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SEC Update: Division of Enforcement Continues to Scrutinize Digital Token Sales

Authors: Robert L. Hickok, Jay A. Dubow and Kate A. Stanley

SEC Update: Division of Enforcement Continues to Scrutinize Digital Token Sales

Reprinted with permission from the December 6, 2018 issue of The Legal Intelligencer. © 2018 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.

In a sign that the Securities and Exchange Commission (SEC) is continuing to aggressively scrutinize token sales and initial coin offerings (ICOs), offers and sales of digital assets conducted by organizations using distributed ledger or blockchain technology are often referred to as “initial coin offerings” or “token sales,” the Division of Enforcement recently announced that it settled registration charges against two companies that sold unregistered digital tokens. Although neither company was accused of fraud or admitted to any wrongdoing, both companies agreed to offer to return funds to investors, register their tokens as securities, file periodic reports with the commission, and pay penalties of $250,000 each. Steven Peikin, co-director of the SEC’s Division of Enforcement described the settlements as a blueprint for companies that have conducted ICOs: “By providing investors who purchased securities in these ICOs with the opportunity to be reimbursed and having the issuers register their tokens with the SEC, these orders provide a model for companies that have issued tokens in ICOs and seek to comply with the federal securities laws.” These settlements are also instructive to companies contemplating ICOs in the future.

‘In the Matter of CarrierEQ, D/B/A AirFox’

According to the SEC, AirFox is a business that sells mobile technology for certain customers to earn free or discounted airtime and data by viewing advertisements on their phones. Between August and October 2017, AirFox raised $15 million by offering and selling approximately one billion digital tokens (AirTokens) to 2,500 purchasers. AirTokens were available for purchase in the United States and abroad. The SEC further alleged that, according to AirFox, users of Android smartphones would be able to earn AirTokens by viewing advertisements in the AirFox App and then could exchange the tokens for free airtime or data and ultimately other goods and services. At the time of the ICO, however, the AirFox App allegedly was released only in “beta” form and had no real users. Referencing AirFox’s business plan, blog posts, social media updates and White Paper, the SEC alleged that the purpose of the token offering was to raise capital to create and fund future development of the AirFox App as well as to fund new business segments. Moreover, according to the SEC, AirFox told prospective purchasers that the AirTokens would increase in value as a result of the company’s efforts and that the AirTokens would be tradeable on secondary markets. AirFox did not register the offering with the SEC before selling the tokens.

After investigating, the SEC concluded that the AirFox offering was an offer or sale of securities under the facts and circumstances test set forth in SEC v. W.J. Howey, 328 U.S. 293 (1946) and its progeny. The SEC highlighted several alleged facts in support of its conclusion that the AirTokens were securities, including:

  • AirFox directed its promotional efforts at investors rather than potential users
  • The AirFox App was only a prototype and the AirFox tokens had no current functionality at the time of ICO
  • AirFox intended to use the proceeds of the token sales to develop its business
  • AirFox suggested to prospective purchasers that AirTokens would increase in value and that it would take efforts to help increase the value of AirTokens, including by building an ecosystem that would create demand for AirTokens
  • AirFox told prospective purchasers that they would be able to trade AirTokens on secondary markets and, in advance of the ICO, AirFox announced that it had come to an agreement with a trading platform that would allow AirTokens to be traded via an “IOU trading system”
  • AirFox developed a “bounty system” that provided AirTokens to people that amplified its marketing efforts and ultimately more than 400 people received tokens for promoting the AirFox ICO
  • AirFox held a pre-sale prior to the public offering, where AirTokens were available at a discount to early purchasers, which the SEC believed encouraged speculative purchasers who intended to trade AirTokens on the secondary market
  • In an August 2017 blog post, AirFox stated that the pre-sale was intentionally directed at “sophisticated crypto investors, angel investors and early backers of the AirToken project” rather than potential users.

Although the terms of AirFox’s ICO required purchasers to agree that they were buying AirTokens for their utility as a medium of exchange for mobile airtime rather than as an investment or a security, the SEC discounted these certifications because at the time of the ICO, the AirTokens did not actually have that functionality. Indeed, according to the SEC, Airfox acknowledged that the prototype of the App “[did not] have any real users,” was “really just for the ICO and just for investment purposes so people know …how it’s going to work.”

Overall, based on these facts and circumstances, the SEC concluded that AirFox marketed, and investors purchased, AirTokens based on their potential future value rather than any current utility and purchasers had a reasonable expectation of obtaining a future profit based upon AirFox’s efforts.

