Thursday, September 13, 2018

ICO Platforms Beware: You May Be Operating as Unregistered Broker-Dealers

On September 11, 2018, the SEC announced that TokenLot LLC, a so called "ICO Superstore," agreed to settle charges brought by the SEC for operating as an unregistered broker-dealer.  The investigation was conducted by the SEC Cyber Unit.

The ICO Superstore enabled U.S. and foreign retail investors to purchase digital tokens during ICOs and engage in secondary trading.  To be precise: (i) TokenLot advertised and sold tokens issued by others; (ii) solicited investors; (iii) processed funds; (iv) enabled secondary trading in those tokens; and (v) advertised and promoted the sale of tokens in exchange for marketing fees paid by token issuers.  In fact, they handled over 200 different digital tokens for a total of 6,100 investors, receiving $471,000 in compensation.  TokenLot made money by charging a percentage of the ICO proceeds, marketing fees, as well as trading profits.

The Securities Exchange Act of 1934 defines a broker as "any person engaged in the business of effecting transactions in securities for the accounts of others."  Section 15(a) of the Exchange Act prohibits anyone to effect any transactions in securities for others unless such person is registered as a broker or dealer.  There are, of course, exceptions to this rule for certain limited categories of people, such as intrastate broker-dealers (Section 15(a)(1) of the Exchange Act), those dealing in exempted securities only (Section 3(a)(12) of the Exchange Act), foreign broker-dealers (Rule 15a-6 of the Exchange Act), issuers, and associated persons of the issuers (Rule 3a4-1 of the Exchange Act).  Some argue that there is also a so-called "finders exemption" developed through the SEC no-action letters, but even if it exists, it is extremely narrow in scope and highly dependent on particular facts and circumstances.

According to the SEC no-action letters and a helpful Guide to Broker-Dealer Registration published on the SEC website, there are four main questions to ask in determining whether certain activity requires broker-dealer registration:

1 - Does the person receive transaction-based compensation?  This is the key factor.
2 - Does the person engage in solicitation of potential investors?  Here, solicitation is interpreted broadly.
3 - Does the person engage in negotiations, provide advice, assist investors? Does the person facilitate the transaction?
4 - Does the person have previous securities sales experience or a history of disciplinary action?

First, the determination that the tokens were "securities" for the purposes of the Securities Act and the Exchange Act is key to the analysis, since there would be no broker-dealer registration requirement if they were facilitating the sales of something that was not a security (although, as you probably know, the definition of "security" is so broad that it even included citrus groves, warehouse receipts, minks, diamonds, pay phones, and chinchillas). 

Second, activities of TokenLot and its owners provide a positive answer to the first three of the B-D questions: the TokenLot promoters marketed the ICOs and tokens to prospective investors, facilitated transactions by receiving purchase orders and investor funds, and transferring digital tokens to investors and funds to the issuer, and they received a percentage of ICO proceeds as compensation.

Although the SEC order was settled and the matter seems closed now, there are potential other charges and liabilities that could have been brought.  For example, the ICO issuers, in addition to conducting unregistered securities offerings, could face aiding and abetting violations for working with an unregistered broker-dealer).  Also, the investors may have a private right of rescission under the Exchange Act Section 29(b) which provides that any contract made in violation of any provision of the Exchange Act is void.  The investors may also have state rescission claims.

This case should be read closely by multiple online platforms that are facilitating ICOs for others.  The SEC position with respect to regulation of online equity platforms has not changed, whether they are facilitating ICOs or traditional equity private placements.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

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