By Daniel G. Viola, Partner of Sadis & Goldberg, LLP, a New York based law firm. Daniel is the Head of the Digital Asset and Compliance Groups at his firm and is also the founder of the Crypto Asset Webinars and the Blockchain Shift Conferences.
Not all offerings of tokens are improper, and when conducted in accordance with federal and state securities laws, can be a positive source of capital for entrepreneurial start-up companies. The U.S. Securities and Exchange Commission (the “SEC”) continues to aggressively investigate fraudulent offerings and to protect investors from alleged wrongdoing. For example, on May 29, 2018, the SEC issued a press release announcing that it obtained a court order halting an ongoing fraud involving an initial coin offering (“ICO”) that raised as much as $21 million from investors in and outside the U.S. The SEC also convinced a court to approve an emergency asset freeze and appoint a receiver for Titanium Blockchain Infrastructure Services Inc. (“Titanium”), the firm behind the alleged scheme. Titanium was also the subject of a “wallet hack” in February 2018, resulting in a theft of a large supply of their token supply. Clearly, ICO issuers must impose proper security precautions to avoid site and wallet hacks. Investor confidence demands a secure environment in order to promote trust. Moreover, Titanium also highlights the importance of investor due diligence and presents a number of valuable marketing lessons that legitimate ICO issuers can learn from.
In general, ICO issuers should not use testimonials in their offering documents or otherwise. Testimonials are suspect for a number of reasons. You could easily misinterpret the tone of a testimonial or leave out important qualifications from a person’s testimony about your product or service even if you have the best of intentions. In addition, if you fail to obtain the written permission from the person providing the testimonial, then you could risk disclosing personal information about the person’s tastes or preferences in violation of privacy laws. Finally, SEC registered investment advisers are strictly prohibited from using client testimonials in their marketing materials as prescribed by specific SEC rules under the Investment Advisers Act of 1940, as amended. These rules would apply to investment advisers offering limited partnership interests or security tokens to investors.
In the SEC’s press release on Titanium, it reiterated warnings to ICO investors about the importance of conducting due diligence on ICOs and their principals and how a fraudulent ICO issuer can deceive investors using social media outlets. Note the following quotes from Robert Cohen of the SEC:
“This ICO was based on a social media marketing blitz that allegedly deceived investors with purely fictional claims of business prospects,” said Robert A. Cohen, Chief of the SEC Enforcement Division’s Cyber Unit. “Having filed multiple cases involving allegedly fraudulent ICOs, we again encourage investors to be especially cautious when considering these as investments.”
Lessons Learned: Issuers should only publish truthful representations in their marketing material, especially if they blast out their representations using social media. Issuers should also confirm, with securities counsel, the ability to market to the general public and the placement of proper risk disclaimers in their marketing material, prior to starting a marketing campaign, since some offering laws preclude an issuer from advertising the sale of securities to the general public. Avoiding testimonials and sales puffery can also help mitigate claims of offering fraud and violations of federal and state antifraud laws. Using industry logos without permission or promoting yourself as an expert without any actual certificates or degrees to support your claims will also attract negative regulatory scrutiny and will be viewed as unprofessional by prospective institutional investors. Finally, issuers must carefully consider the Howey Test when analyzing their offerings. The SEC also sued Titanium for not registering their offering or relying on a valid offering exemption. In the complaint against Titanium, the SEC requested the following sanctions: preliminary and permanent injunctions; return of allegedly ill-gotten gains plus interest and penalties; and a bar against the principal of Titanium to prohibit him from participating in offering digital securities in the future. If you have any questions, please call Dan Viola at 212–573–8038.