A Tale of Two Token Sales: the SEC Offers a Path Forward for Certain Unregistered Token Sales

On November 16, 2018, the US Securities and Exchange Commission (SEC) announced two new cryptocurrency enforcement actions against token sale issuers for violations of the registration provisions of Section 5 of the Securities Act of 1933. The settlements are particularly notable because: (i) they are the first Section 5-only cryptocurrency cases where the SEC imposed a civil penalty; (ii) they provide recent examples of the factors weighed by the SEC in applying the “Howey” Test to a token offering; and (iii) the remedies—requiring the issuers to register the securities under the Securities Exchange Act of 1934 and to file periodic reports—provide a potential path forward for certain token issuers that the SEC may view as having offered and sold digital asset securities in violation of Section 5. In an accompanying “Statement on Digital Asset Securities Issuance and Trading” (the “Joint Statement”) issued by the SEC’s Corporation Finance, Trading and Markets, and Investment Management divisions (the “Divisions”), the SEC noted its efforts to have issuers who offer unregistered digital assets that the SEC believes to be securities provide information comparable to that of a registered offering to investors. The Joint Statement also addressed other recent enforcement actions involving broker-dealer registration, investment vehicles investing in digital asset securities, and secondary market trading of digital asset securities including online cryptocurrency exchanges.

One of the November 16 actions involved Paragon Coin, Inc. (Paragon), an online entity established to implement blockchain technology in cannabis businesses, which sold roughly $12 million worth of Paragon digital tokens (PRG). The other action involved CarrierEQ, Inc., doing business as AirFox (AirFox), which raised approximately $15 million by selling AirTokens. The issuer intended to use the proceeds to finance an international business capitalizing on its existing technology, which allows purchasers of certain prepaid mobile telecommunications services to earn free or discounted airtime or data by interacting with advertisements on their phones.

Both offerings share a number of common features. Both cases concern offerings commenced after the SEC issued its July 2017 report of investigation concerning The DAO. Our alert concerning The DAO report is available here. Both offerings included tokens that were not yet usable for the contemplated applications and apparently were made available to US persons without any indication as to whether token purchasers were accredited investors. Additionally, both offerings were accompanied by statements that could be viewed as seeking to drive future appreciation of the token through the efforts of the promoter. Finally, both issuers made statements suggesting that token value would increase as a result of the developers’ efforts. 

The facts highlighted by the SEC in both actions suggest certain criteria the SEC weighs in applying the Howey Test in the cryptocurrency context: 

