The SEC's "token" enforcement action against Ripple for XRP

Why does the SEC allow firms to raise millions, even billions, via exempt offerings, only to bust them later for an alleged illegal securities offering, often after the money is long gone?

On December 22, a few days before Christmas, when you think everyone at SEC has turned off their computers until the new year, the SEC charged Ripple Labs and two of its executives with conducting a $1.3 billion unregistered securities offering.

According to the SEC's complaint, Ripple; Christian Larsen, the company's co-founder, executive chairman of its board, and former CEO; and Bradley Garlinghouse, the company's current CEO, raised capital to finance the company's business. The complaint alleges that Ripple raised funds, beginning in 2013, through the sale of digital assets known as XRP in an unregistered securities offering to investors in the U.S. and worldwide. Ripple also allegedly distributed billions of XRP in exchange for non-cash consideration, such as labor and market-making services. According to the complaint, in addition to structuring and promoting the XRP sales used to finance the company's business, Larsen and Garlinghouse also effected personal unregistered sales of XRP totaling approximately $600 million. 

It was the last big enforcement move by outgoing SEC Chairman Jay Clayton.  The next day, December 23, was his last.

CNBC, Jun 6, 2018

Note: The video asks about whether the SEC will approve a Bitcoin ETF. That still has not happened. But when the subject came up in 2018 there were a lot of comment letters to the SEC about Ripple and XRP. That raises the question: What is the impact on Grayscale XRP Trust and Arrington XRP Capital?

The New York Times added some color:

The suit, filed in federal court in New York, also names Ripple’s current chief executive, Brad Garlinghouse, and its former chief executive, Chris Larsen. The agency accused both men of selling the XRP token to enrich themselves despite knowing it had little actual use.

“Ripple sold XRP widely into the market, specifically to individuals who had no ‘use’ for XRP as Ripple has described such potential ‘uses’ and for the most part when no such uses even existed,” the complaint said.

Ripple had marketed XRP as a new kind of currency that would make it easier for banks and financial institutions to transfer money around the world.

The SEC’s press releases for the ICO-digital asset actions have gradually adopted a template.   

The Securities and Exchange Commission announced today that it has [filed an action/settled an action] against [the latest initial coin offering or ICO, now referred to as digital asset securities since ICO is passé,] alleging that they raised [hundreds of millions and even billions] through an [unregistered offering of digital securities.]

The SEC enforcement folks must get tired of repeating the principle of “regulating by disclosure” over and over, each time in slightly different plain English, trying to get it to stick.

"The registration requirements are designed to ensure that potential investors – including, importantly, retail investors – receive important information about an issuer's business operations and financial condition," said Marc P. Berger, Deputy Director of the SEC's Enforcement Division in the new enforcement action against Ripple.

It’s a broken record.

"The securities registration and exemption framework is designed to ensure investor protection and access to material information, while also facilitating capital formation. Failure to follow this framework harms investors and our markets," said Kristina Littman, Chief of the SEC Enforcement Division's Cyber Unit when the SEC brought an enforcement action against Unikrn for its UnikoinGold token in September of 2020.

“All investors are entitled to receive certain information from issuers in connection with a securities offering, whether it involves more traditional assets or novel ones,” said John T. Dugan, Associate Director for Enforcement in the SEC’s Boston Regional Office in regard to the SEC’s enforcement action in February of 2020 against Enigma for its ENG tokens.

BCOT did not provide ICO investors with the information they were entitled to receive in connection with a securities offering,” said Carolyn M. Welshhans, Associate Director in the SEC’s Division of Enforcement when the SEC brought an action against Blockchain of Things Inc. (BCOT) in December 2019. The press release added that BCOT conducted the ICO starting in December 2017 “after the Commission had warned in its DAO Report of Investigation that ICOs can be securities offerings.”

Telegram, the chat software, filed a Form D with the SEC on Feb. 13, 2018 saying it had started raising $850 million out of a billion dollar-plus target beginning on January 29 of that year. A Coindesk article said that Telegram was using the SAFT structure to raise money from accredited investors before a functioning network is built. The company said in the filing it would use the funds for the development of “the TON Blockchain, the development and maintenance of Telegram Messenger and the other purposes described in the offering materials.”

A Form D is the notice filed by a company for an offering that is exempt from full SEC registration requirements. The key criteria for the Form D exemption is that only “accredited investors,” that is, individuals that have a net worth of over $1 million, or that have consistently made over $200,000 per year in income, or companies that have over $5 million in assets, can invest. Companies don’t have to file the Form D before the offering takes place, but instead within 15 days after the first sale of securities in the offering.

