Coinbase Employee, Ishan Wahi, improperly provided “tips” to his brother and a close friend regarding the timing and content of Coinbase’s “listing announcements.”[35] The defendants collectively earned over $1.1 million by trading crypto tokens ahead of the listing announcements.[36] In its complaint, the SEC claimed that “at least 9” of the 25 different digital assets traded by the defendants were securities.[37] Three of the “at least 9” tokens identified in Wahi were issued during the ICO bubble, yet the Commission has not charged the relevant issuers with violations of Section 5.  While Wahi confirms the SEC’s view that certain, but not all, crypto currency tokens are securities under the Howey test, the SEC has yet to introduce a consistent enforcement framework beyond the agency’s ipse dixit and idiosyncratic case selection.[38]  

C. Statute of Limitations

Under the federal securities laws, the SEC can seek both monetary and non-monetary relief.[39] In SEC enforcement actions, non-monetary relief typically involves injunctive relief, often called “obey-the-law” injunctions, which require defendants to stay in compliance with certain federal securities laws.[40] Monetary penalties include disgorgement, which requires defendants to repay profits earned by their misconduct, and civil penalties.[41]

SEC enforcement actions are subject to numerous statutes of limitations, which are tied to the relief the agency seeks rather than the underlying securities law violation.  In 2021, Congress passed the National Defense Authorization Act (“NDAA”) over President Trump’s veto.[42] The NDAA codifies the SEC’s authority to seek disgorgement and bifurcates the statute of limitations applicable when seeking disgorgement for scienter and non-scienter based violations of the federal securities laws.[43] It extends the limitations period to seek disgorgement for scienter-based violations to 10 years.[44] However, the NDAA does not change the 5-year statute of limitations for civil penalties and for disgorgement in cases brought under statutes that do not require a showing of scienter—i.e., Section 5.[45] Thus, for the vast majority of ICOs occurring during the 2017-2018 boom, their respective issuers are likely no longer within the SEC’s limitations period for monetary relief. And, as we enter 2023, the five-year statute of limitations will only continue to run.

III. Takeaways

As the SEC continues to talk tough on cryptocurrency, its focus on exchanges and inaction against issuers continues to foster uncertainty, sending mixed messages to the crypto industry. The SEC maintains that nearly all of the roughly 10,000 digital assets on the market are securities, but the agency has done little to prove its claims against the parties most able and best situated to join issue with the SEC’s charges—the token issuers themselves.  Because the SEC daily loses the legal right to sue ICO issuers for monetary relief, the SEC forces exchanges and other market participants, rather than issuers themselves, to defend the legality of token issuances over which they had no control or involvement, now years after the ICOs in question.

Footnotes

[1]  See MacKenzie Sigalos, et al., Crypto firm BlockFi files for bankruptcy as FTX fallout spreads, CNBC (Nov. 28, 2022), https://www.cnbc.com/2022/11/28/blockfi-files-for-bankruptcy-as-ftx-fallout-spreads.html; Dave Michaels, SEC Faces Calls to Boost Crypto-Exchange Enforcement After FTX Collapse, WSJ (Dec. 8, 2022), https://www.wsj.com/articles/sec-faces-calls-to-boost-crypto-exchange-enforcement-after-ftx-collapse-11670474070; Sumeet Chatterjee, et al., After FTX collapse, pressure builds for tougher crypto rules, Reuters (Dec. 2, 2022), https://www.reuters.com/business/finance/after-ftx-collapse-pressure-builds-tougher-crypto-rules-2022-12-02/. 

[2] We note that the SEC’s complaint charges SBF with violating the anti-fraud provisions of the Securities Act and the Exchange Act but does not allege that the underlying digital assets were securities. 

[3] See SEC Press Release No. 2022-219, SEC Charges Samuel Bankman-Fried with Defrauding Investors in Crypto Asset Trading Platform FTX, (Dec. 13, 2022), https://www.sec.gov/news/press-release/2022-219.

[4] Id.

[5] See Andrey Kartsev, Best and Worst of ICO Gold Rush: How Technology Created a Market and Greed Doomed It (Dec. 2021), https://coinmarketcap.com/alexandria/article/best-and-worst-of-ico-gold-rush-how-technology-created-a-market-and-greed-doomed-it.

[6] See Statement of SEC Chair Gary Gensler, Kennedy and Crypto, (Sept. 8, 2022), https://www.sec.gov/news/speech/gensler-sec-speaks-090822. See also SEC Press Release No. 2022-219, BSEC Issues Investigative Report Concluding DAO Tokens, a Digital Asset, Were Securities, (July 25, 2017), https://www.sec.gov/news/press-release/2017-131; Division of Corporation Finance, Division of Investment Management, and Division of Trading and Markets Statement, Statement on Digital Asset Securities Issuance and Trading, (Nov. 16, 2018), https://www.sec.gov/news/public-statement/digital-asset-securites-issuuance-and-trading: SEC Complaint, S.E.C. v. Wahi, Case 2:22-cv-01009 (2022), https://www.sec.gov/litigation/complaints/2022/comp-pr2022-127.pdf. 

[7] See Section 21(d)(8) of the Exchange Act, 15 U.S.C § 78u; Gabelli v. SEC, 568 U.S. 442 (2013).