‘In the Matter of Paragon Coin’

The settlement papers from In the Matter of Paragon Coin, tell a similar story. According to the SEC, Paragon was established in 2017 to implement blockchain technology in the cannabis industry. As part of its business, Paragon offered and sold digital tokens (PRG tokens) between August and October 2017. Through this initial offering, which included sales to United States purchasers as well as foreign purchasers, Paragon raised approximately $12 million worth of digital assets, which it intended to use to develop and implement its business plan. Paragon did not register the offering with the SEC.

The SEC highlighted several alleged facts in support of its conclusion that the PRG tokens were securities, many of which were also highlighted in the AirFox Order, including:

  • Paragon made statements in blogs and social media that the PRG token offering was an opportunity for purchasers to make a profit
  • Paragon intended to build an “ecosystem” around the tokens which would help them increase in value. For example, a representative of Paragon stated that it “will be using this money to build an entire ecosystem around our token that we’re expecting to bring much more value to the token than what it’s offered at right now” and that the representative expected the tokens to “appreciate in value due to [their] limited supply and the ecosystem we’re building around to build a strong demand”
  • Paragon controlled the number of PRG tokens in circulation and had a “deflation algorithm,” which would decrease supply of tokens to increase their value
  • Paragon’s White Paper stated that 200,000,000 tokens would be generated and then there would be “no further production of tokens so, over time, the tokens in circulation, shall reduce in number and increase demand”
  • Paragon’s White Paper described how the token sale would raise capital to fund and develop various Paragon business segments
  • At the time the PRG tokens were sold, they could not be used to buy goods or services
  • Before and after the PRG tokens were distributed, Paragon arranged to have the tokens listed on various secondary exchanges and, following the offering, the tokens were in fact traded on multiple trading platforms;
  • Paragon held a token “pre-sale,” where investors could buy tokens at a significant discount, with earlier investors receiving larger discounts, and
  • Paragon engaged a celebrity to promote the token offering.

After an investigation, the SEC concluded that the PRG tokens were unregistered securities because, among other things, purchasers had a “reasonable expectation of profits from their investment in the Paragon enterprise,” Paragon primed purchasers’ expectations of profit, and the proceeds from the offering were intended to be used by Paragon to develop and implement its business, see United Housing Foundation v. Forman, 421 U.S. 837, 852-53 (1975) (explaining that the “touchstone” of an investment contract “is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others”).

Settlement Terms

Both settlements contain similar terms. There is no allegation of fraud and neither company admitted or denied the allegations against them. However, both companies agreed to pay civil penalties of $250,000 each, to offer refunds to token purchasers with interest, to register their tokens as securities, and to make periodic reports as required by the Securities Act.

The civil penalties are notable and may indicate that the SEC is stepping up its enforcement of unregistered token sales. In July 2017, the SEC issued a report of its investigation into The DAO, a virtual organization that sold tokens in an ICO (the “DAO Report”). Although the SEC concluded that the tokens were unregistered securities, it declined to bring charges or otherwise make findings of violations. It did, however, issue a lengthy report on its investigation and conclusions, effectively warning the industry that federal securities laws would apply to digital assets if they met the Howey facts and circumstances test. “The innovative technology behind these virtual transactions does not exempt securities offerings and trading platforms from the regulatory framework designed to protect investors and the integrity of the markets,” cautioned Stephanie Avakian, co-director of the SEC’s Division of Enforcement in a press release accompanying the report.

Notably, both the AirFox and Paragon ICOs occurred after the SEC released the DAO Report. Thus, it appears likely that, as time goes on and the SEC continues to warn that federal securities laws apply to the sale of digital assets, the consequences for failing to register certain token offerings may increase.


The press release announcing these settlements warned that “the SEC continues to be on the lookout for violations of the federal securities laws with respect to digital assets.” As this will likely be a continued area of focus for the SEC, companies planning ICOs should carefully consider how their digital offerings are structured and whether they qualify as securities that should be registered.

Factors that token sellers should consider include:

  • Is the ICO raising capital to develop the business?
  • Is the offeror working to create an “ecosystem” around the tokens that will increase their value over time?
  • Do marketing materials suggest that the tokens will increase in value over time?
  • Are tokens promoted as being able to be shared and traded on secondary markets?
  • Do the tokens have any present utility?
  • Are marketing efforts directed at potential users or potential investors?
  • Are tokens used as a “reward” or payment to promoters of the ICO?
  • Are celebrity endorsements being used to market the tokens?

Additionally, it should be noted that neither of these offerings involved any allegations of fraud. Of course, such conduct would result in more severe regulatory treatment.

Finally, companies contemplating ICOs should also consider whether their offerings are structured in a way that they might qualify for registration exemptions.

This will surely continue to be a priority area for the SEC’s Enforcement Division and companies should carefully weigh these issues as they consider token sales.

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.

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