• Public Solicitation Efforts – Both AirFox and Paragon published whitepapers that included details about their planned token sales. Both companies also used numerous webpages, blog pages, social media accounts, and message boards to market their tokens. Paragon also engaged a celebrity rapper to promote its token sale.
• Absence of Current Utility – Neither PRG nor AirTokens had a current utility at the time of the respective offerings. Given the lack of utility, the SEC discounted the AirFox token purchasers’ representation in the terms of sale that they were buying AirTokens for their utility as a medium of exchange for mobile airtime, and not as an investment or a security.
• Statements Regarding Application of Proceeds through Managerial Efforts to Develop Platform – Paragon indicated in its whitepaper that it would use proceeds from the offering for development of the Paragon platform and to build an “ecosystem” around the token. Paragon highlighted the credentials, abilities and management skills of its agents and employees; for instance, its whitepaper noted their “depth of experience across business, technology, blockchain, smart contracts, and the cannabis industry,” and warned that the value of PRG was linked to the efforts of the developer. AirFox also indicated that funds would be used to further develop the system and pay for research, as well as sales, legal, administrative, and marketing expenses. AirFox told investors that AirTokens would increase in value as a result of its development efforts. AirFox indicated that its new international platform would include the existing airtime and data rewards system along with new features like user-to-user transfer of AirTokens, peer-to-peer lending and microloan features, credit scoring, and eventually commercial and retail usage of AirTokens.
• Statements Regarding Increased Demand for the Token – Paragon indicated that it would expend significant efforts to develop an “ecosystem” that would increase the value of the PRG tokens. In one of AirFox’s applications to a major digital token trading platform, the company explained that token value would increase over time: “[o]ver the next two years, the utility of the token will expand and therefore, more people across the world will need to have AirTokens in their possession to participate on our platform and ecosystem.” AirFox’s principals also said that they believed the undeveloped microlending functionality would create demand for AirTokens from large-scale lenders that would be required to purchase AirTokens in the public markets in order to participate.
• Statements Regarding Efforts to Stabilize or Increase Token Value – Paragon’s whitepaper stated that “PRG is designed to appreciate in value as our solutions are adopted throughout the cannabis industry and around the world. Our model incentivizes PRG owners to hold their tokens as long term growth assets, in addition to spending PRG on any of our platforms.” Paragon repeatedly highlighted, including in its whitepaper and marketing materials, a built-in “deflation algorithm” that it designed to decrease supply of PRG tokens and increase the value of PRG tokens. Paragon also described a “Controlled Reserve Fund” which would “intervene by buying back PRG in an effort to stabilize the market price” if value of the PRG tokens dropped significantly. According to AirFox’s whitepaper, the company would maintain the value of AirTokens by purchasing mobile data and other goods and services with fiat currency that could be then purchased by holders of AirTokens. AirFox also said in the whitepaper that the company would buy and sell AirTokens as needed to facilitate the purchase and sale of goods and services with AirTokens.
• Statements Relating to Appreciation through Scarcity – Paragon represented that only 200 million PRG tokens would be generated, and that “over time, the tokens in circulation shall reduce in number and increase demand.” AirFox announced that it was reducing the contemplated token supply in the initial coin offering from 150 billion to 1.5 billion without changing the anticipated market cap “to alleviate concerns raised by many current and potential token holders and token exchanges who prefer each individual token to be worth more.”
• Statements Regarding Future Secondary Trading and Liquidity – In its development timeline, Paragon noted “listing” of PRG on “major exchanges” within one month of the close of the offering as milestones for 2017 and 2018. Prior to the initial coin offering, AirFox told prospective investors that it planned to enter into agreements with token exchanges to ensure that the AirToken would be traded on the secondary market.
• Targeted Investor Base and Incongruence between Marketing Efforts and Opportunities for Use – Rather than promoting AirToken solely to prospective users of the platform, AirFox also marketed the AirToken to US persons, who were not intended to use the app. AirFox stated that an AirToken presale was directed at “sophisticated crypto investors, angel investors and early backers of the [AirToken] project.”

Although most of the above characteristics individually could be legitimate features of non-securities offerings, the combination of these factors led the SEC to conclude that PRG and AirTokens were securities under the Howey Test because each offering involved: (1) an investment of money (2) in a common enterprise (3) where there is a reasonable expectation of profits (4) from the efforts of the promoter or third-party. According to the SEC’s orders, both Paragon and AirFox offered and sold unregistered tokens that were securities when no exemption was available. 

Under the SEC orders, AirFox and Paragon have agreed to compensate any investor who purchased their tokens in the unregistered offerings if such investor makes a claim. Additionally, AirFox and Paragon must register their tokens as securities under Section 12(g) of the Securities Exchange Act of 1934 and file periodic reports with the SEC. In the Joint Statement, the Divisions noted that these post-sale disclosure measures are aimed at helping holders of PRG and AirToken “make a more informed decision as to whether to seek reimbursement or continue to hold their tokens.”

In view of these settlements and the Joint Statement, it would be prudent for issuers of digital assets to consult with counsel.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Eric Sibbitt, an O'Melveny partner licensed to practice law in California and New York, Andrew J. Geist, an O'Melveny partner licensed to practice law in New York, David Kirman, an O'Melveny partner licensed to practice law in California, Steve Bunnell, an O'Melveny partner licensed to practice law in the District of Columbia, Robert Plesnarski, an O'Melveny partner licensed to practice law in the District of Columbia and Pennsylvania, James M. Harrigan, an O'Melveny counsel licensed to practice law in the District of Columbia and Maryland, and Andrew A. Nizamian, an O'Melveny associate licensed to practice law in California, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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