[8] See Annika Feign, What Is an ICO?, CoinDesk (Dec. 11, 2022), https://www.coindesk.com/learn/what-is-an-ico/.  

[9]  Id.

[10] Id.

[11] Id.

[12] Id.

[13] The ICO bubble peaked between mid-2017 and early 2018. By some estimates, there were 966 ICOs in 2017 raising more than $10 billion and 2,284 ICOs in 2018 raising $11.4 billion. See Daniele Pozzi, ICO Market 2018 vs 2017: Trends, Capitalization, Localization, Industries, Success Rate, Coin Telegraph (Jan. 5, 2019),  https://cointelegraph.com/news/ico-market-2018-vs-2017-trends-capitalization-localization-industries-success-rate.

[14] See Andrey Kartsev, supra note 5.

[15] Id.

[16] See Camila Russo & Ilya Khrennikov, Big Investors Circle Telegram’s ICO While Veteran Crypto Insiders Pass, Bloomberg (Feb. 2, 2018), https://www.bloomberg.com/news/articles/2018-02-02/big-investors-circle-telegram-offering-as-crypto-insiders-pass; Andrey Kartsev, supra note 5.

[17] Ernst & Young, Initial Coin Offerings (ICOs) the Class of 2017 – One Year Later, (Oct. 19, 2018), https://assets.ey.com/content/dam/ey-sites/ey-com/en_gl/news/2018/10/ey-ico-research-web-oct-17-2018.pdf.

[18] See Annika Feign, supra note 8.

[19] 15 U.S.C. § 77e(a).

[20] Id.

[21] See SEC Complaint at 6—7, SEC v. Telegram Group Inc., No. 1:19-cv-09439-PKC (S.D.N.Y. March 24, 2020), https://www.sec.gov/litigation/complaints/2019/comp-pr2019-212.pdf.

[22] See SEC Statement, Spotlight on Initial Coin Offerings (ICOs), (July 14, 2021), https://www.sec.gov/ICO (“ICOs that are securities most likely need to be registered with the SEC or fall under an exemption to registration.”).

[23] See SEC Press Release No. 2022-219, BSEC Issues Investigative Report Concluding DAO Tokens, a Digital Asset, Were Securities, (July 25, 2017), https://www.sec.gov/news/press-release/2017-131.

[24] Id.

[25] Id.

[26] Id.

[27] See State of Division of Corporation Finance, Division of Investment Management, and Division of Trading and Markets, Statement on Digital Asset Securities Issuance and Trading, (Nov. 16, 2018), https://www.sec.gov/news/public-statement/digital-asset-securites-issuuance-and-trading.

[28] Id.

[29] See Crypto Assets and Cyber Enforcement Actions, SEC, https://www.sec.gov/spotlight/cybersecurity-enforcement-actions (last visited Dec. 20, 2022).

[30] SEC Press Release No. 2020-146, Telegram to Return $1.2 Billion to Investors and Pay $18.5 Million Penalty to Settle SEC Charges, (June 26, 2020), https://www.sec.gov/news/press-release/2020-146.

[31] Id.

[32] SEC Press Release No. 3-20952, Unregistered ICO Issuer Agrees to a Springing Penalty of Up to $30.9 Million, (Aug. 9, 2022), https://www.sec.gov/enforce/33-11089-s.

[33] Id.

[34] See SEC Complaint, S.E.C. v. Wahi, Case 2:22-cv-01009 (2022), https://www.sec.gov/litigation/complaints/2022/comp-pr2022-127.pdf. (recognizing POWR and XY as securities).

[35] Id.  

[36] Id.

[37] See Id. Unhelpfully, the SEC does not explain whether it contends the remaining 16 tokens are securities or why or why not it so contends.

[38] See Justin B. Cohen, Cryptic Guidance? Despite Regulatory Ambiguity, New SEC Enforcement Could Drive Increase in Cryptocurrency-Related Shareholder Class Actions, National Law Review (Sept. 14, 2022),  https://www.natlawreview.com/article/cryptic-guidance-despite-regulatory-ambiguity-new-sec-enforcement-could-drive.  

[39] See Statement of SEC Enforcement Division Co-Director Steven Peikin, Remedies and Relief in SEC Enforcement Actions, (Oct. 3, 2018), https://www.sec.gov/news/speech/speech-peikin-100318.

[40] Id.

[41] Id.

[42] National Defense Authorization Act for Fiscal Year 2021, H.R. 6395, 116th Congress (2020). See also Kara Brockmyer, et al., The SEC’s Expanded Disgorgement Authority Complicates Investigations and Settlements, Debevoise & Plimpton Update (Jan. 4, 2021), https://www.debevoise.com/-/media/files/insights/publications/2021/01/20210104-the-secs-expanded-disgorgement-authority.pdf.  

[43] Kara Brockmyer, et al., The SEC’s Expanded Disgorgement Authority Complicates Investigations and Settlements, Debevoise & Plimpton Update (Jan. 4, 2021), https://www.debevoise.com/-/media/files/insights/publications/2021/01/20210104-the-secs-expanded-disgorgement-authority.pdf.  

[44] Id.

[45] Id. See also Gabelli v. SEC, 568 U.S. 442 (2013).

Stephan Schlegelmilch is a Counsel and Ezra Newman and Cameron Wolfe are Associates at Debevoise & Plimpton LLP. This article first appeared in the firm’s FinTech Blog.

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