LGO Markets Regulatory Update — Week of November 19, 2018

In this update, we talk about the SEC’s Paragon and Airfox ICO enforcements, the Ripple class action lawsuit, and the U.S. midterm elections, discussing the use of digital assets in campaign financing.

SEC Settles Charges in First Non-Fraud ICO Action After Munchee, Provides “Model” for Retroactive Compliance

The SEC released details of two settlements with ICO token issuers last Friday in which both companies agreed to reimburse investors, pay civil penalties in the amount of $250,000, register their tokens pursuant to the Exchange Act of 1934 (preparing initial disclosures within 90 days), and submit special reports to the SEC to demonstrate compliance with all aspects of the order. The companies, Boston-based startup Airfox and cannabis blockchain venture Paragon, each conducted ICOs in 2017 after the SEC’s DAO Report without registering them under securities laws or qualifying for an exemption.

CarrierEQ Inc., operating under the name Airfox, raised about $15 million from more than 2,500 investors through the sale of its AirTokens, promising to create a mobile app that rewards users with tokens for interacting with ads and sharing data. Airfox advertised the sale through their social media pages, website, messaging boards, and by paying hundreds of individuals to promote the token on their blogs and YouTube channels.

Paragon issued its PRG token, an ERC-20 token, raising $12 million, in anticipation of using blockchain technology to “organize, systematize and bring verification and stability to the cannabis industry.” PRG was sold through private agreements, a pre-sale, and public sale reaching American investors. PRG was also promoted by a rapper known as The Game. Paragon’s whitepaper stated that PRG was “designed to appreciate in value” by the establishment of the “ecosystem” and a platform for secondary trading.

The SEC proposed that these enforcement actions should serve as a model of the remedial efforts other ICO issuers who similarly failed to register their token sales should consider in an attempt at retroactive compliance: reimburse investors of their contributions and promptly register the tokens as securities. In a public statement issued in tandem with the press release and orders, it elaborated: “These two matters demonstrate that there is a path to compliance with the federal securities laws going forward, even where issuers have conducted an illegal unregistered offering of digital asset securities.”

Ripple Fights to Move Class Action to Federal Court, Lawyers Hint at Possible Defense Strategy

According to court documents released last week, Ripple’s ongoing legal battle will play out before a federal court in California. Ripple Labs and its co-defendants, including Ripple’s subsidiary XRP II and a litany of Ripple executives and directors, filed a motion for removal of the consolidated class action lawsuit first filed by aggrieved investors back in May with allegations that defendants violated securities laws in connection with the sale of Ripple’s native cryptocurrency XRP, which has declined precipitously in value since the all time high of $3.84 in January 2018.

Specifically, plaintiffs allege that XRP possessed “all the traditional hallmarks of a security” when it was sold in the “never ending ICO,” causing investors financial detriment exceeding $150 million. Plaintiffs distinguished XRP from mined virtual currencies like bitcoin and ethereum, stating that all 100 billion XRP were created by Ripple Labs “out of thin air” in 2013.

Defendants’ lawyers foreshadowed a possible defense to the contentions that XRP is a security, stating that plaintiffs did not allege they lacked adequate information about the nature of the transactions. Interestingly, SEC Director William Hinman pointed to informational asymmetry as a factor to consider when assessing whether a token meet the elements of a security. Additionally, in the SEC’s recent Statement on Digital Asset Securities Issuance and Trading, it reiterated that the purpose of registration is to permit investors to make informed choices regarding their investments.

Plaintiffs quickly submitted notice to the court that they plan to file a motion to challenge the removal within 30 days. The California federal court will either grant the motion, transferring the dispute back to the state court, or deny it, keeping the case in federal court. To succeed, plaintiffs must sufficiently contend that defendants failed to meet the standards for removal under the U.S. Class Action Fairness Act (CAFA), which requires a class of more than 100 plaintiffs, more than $5 million requested in damages, and a class where at least one plaintiff is citizen of a state different than that of the defendants.

The move may help the defense find more favor by bypassing the state court system. It is also worth noting that Ripple recently added ex-SEC Chairman Mary Jo White to their legal team. The addition comes just a few months after the departure of Ripple’s General Counsel, Brynly Llyr, back in September.

Blockchain Makes Headlines During U.S. Midterms While State Officials Take Aim at Crypto Political Contributions

In a move toward mainstream politics, candidates’ blockchain and cryptocurrency platforms made headlines nationwide during the U.S. midterm elections. According to a report published by the Digital Asset Trade Association (DATA), a DLT advocacy group, pro-crypto governors took office in California, Colorado, and Wyoming. DATA’s report rated all state candidates for governor on their crypto-friendliness in 12 categories, including favor towards blockchain-friendly policies, accepting tax payments in cryptocurrency, establishing crypto-focused working groups, and recognizing the legal enforceability of smart contracts.

Democrat Jared Polis, co-founder of the Congressional Blockchain Caucus, won the race for governor in Colorado, scoring high marks on his overall crypto-friendliness. He ran on a mission to make the state the “national hub for blockchain innovation in business and government.” He described his goal to create a regulatory sandbox for “open blockchain tokens,” similar to that of Wyoming, and use the technology to increase government transparency.

California’s governor-elect Gavin Newsom famously tweeted at Polis back in 2014 regarding accepting bitcoin political donations:

While many celebrated the accession of pro-blockchain candidates to office, state officials in Michigan were taking aim at the use of virtual currencies for political contributions. Shortly after the midterms, Michigan’s Secretary of State Ruth Johnson released a statement effectively banning bitcoin and other virtual currencies from being used in state campaign financing.

According to the letter, under Michigan’s Campaign Finance Act, political donations must be of monetary denomination, the value of which is reasonably precise. The letter described bitcoin as a “fiduciary currency” rather than a “commodity-based currency,” likening it to more of a security than a traditional currency due to its fluctuating value and volatile nature. It goes on to detail how allowing committees to accept cryptocurrencies as political contributions would “create a quagmire for reports” required under state law.

Michigan is not the first state to ban virtual currency political contributions. California’s campaign oversight regulators announced a ban on digital assets as political contributions back in September, following the same decision made in South Carolina. Bitcoin political contributions are permitted at the federal level within limits. Only time will tell whether bitcoin grows into a mainstay of political financing or whether more states follow in the likes of Michigan, California, and South Carolina.

The information provided is for informational purposes only. It does not constitute legal or investment advice.

Sources used in this article:

https://www.sec.gov/news/press-release/2018-264

https://www.sec.gov/litigation/investreport/34-81207.pdf

https://digitalasset.org/wp-content/uploads/2018/11/IN-PROCESS_DATA-Scorecard_Rev-1.pdf

https://www.congressionalblockchaincaucus.com/

https://www.michigan.gov/documents/sos/FINAL_preliminary_DR_CLEAN_002_638167_7.pdf