Telegram promised to distribute digital tokens called “Grams” when its blockchain launched, no later than October 31, 2019. At that time purchasers and Telegram would have been able to re-sell billions of Grams into US retail markets.

But the SEC waited until the last minute, October 11, 2019, to file an emergency action and obtain a temporary restraining order to stop Telegram and its wholly-owned subsidiary, TON, from delivering its tokens to 171 initial pre-purchasers worldwide who had bought approximately 2.9 billion Grams at discounted prices. Those purchasers included more than 39 in the US who bought one billion Grams.

The SEC’s order said that the alleged unregistered, ongoing digital token offering by two offshore entities conducted in the US and overseas had raised more than $1.7 billion of investor funds.

“Our emergency action today is intended to prevent Telegram from flooding the U.S. markets with digital tokens that we allege were unlawfully sold,” said Stephanie Avakian, Co-Director of the SEC’s Division of Enforcement. “We allege that the defendants have failed to provide investors with information regarding Grams and Telegram’s business operations, financial condition, risk factors, and management that the securities laws require.”

If it was an unlawful sale in the first place, why did the SEC let it happen right under their own nose?

In February of 2018, I wrote:

Securities and Exchange Commission Chairman Jay Clayton has repeatedly reassured the public that no initial coin offerings have been “registered” with the SEC, but plenty of them are coming onto the market through what could be a back door.

Potentially, these ICOs could get distributed beyond just accredited investors and into the hands of retail investors and consumers…However, a report in Quartz says that “investors who got in on an earlier, private investment round, are already flipping their GRAM cryptotokens for twice the price they paid” and that the GRAM coins held by the SAFT accredited investors, could then be resold to consumers.

In the Telegram enforcement action, the SEC reiterated that saying your token is currency, not a security, doesn’t make it so.  

“We have repeatedly stated that issuers cannot avoid the federal securities laws just by labeling their product a cryptocurrency or a digital token,” Steven Peikin, Co-Director of the SEC’s Division of Enforcement. “Telegram seeks to obtain the benefits of a public offering without complying with the long-established disclosure responsibilities designed to protect the investing public.”

Bloomberg reported at the time that the company told investors it had been in talks with the SEC for the prior 18 months. So, within a few months of the company filing the Form D, the SEC started talking to them, all the while they were raising more money. Apparently the SEC was not in time to catch the bull before it jumped the fences and headed out to find its fortune.

After the SEC’s order, I predicted in an article in MarketWatch, that Telegram would have a hard time beating the SEC. That’s because the SEC had already forced another token project, Kik, to fold after thinking it could fight the SEC.

In June of 2019 the SEC had sued Kik Interactive Inc. for conducting what it said was an illegal $100 million securities offering of digital tokens. The SEC charged that Kik sold the tokens to U.S. investors without registering their offer and sale as required by the U.S. securities laws. Most token sales shunned U.S. investors, out of fear of SEC scrutiny, but not all of them did so, including Kik and Telegram.

Kik also used Form D exempt offerings to start raising money initially in late 2017, nearly two years prior. Kik started out by raising money from only wealthy “accredited” investors but then targeted a broader base.

See also: SEC action threatens billions raised in initial coin offerings that ostensibly targeted only wealthy investors

The SEC alleged Kik did not do enough to determine whether all investors qualified as “accredited investors,” despite a know-your-customer process and other anti-money-laundering policies. It also allegedly did not determine whether investors intended to profit from their purchase or to immediately resell and distribute the digital coin.

The SEC’s Kik complaint said Kik had sold its “Kin” tokens to the public at a discounted price to wealthy purchasers, just like Telegram and its Grams, in this case raising more than $55 million from US investors. 

In the Kik complaint, the SEC also tries to remind the public and wannabe token promoters about the Howey test.

“Kik told investors they could expect profits from its effort to create a digital ecosystem,” said Robert A. Cohen, Chief of the Enforcement Division’s Cyber Unit.  “Future profits based on the efforts of others is a hallmark of a securities offering that must comply with the federal securities laws.”

In a MarketWatch article in January of 2019, when the SEC first filed charges against Kik, I detailed how the SEC continued to let these token projects raise money from investors globally via the US SEC Form D exempt offering model, only to cut them down when perhaps they might try to spread out to US retail investors. The sudden enforcement action may also have been a case of “window-dressing” the stats. The numbers were now big enough to create a splash in funds “recovered” for investors and fines.

