Cryptocurrency

In the Matter of Tomahawk Exploration LLC: No Such Thing as a Free Launch

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The issuance of digital tokens in exchange for services rather than money still can constitute an offering of securities, according to findings recently made by the Securities and Exchange Commission in a settled enforcement action, In the Matter of Tomahawk Exploration LLC and David Thompson Laurance, Securities Act Rel. No. 33-10530, Exchange Act Rel. No. 34-83839, Admin. Proc. File No. 3-18641 (Aug. 14, 2018). Tomahawk Exploration LLC offered and distributed digital assets in the form of tokens called “Tomahawkcoins,” or “TOM tokens” through an initial coin offering (“ICO”). The company offered a “Bounty Program,” whereby Tomahawk dedicated 200,000 TOM tokens to pay third parties, offering between 10 and 4,000 TOM tokens in exchange for the following activities:

  • marketing efforts;
  • making requests to list TOM tokens on token trading platforms;
  • promoting TOM tokens on blogs and online forums such as Twitter or Facebook;
  • creating professional picture file designs;
  • YouTube videos, other promotional materials; and
  • online promotional efforts that targeted potential investors and directed them to Tomahawk’s offering materials.

According to the SEC’s Cease-and-Desist Order, between July and September 2017, Tomahawk issued more than 80,000 TOM tokens as bounties to approximately forty wallet holders on Tomahawk’s decentralized platform in exchange for the activities listed above. The decentralized platform on which Tomahawk issued the TOM tokens was publicly accessible to U.S. persons and others throughout the offering period.

Based on the specific facts and circumstances outlined above, the SEC reasoned that the TOM tokens were considered securities because they were investment contracts under SEC v. W.J. Howey Co., 328 U.S. 293 (1946), and its progeny, including the cases discussed by the SEC in its Report Of Investigation Pursuant To Section 21(a) Of The Securities Exchange Act Of 1934: The DAO (Exchange Act Rel. No. 81207) (July 25, 2017). The SEC applied the Howey test and stated that “[t]he TOM tokens were offered in exchange for the investment of money or other contributions of value” and that “[t]he representations in the online offering materials created an expectation of profits derived from the efforts of others, namely from the oil exploration and production operations conducted by Tomahawk and Laurance and from the opportunity to trade TOM tokens on a secondary trading platform.” In addition, the Tomahawkcoins also represented a transferable share or option on an equity share of Tomahawk Exploration LLC, which would be considered securities under the federal securities laws under Section 2(a)(1) of the Securities Act of 1933 (the “Securities Act”) and Sections 3(a)(10) and 3(a)(11) of the Securities Exchange Act of 1934 (the “Exchange Act”). The SEC also determined that the TOM tokens were equity securities because they were “penny stocks” under Section 3(a)(51) of the Exchange Act and Rule 3a51-1 thereunder.

Of particular note is the SEC Staff’s argument that the TOM tokens issued under the Bounty Program constituted an offer and sale of securities because the respondents provided TOM tokens to investors in exchange for investors’ services designed to advance the company’s economic interests and foster a trading market for its securities. Paragraphs 33 and 34 of the Order explained that distributing TOM tokens in exchange for the provision of services could still be deemed an offer of securities under Section 2(a)(3) of the Securities Act because it involved “an attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value.” The SEC found that notwithstanding “[t]he lack of monetary consideration for purportedly ‘free’ shares,” the issuance of the TOM tokens as a “gift” of a security through the Bounty Program constituted a “sale” or “offer to sell” within the meaning of the Securities Act as stated in SEC v. Sierra Brokerage Servs., Inc., 608 F. Supp. 2d 923, 940–43 (S.D. Ohio 2009), aff’d, 712 F.3d 321 (6th Cir. 2013).

Consequently, the SEC found that the Respondents violated the securities registration provisions, Sections 5(a) and 5(c) of the Securities Act, prohibiting the selling or offering of a security through any means or instrument of transportation and communication in interstate commerce or the mails without an effective registration statement or qualifying exemption. The SEC also found violations of the antifraud provisions, Section 10(b) of the Exchange Act and Rule 10b-5(b) promulgated thereunder, arising from materially false and misleading statements found on Tomahawk’s ICO website and in its white paper.

