The Sheriffs are in Town: Recent Developments in Initial Coin Offerings (ICO) Enforcement and Investor Education

In the months following director William Hinman’s noteworthy speech on whether and when a digital asset is subject to securities laws, U.S. regulators have continued their stern warnings regarding the importance of compliance with the securities laws. This post highlights three important regulatory updates:

  1. On August 14, 2018, the Securities and Exchange Commission (SEC or Commission) issued an administrative order, In the Matter of Tomahawk Exploration LLC and David Thompson Laurance, taking action against an unregistered and fraudulent initial coin offering (ICO).
  2. On August 28, the North American Securities Administrators Association (NASAA) released an update on the progress of its ongoing Operation Cryptosweep.
  3. The Financial Industry Regulatory Authority (FINRA) issued two investor alerts, on July 27 and August 16, regarding blockchain tokens and ICOs.

Tomahawk: “Free” Tokens or Convertible Equity Instruments Constitute the Offer and Sale of Securities

According to the SEC’s order, Tomahawk Exploration LLC (Tomahawk or Company) and its founder attempted to raise money for its oil and gas exploration business through the offer and sale of blockchain tokens called “Tomahawkcoins” from July through September 2017. The SEC’s enforcement action highlights important considerations for blockchain companies: (i) distributing tokens using “free” distributions through bounty programs and airdrops may constitute the offer and sale of securities; (ii) tokens that are convertible into equity securities are likely to be securities; (iii) don’t commit fraud.

Bounty Programs and Airdrops. Tomahawk was unsuccessful in raising money directly through an ICO and launched a “bounty program” for third parties to earn Tomahawkcoins in exchange for marketing efforts. The bounty hunters would make requests to list the tokens on trading platforms, promote the tokens on social media and create promotional materials such as YouTube videos. The SEC’s order noted that the lack of monetary consideration is not dispositive and such a “free” distribution may still constitute an offer or sale of securities. The SEC stated that Tomahawk received value in the form of online marketing and the creation of a public trading market for its securities. The same legal analysis may apply to other “free” distributions of tokens through airdrops or other incentive programs, which would then be subject to U.S. securities laws.

Convertible Equity Securities. While the SEC determined that when offered, Tomahawkcoins were securities because they constitute “investment contracts” under the Howey test, token holders also received an option to convert the tokens into equity shares of the Company.1  As a result, the SEC also found that, when offered, the Tomahawkcoins were equity securities because they were convertible, with or without consideration, into equity securities through the conversion feature. As first stated in the DAO Report, and reaffirmed in subsequent SEC enforcement actions, the SEC will apply the Howey test to blockchain tokens to determine whether the offer and sale of tokens is an “investment contract” subject to U.S. securities laws. Tomahawk serves as a reminder that blockchain tokens may be a digital representation of any tangible or intangible asset, including an equity security that is subject to the securities laws for reasons other than being an “investment contract.”

Fraud. The SEC held that the offer and distribution of Tomahawkcoins violated Section 5 of the Securities Act of 1933 because no registration statement was filed or in effect with the Commission and no exemption from the registration requirements applied. The SEC further found that Tomahawk and its founder violated the antifraud provisions of the securities laws.2 They made false statements regarding the Company’s prospects for success by using inflated projections of oil reserves and production, misrepresented Tomahawk’s lease holdings for the project and incorrectly stated that the Company’s founder had a “flawless background” despite a prior criminal conviction related to securities offerings. Lastly, Tomahawk published an article (in response to SEC’s DAO Report) incorrectly stating that their ICO would be exempt from securities regulation because the Company was abandoning its plan to be quoted on the OTC market.

Operation CryptoSweep: State Securities Regulators are Uncovering More Than Simple Securities Fraud

On August 28, the NASAA announced an update of its Operation Cryptosweep. A coordinated sweep of investigations and enforcement actions related to ICOs and cryptocurrencies was announced in May 2018 and involves 44 state and provincial securities regulators from the U.S. and Canada. The latest NASAA update revealed that over 200 active investigations of ICOs and cryptocurrency-related investment products are underway. The joint effort has resulted in nearly 50 enforcement actions since the initiative commenced in May.

NASAA president and Alabama Securities Commission director Joseph P. Borg noted that while some of the enforcement investigations involve suspected securities fraud, regulators are finding many other potential violations of state and provincial securities laws, such as failure to properly register a product prior to the offer and sale of securities. Borg stated that “it is important for individuals and firms selling these products to be mindful that … state and provincial laws or regulations may apply.” He encouraged sponsors of these products to seek legal advice and stated that “a strong culture of compliance should be in place before, not after, these products are marketed to investors.” It is clear that Operation Cryptosweep extends beyond token offerings. State regulators are also investigating trading platforms or mining operations that may be operating as unregistered brokers or dealers.

FINRA Investor Alerts

FINRA issued two recent investor alerts regarding ICOs and digital assets, demonstrating that these matters continue to be a top priority for the self-regulatory agency responsible for oversight of broker-dealers trading in digital assets. The alerts caution investors about fraudulent offerings and scams, including warnings to investors for projects that have “poor online presence, a white paper lacking in technical details, celebrity endorsements, guarantees of big profits, or unrealistic expectations about the type of platform or service the company is proposing to build,” which may be red flags of a potential scam. FINRA’s warning highlights similar themes to the mock ICO website the SEC recently launched as part of an investor education initiative.

FINRA noted that the use of Simple Agreements for Future Tokens (SAFTs) would still need to comply with state and federal securities laws. The alert states that there are no guarantees that the SEC or the courts would agree with a company’s assessment that a token originally issued under a SAFT as a security can transform over time into a “utility” or consumptive use token. This alert follows on the same themes discussed in director Hinman’s speech. In a footnote to the written version, director Hinman’s speech states his personal belief that “a token once offered in a security offering can, depending on the circumstances, later be offered in a non-securities transaction” but many may not, and that regardless of whether a SAFT is used, whether something is a security remains subject to a facts and circumstances analysis of the specific token sale.


Federal, state and self-regulatory agencies are focused on investor education and enforcement of securities laws related to token offerings, secondary trading platforms and mining operations. It is important for industry participants to understand the regulatory framework prior to launching blockchain solutions.

Under the test laid out by the Supreme Court, in brief summary, a transaction is an investment contract if there is an investment of money in a common enterprise with the expectation of profit derived from the efforts of others. SEC v. W. J. Howey Co., 328 U.S. 293 (1946).

The SEC has focused on combatting fraudulent token sales in the past. See, for example, actions against Centra TechArise BankPlexCorps, and REcoin Group.