Kik’s primary defense against the SEC’s charges was that its token Kin was not a security but instead possessed the characteristics of such currencies as Bitcoin and Ether, which the SEC does not regulate as securities. That’s the same defense Ripple is using for XRP.

At the time Kik’s CEO, Ted Livingston, was unintimidated by the SEC, vowing to fight.

We have been expecting this for quite some time and we welcome the opportunity to fight for the future of crypto in the United States. We hope this case will make it clear that the securities laws should not be applied to a currency used by millions of people in dozens of apps.

In a press release issued after the SEC’s announcement, Kik’s general counsel Eileen Lyon said that the SEC’s complaint against Kik was based on a flawed legal theory because the SEC had stretched the so-called Howey test — named for the legal precedent forming the SEC’s basis for judging whether something is an investment contract and, therefore, a security — well beyond its definition.

We do not believe they will withstand judicial scrutiny.

She was wrong.

Kik capitulated on September 24, 2019, shutting down its core messaging service. Its CEO said in a blog post that the ongoing dispute with SEC forced Kik to shut down its app and shrink its crypto operations.

“After 18 months of working with the SEC the only choice they gave us was to either label Kin a security or fight them in court,” Livingston wrote. “So with the SEC working to characterize almost all cryptocurrencies as securities we made the decision to step forward and fight.”

I wrote more than once at MarketWatch that hundreds of coin offerings were coming to the market through the Form D back door.

Often the ultimate goal was for the cryptotokens issued as a result of these fund raisings to be distributed beyond accredited investors and into the hands of retail investors and consumers.

The volume skyrocketed to a peak of 99 in the second quarter of 2018. MarketWatch estimated there were 287 ICO-related fund raisings accepted by the SEC, with a total stated value of $8.7 billion, in 2018. That was a significant increase from 44 fund raisings filed, with a total stated value of $2.1 billion, in 2017. The pace slowed in the last half of 2018 but MarketWatch counted 33 ICO-related fund raisings accepted by the SEC in the first quarter of 2019, with a total stated value of $1.9 billion.

The trend continued during 2019.  In fact, that story was one of my last ones for MarketWatch in October 2019.

A few brave initial-coin-offering promoters are still using the SEC’s Form D exempt offering process to gain access to accredited investors with no pre-review by the Securities and Exchange Commission, but there’s been a steep drop-off since the SEC started suing, and settling, with some early promoters.

The markedly diminished activity so far in 2019 compares to 2018, when the SEC accepted 287 ICO-related fundraisings with a total stated value of $8.7 billion via Form D’s. 

ICO-related fundraising activity hits its peak with 99 filings in the second quarter of 2018. That was a significant ramp from 2017, when the activity rose from zero in the first quarter to one filing in the second quarter to a total of 44 ICO-related fundraisings, with a total stated value of $2.1 billion, by the end of 2017.

How many of token promotion companies, besides Ripple, Kik, Telegram, targeted by the SEC for splashy, tsk tsk enforcement actions since the DAO report came out used the Form D exempt offering back door — one the SEC could have easily closed earlier — to raise funds? 

Quite a few.

Unikrn raised its funding via Form D exempt offerings in 2014 and 2015. The hammer didn’t come down on Unikrn, Inc. and its UnikoinGold token until just a few months ago, in September 2020. Unikrn agreed to settle the charges it raised approximately $31 million through its through its unregistered initial coin offering (ICO) of digital asset securities, the UnikoinGold (UKG) token. by paying a $6.1 million penalty. I guess the rest of the money was gone, because the SEC says that was substantially all of the company's assets. The SEC plans to distribute the money to investors through a Fair Fund.

The SEC’s press release reads like an outline for the Howey test.

Unikrn promised investors that it would facilitate a secondary trading market for the tokens and that its efforts to increase the usages for the UKG token would increase demand for and in turn, the value of, the tokens.

Enigma filed its Form D exempt offering with the SEC in September of 2017. The purpose was tell the SEC it was raising $25 million from what it said was the “sale and issuance of rights to receive ENG tokens in the future” via SAFTs. Enigma also conducted a one-day “Crowd Sale” on September 11, 2017 and sold tokens to any and all general public investors, according to the SEC’s complaint.

Earlier in 2020, Enigma agreed to return funds to harmed investors via a claims process, register its tokens as securities, file periodic reports with the SEC, and pay a $500,000 penalty after raising approximately $45 million by selling 75 million digital tokens (ENG Tokens) in an Initial Coin Offering in the summer and fall of 2017. The ENG Tokens were supposed to be sold only to accredited investors and were sold at an approximate 10% discount relative to the ENG Tokens later sold.