Tomahawk is a new application of the principle that the issuance of “free” securities for some economic benefit would still constitute a sale of, or an offer to sell, securities. The SEC previously applied this principle in 1999, when SEC Staff issued at least three No-Action Letters indicating its view that Internet stock giveaways would constitute unlawful “sales” of securities if not subject to a registration statement or a valid exemption from registration:

  • In the Vanderkam & Sanders No-Action Letter, SEC No-Action Letter 1999 WL 38281 (Jan. 27, 1999), the SEC Staff opined that “the issuance of securities in consideration of a person’s registration on or visit to an issuer’s Internet site would be an event of sale.” According to the Letter, such an issuance would violate Section 5 of the Securities Act unless it was the subject of a registration statement or a valid exemption from registration.
  • In the Simplystocks.com No-Action Letter, SEC No-Action Letter, 1999 WL 51836 (Feb. 4, 1999), Simplystocks proposed to distribute free stocks randomly to members of a pool of entrants who logged in to Simplystocks’ website and provided their name, address, social security number, phone number and email address and chose a login name and password. Visitors would receive one entry into the stock pool for each day they logged in to the Simplystocks website. The SEC Staff were of the opinion that the Simplystocks.com stock giveaway would be an event of sale within the meaning of Section 2(a)(3) of the Securities Act and must be the subject of a registration statement or a valid exemption from registration.
  • In the Andrew Jones and James Rutten No-Action Letter, SEC No-Action Letter, 1999 WL 377873 (Jun. 8, 1999), the SEC Staff opined that the issuance of three free shares of common stock to the first one million people who register with the issuer to receive the shares, whether or not through the issuer’s Internet site, and the issuance of one additional share (up to a specified maximum) to each shareholder who referred others who also become a shareholder, was an event of sale within Section 2(a)(3) of the Securities Act. The Staff opined that such an issuance would be unlawful under Section 5 of the Securities Act unless registered or exempt from registration.

Tomahawk additionally highlights the potential issues for “air drops” and the “free” distribution of tokens to recipients, as well as a further consideration to the “investment of money” prong under the Howey analysis. Moreover, the fraudulent statements found in the ICO website and white paper further drives home the point that any and all documentation intended to be disseminated, whether in the public or private spheres, should be carefully reviewed and vetted by counsel. As with all matters in the blockchain and crypto-space, all facts and circumstances related to the distribution of digital assets must be carefully considered prior to and when conducting any type of distribution or sale to recipients and users.

Looking Out for Main Street: SEC Focuses on Retail, Cybersecurity and Cryptocurrency

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The Commissioners and senior officials of the Securities and Exchange Commission (“SEC” or “Commission”) addressed the public on February 23-24 at the annual “SEC Speaks” conference in Washington, D.C. Throughout the conference, many speakers referred to the new energy that SEC Chairman Jay Clayton had brought to the Commission since his confirmation in May 2017. The speakers also seemed relieved that the SEC was finally operating with a full set of commissioners since the recent additions of Robert J. Jackson, Jr. and Hester M. Peirce. Clayton’s address introduced the main refrain of the conference: that the SEC under his leadership is focused on the long-term interests of Main Street investors. Other oft-repeated themes included the challenges presented by cybersecurity and the fast-paced developments in cryptocurrency and blockchain. To address these shifts in focus, the Enforcement division plans to add more resources to the retail, cybersecurity and cryptocurrency spaces.

Following are the key litigation and enforcement takeaways.

Main Street Investors

Commissioner Kara Stein picked up on Clayton’s Main Street investors focus when she asked whether increasingly complex and esoteric investments, such as product strategies and structures that utilize derivatives, were appropriate for retail investors. She explained that it was not a question whether the financial industry could develop and sell these products, but whether it should. She said it was not clear that financial professionals fully understood the products they were selling, and that even if brokers and advisers made disclosures regarding the potential outcomes and risks to investors, complete disclosures might not even be possible due to the products’ complexity. Both SEC and FINRA Enforcement have brought actions related to the sales practices of inverse and leveraged ETFs, as well as the purchase and sale of complex products. Stein opined that gatekeepers needed to remember the real people behind every account number when they were advising clients on how to handle these types of products.