Enigma apparently did everything wrong, according to the SEC’s complaint, including counting on a Simple Agreement for Future Tokens, or SAFT, legal framework to keep it out of trouble with the SEC.

SAFTs were a short-lived but heavily hyped innovation introduced in October  2018 in a whitepaper by Marco Santori, formerly an attorney at Cooley LLP, and Juan Batiz-Benet and Jesse Clayburgh of blockchain developer Protocol Labs. They proposed a new approach to structuring ICO deals to meet the SEC’s requirements to avoid being considered a security.

The approach was very successful, for a while. Most of the ICOs filed using Form D from mid-2017 — but not all and not KodakCoin — until early 2018 used this legal template.

However, the SEC started selectively targeting ICOs that were created using SAFTs, as reported by both The Wall Street Journal and CoinDesk. The bottom-line was that there was no way to convert a private sale of tokens to accredited investors into a broader distribution and sale of the took to the general public without registering the offering as securities.  That has always been what most token promoters wanted to avoid.

Here’s a good explanation by attorney Anthony Zeoli about why SAFTs supposedly died as a technique to get around SEC registration:

“…let’s remember what a SAFT boils down to: It’s a private security sale (typically to accredited investors only under Rule 506(b) or (c)) where the investor will automatically receive tokens once the issuer sells the tokens “to the general public in a publicized product launch” (typically referred to as a “Network Launch).

Now again assuming that the resulting tokens are securities, the only SEC compliant method for facilitating a sale of such tokens to the “general public” is to register the securities (i.e. via Reg A+ or a full blown IPO). Yes, there is Reg CF and Rule 506(c) which will allow for a form of public sale but when we are talking about a cryptocurrency asset being made public we are talking about expected widespread use, and large volumes, which would basically make those exemptions unworkable so we will ignore them and assume a full registration of the subject tokens will be required.

Pulling that all together, a SAFT sold in a private security sale would give the investor the right to automatically receive tokens once the issuer registers its tokens with the SEC for public sale. Put another way, by using a SAFT an issuer is essentially doing a private pre-sale of its future public securities which is a big no-no in eyes of the SEC.”

Reginald “Reggie” Middleton, filed a Form D in June of 2014 to raise $200,000, for something hybrid, with $50,000 going out as sales compensation to someone who in August of 2019 would sue Middleton.

1.     Middleton has breached his fiduciary duties to Hall and Veritaseum, Inc., by inter alia, misappropriating the assets of Veritaseum, Inc., including its intellectual property, for his personal benefit and the benefit of the Veritaseum Enterprise, which consists of alter ego defendants Veritaseum, LLC, Veritaseum Securities, LLC, Veritaseum Assets, LLC and Veritaseum Holdings, LLC.

2.     Middleton has also breached an agreement between Hall and Middleton through which the parties agreed to exchange Hall's ownership interest in Veritaseum, Inc. for cryptocurrency "coins" issued by Middleton's nascent Veritaseum Enterprise. Middleton's breach has resulted in millions of dollars in damages to Hall.

In August of 2019 the SEC announced fraud charges against Reginald “Reggie” Middleton and two entities he controls, Veritaseum, Inc. and Veritaseum, LLC (collectively Veritaseum). 

The SEC’s complaint, filed in federal court, alleged that Middleton marketed and sold securities called “VERI” tokens on the internet, “inducing retail investors to invest based on multiple material misrepresentations and omissions.” The court entered an emergency freeze order “to preserve at least $8 million of the $14.8 million the defendants raised in 2017 and 2018 in an offering of digital securities.”

On November 1, 2019, the Court entered a final judgment that ordered the Defendants to pay $7,891,600 in disgorgement and $582,535 in prejudgment interest, and Middleton to pay a $1,000,000 civil penalty. The final judgment created a Fair Fund, pursuant to Section 308(a) of the Sarbanes-Oxley Act of 2002, so the penalty, along with the disgorgement and prejudgment interest, can be distributed to investors harmed by the Defendants’ conduct described in the Complaint (the “Fair Fund”). 

The SEC’s first cases imposing civil penalties solely for ICO securities offering registration violations are an interesting hybrid of how the trend could have been stopped in its tracks earlier. All the SEC had to do is screen the Form D filings and tell folks, “Stop it!”

That’s necessary because the honor system doesn’t work. These companies don’t really want to register. That is not how the insider investors and promoters make big money.

Here’s The New York Times on Ripple’s corporate structure and how that benefits its executives and XRP’s executives:

The suit says that to lock in their fortunes, Mr. Larsen and Mr. Garlinghouse previously sold nearly two billion units of XRP that the company had given them.