Steven Peikin, Co-Director of the Division of Enforcement, described the SEC’s Share Class Selection Disclosure Initiative as one way in which Enforcement was trying to help Main Street investors. The Initiative was created to address the problem of investment advisers putting their clients into higher fee share classes when no fee or lower fee classes were available. The SEC is incentivizing advisers to self-report this issue by promising not to impose any penalties, and only requiring them to disgorge their profits to investors. Peikin encouraged investment advisers to take advantage of this opportunity, indicating that if the Commission learned that an adviser had engaged in this conduct and did not self-report, it would be subject to significant penalties. The Chief of the SEC’s Broker-Dealer Task Force shared that AML programs and SAR-filing obligations are also a priority for the Enforcement division and OCIE exams. READ MORE →

SEC’s OCIE Announces 2018 Areas of Focus

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On February 7, 2018 the SEC’s Office of Compliance Inspections and Examinations (OCIE) announced its 2018 National Exam Priorities. The priorities, formulated with input from the Chairman, Commissioners, SEC Staff and fellow regulators, are mostly unchanged from years past (New Year, Similar Priorities: SEC Announces 2017 OCIE Areas of Focus, Orrick.com). However, the publication itself is presented in a more formal wrapper that begins with a lengthy message from OCIE’s leadership team describing the Office’s role and guiding principles, including that they are risk-based, data-driven and transparent, and that they embrace innovation and new technology.

2018 Priorities

OCIE’s principal 2018 priority, not surprisingly, appears to be the protection of retail investors, including seniors and those saving for retirement. OCIE specifically stated that it will focus on the disclosure of investment fees and other compensation received by financial professionals; electronic investment advisors – sometimes known as “robo-advisors”; wrap fee programs in which investors are charged a single fee for bundled services; and never-before-examined investment advisors. As to the latter, OCIE indicated that in the most recent fiscal year, it examined approximately 15 percent of all investment advisors, up from 8 percent five years before. It remains to be seen whether that increasing trend will continue.

Noting that the cryptocurrency and initial coin offering (ICO) markets “present a number of risks for retail investors,” OCIE included them as a priority for the first time. Examiners will focus on whether financial professionals maintain adequate controls and safeguards over the assets, as well the disclosure of investment risks.

Other 2018 priorities are compliance and risks in critical market infrastructure; cybersecurity protections, which OCIE states are critical to the operation of our markets; and anti-money laundering programs. In addition, OCIE has prioritized its examinations of FINRA and MSRB to ensure that those entities continue to operate effectively as self-regulatory organizations subject to the SEC’s oversight. READ MORE →

Financial Derivatives Intermediaries Who Trade Virtual Currencies Face the NFA’s Enhanced Reporting Requirements

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Derivatives regulators continue to take actions that pull virtual currencies – also known as digital currency or cryptocurrency, the best known of which is bitcoin – into their regulatory schemes. In December, the National Futures Association (NFA), the futures industry’s self-regulatory organization, issued three Notices to Members that expand the notification and reporting requirements for futures commission merchants (FCMs), introducing brokers (IBs), commodity pool operators (CPOs) and commodity trading advisers (CTAs) trading in virtual currencies and related derivatives. In issuing these directives, the NFA cited the fact that a number of CFTC-regulated trading venues were in the process of offering derivatives on virtual currency products and stated that it was expanding the notification and reporting requirements due to the volatility in the underlying virtual currency markets.

Specifically, the NFA’s notices:

  • direct each FCM for which NFA is the DSRO to immediately notify NFA if the firm decides to offer its customers or non-customers the ability to trade any virtual currency futures product. NFA also requires each FCM to report on its daily segregation reports the number of customers who traded a virtual currency futures contract (including closed out positions), the number of non-customers who traded a virtual currency futures contract (including closed out positions), and the gross open virtual currency futures positions (i.e. total open long positions, total open short positions);
  • direct each IB to immediately notify NFA if it solicits or accepts any orders in virtual currency derivatives. NFA also requires each IB that solicits or accepts orders for one or more virtual currency derivatives to notify NFA by amending its annual questionnaire, by answering this question: Does your firm solicit or accept orders involving a virtual currency derivative (e.g. a bitcoin future, option or swap)? In addition, starting with the current quarter, IBs that solicit or accept orders for virtual currency derivatives will also be required to report the number of accounts they introduced that executed one or more trades in a virtual currency derivative during each calendar quarter;
  • direct each CPO and CTA to immediately notify NFA if it executes a transaction involving any virtual currency (such as bitcoin) or virtual currency derivative (such as a bitcoin future, options or swap) on behalf of a pool or managed account. NFA’s Notice requires that CPOs and CTAs provide such notice by amending their annual questionnaire, to which NFA added questions that inquired, for CPOs, whether the firm operates a pool that has executed a transaction involving a virtual currency or virtual currency derivative and, for CTAs, whether the firm offers a trading program for managed account clients that have transacted in a virtual currency, or managed an account that transacted in a virtual currency derivative. In addition, beginning with the current quarter, the NFA is requiring CPOs and CTAs to report on a quarterly basis the number of their pools or managed accounts that executed at least one transaction involving a virtual currency or virtual currency derivative.

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