XRP, which has been traded since 2012, has long been dogged by questions about how it is different from other cryptocurrencies. Unlike Bitcoin, which was released through a decentralized network of computers, XRP tokens were created and distributed by the founders of Ripple and the company they created.

On Nov. 16, 2018, the SEC settled charges against CarrierEQ Inc. (Airfox) and Paragon Coin Inc., both of whom conducted ICOs in 2017, after the SEC warned them ICOs can be securities offerings via its DAO Report of Investigation in July of 2017. 

Airfox, a Boston-based startup, raised approximately $15 million worth of digital assets, memorialized in its Form D in August 2016, “to finance its development of a token-denominated “ecosystem” starting with a mobile application that would allow users in emerging markets to earn tokens and exchange them for data by interacting with advertisements.” 

Paragon, an online entity, raised approximately $12 million worth of digital assets to develop and implement its business plan to add blockchain technology to the cannabis industry and work toward legalization of cannabis. They were fined $250,000.

Paragon pretended to for a brief time, to go legit, filing a registration statement with the SEC for ParagonCoin in March 2019. The SEC sent it an extensive comment letter, asking the company to answer some questions and revise its filings in April of that year and then again in August of 2019 when the company did not respond.

The SEC said in its complaint that Paragon did not qualify for an exemption from registration and did not even attempt to qualify by filing a Form D. Paragon announced the ICO — which it termed an “initial token crowdsale” — through a white paper on its website and marketed the ICO on various social media platforms.

Paragon “engaged a celebrity to promote the offering,” the rapper Jayceon Terrell Taylor, also known as “The Game.” Paragon paid Taylor to issue statements on various social media sites promoting Paragon and the offering and told potential investors that Taylor was on Paragon’s “Advisory Board.”

In November of 2019 The Wall Street Journal reported that some of the SEC’s settlements had hit some snags with regard to returning money to investors. 

The firms collectively raised about $40 million through illegal sales of digital tokens during the height of the cryptocurrency boom in 2017, when over $5.4 billion was raised. In exchange for paying lower fines, the companies were supposed to meet the 's fundraising rules. The agency touted the pacts as a template for resolving similar cases.

But two of the companies missed their original deadline last month to repay people who bought their tokens. A third startup is more than five months behind its target date for giving investors information needed to judge whether to seek a refund. All three say on their websites the SEC has given them more time to do the work, although the regulator doesn't itself disclose that.

Two of the startups -- Airfox and Paragon Coin Inc. -- agreed to pay fines of $250,000 each when they settled with the SEC in November 2018. The deals didn't accuse the firms of fraud. Instead, the SEC charted a path for the companies to make amends by bringing their initial coin offerings, or ICOs, under SEC oversight and offering refunds to investors…Airfox offers mobile banking to people in developing countries, including Brazil. Paragon said it is applying the database technology behind cryptocurrencies to the cannabis industry. Paragon enlisted the Game, a rapper with a noted fondness for weed, to tout its coin sale in 2017.

A third company, Gladius Network LLC, didn't pay a penalty when it settled. The SEC gave the company credit for self-reporting its violations.

As a first step toward compliance, the companies were required to submit a registration …Airfox and Paragon filed the disclosures. Paragon failed to answer an SEC letter with dozens of follow-up questions about its accounting and the shareholder rights that come with its tokens, according to agency filings. It also hasn't issued any quarterly updates for investors since registering its tokens in March, according to SEC data.

Gladius's settlement called for filing its registration statement by May 20, 2019. Its website says the deadline was extended until Nov. 18….Airfox and Paragon were supposed to pay back investors seeking refunds by Oct. 16 but missed that deadline. Airfox said it received an extension until Dec. 28 to complete the payback.

In April of 2020 ParagonCoin told its investors it was filing for bankruptcy. And in August of 2020, investors in ParagonCoin that want their money back couldn’t find the celebrity couple behind the project.

“The attorneys representing the defendants have withdrawn as counsel,” said attorney Donald Enright, who represents plaintiffs in this crypto-fueled legal dispute. Enright added the defendants “defaulted” by failing to appear in court and respond to the claims…The defendants’ former counsel, attorney Howard Schiffman, declined to comment other than to say his law firm hasn’t worked with or heard from the accused in “years.”

Next up?  I’ll check up on whether the SEC allowed any token coin offerings to raise money via Form D exempt offerings during 2020, and is now waiting for them to bulk up to create more nice and fat, juicy, “only for show” fines and Fair Funds.

© Francine McKenna, The Digging Company LLC, 2020