ICOs have had a pretty smooth ride up until now. Regulators have been slow to move on the world’s fastest growing fundraising model. But, that free ride is quickly coming to an end. The Securities and Exchange Commission (SEC) and other regulatory bodies have now started officially charging businesses for violating the law, and even arresting the operators of those companies.

This probably isn’t surprising many. The ICO boom has brought with it some of the most depraved and profitable scams the world has ever seen. For most in the industry, the important questions are:

What laws exactly has the SEC charged the companies with violating?

What does this mean for future ICOs?

We would like to thank the team at Mobu for their contributions to the design and implementation of the research and to the analysis of the result.

The ICO Crackdown

Ethereum cofounder Joe Lubin said in an on-stage discussion in 2017 that he’d spoken to the SEC and that they were “in information-gathering mode”. That information gathering is quickly turning into action. A few examples can give us an idea of what’s going on.

Recoin and DRC

In September 2017, the US Securities and Exchange Commission shocked the crypto world by taking bold action against the operator of an ICO for the first time. In a press release, the SEC announced that they’d charged an entrepreneur named Maksim Zaslavskiy for breaking the law as the founder of two separate ICOs.

Zaslavskiy started off his fraudulent ICO scheme with Recoin, marketing it as “The First Ever Cryptocurrency Backed by Real Estate”. He used promises of huge returns and lies about a “team of lawyers, professionals, brokers, and accountants” to raise hundreds of thousands of dollars from thousands of investors. There was no team and the coin was backed by nothing.

The SEC caught on to the scam quickly, and in August, warned Zaslavskiy he was breaking the law. He then made a quick pivot to his second ICO, DRC tokens backed by fully insured diamond investments. He brought his Recoin investors with him to keep funds and continue collecting money. But, you guessed it, there were no diamonds either.

The SEC filed a complaint that Zaslavskiy was trying to “skirt the registration requirements of federal securities law” and eventually arrested him. He now faces charges of securities fraud conspiracy that carry a maximum sentence of 5 years in jail.

In a statement from the two companies, Maksim Zaslavskiy says he thinks the whole scenario boils down to a “lack of legal clarity as to when an ICO or a digital asset is a security,”

PlexCoin

Next, the SEC stepped things up even more with their brand new Cyber Unit. In December 2017, the unit froze the assets of PlexCorps for their allegedly fraudulent PlexCoin ICO.

The ICO, masterminded by Dominic Lacroix and his partner Sabrina Paradis-Royer, capitalized on the current crypto hype and new investor naivety to raise around $15 million. They promised ridiculous returns of 1,354% in a month. Thousands of inexperienced investors, full of ICO optimism and fear of missing out, believed them.

Of course, nobody can promise those kinds of returns, and the SEC took notice. The complaint filed by the SEC seeks to get the money back from the PlexCoin ICO and ban the pair from offering digital securities again. The SEC is still after Lacroix and Paradis-Royer, and Canadian authorities are chasing the pair too, with a possible jail sentence.

The Cyber Unit wanted to make a statement with this first case, warning other ICO founders that this was “exactly the kind of misconduct the unit will be pursuing”.

Centra

You might have heard of the Centra Tech ICO. It was vigorously marketed and had social media shout-outs from Floyd Mayweather and DJ Khaled. Centra Tech was claiming to be working on a crypto debit card for spending cryptocurrency anywhere that accepted VISA or Mastercard. They even boasted of partnerships with VISA and Mastercard.

None of this was true, and the false claims helped Centra co-founders Sohrab Sharma and Robert Farkas raise $32 million through an ICO. US law enforcement jumped in quickly, and dramatically arrested Robert Farkas before he could flee the country on a flight. They also arrested Sharma. They were charged with fraud, as the SEC stated that “Endorsements and glossy marketing materials are no substitute for the SEC’s registration and disclosure requirements”.

It is important to note that, while the Centra co-founders appeared in court, Manhattan Deputy U.S. Attorney Robert Khuzami said: “While the cryptocurrency industry may be a new frontier, it is subject to the same laws against investor fraud as any other type of company.”

What This Means for ICOs

You might look at these cases and think there is nothing to worry about for most ICOs. The legal action we’ve seen so far has been only against the most brazen fraud cases. But that might be a bit naive. Yes, lawmakers are starting off with the lowest hanging fruit, the most obvious scams. But there are indicators in these cases that many more ICOs are treading on thin ice too.

In the cases above, the United States SEC declared that the tokens issued were securities. That means they come under securities law and are subject to all the relevant rules and regulations. It’s not just the US that is starting to make this distinction, either. The European Securities and Markets Authority (ESMA) released a statement warning those running ICOs that they “must give careful consideration as to whether their activities constitute regulated activities.” Otherwise they too could face the hammer.

What Constitutes a Security?

Most ICOs these days tout themselves as utility tokens, saying the tokens are meant to be used on some future platform. But the law may say otherwise. As the US is taking the lead in the ICO crackdown, looking at how US law defines a security is a good place to start.

In the US, the Howey test is an easy way to determine if an asset falls under securities law, even if it has another name (like token). An asset passes the Howey test, and is legally a security, if:

It is an investment of money

There is an expectation of profits from the investment

The investment of money is in a common enterprise

Any profit comes from the efforts of a promoter or third party

At first glance, it looks like many ICOs pass the Howey test. Despite what founders might say, ICO investors have a high expectation of return, even for most ‘utility’ tokens. It’s still a legal grey area, but the regulatory waters are starting to look more dangerous.

Investment expert and CEO of Liquid M. Capitaland, Vincent Molinari, said in an interview regarding regulation and ICOs that while there is “No question” that ICOs are here to stay. But, it’s a matter of finding “the right guardrails around them to protect investors and know your customer.” This is especially true, as he thinks that “most perceived utilities are acting like securities”, and therefore should fall under the relevant regulations.

In an in-depth discussion on the Recoin and DRC scam, specialist crypto lawyers Gregory Rigano and Conor O’Hanlon pointed out that:

“[T]he fact that this person was charged with selling an unregistered security is something that can be applied to a lot of potential token sales if they are not structured a proper way”, and that “it will be interesting to see where the SEC goes from here, whether they potentially go after other violations of selling unregistered securities that are less focused on clear fraud.”

Crypto Startups Should Take Notice

Those planning to run an ICO need to take these points seriously. Even if you are convinced your ICO is legal (like Maksim Zaslavskiy does), the law might think otherwise. Startups need to make sure they prepare and protect themselves.

What To Do About It

ICOs, especially those that pass the Howey test, need to find ways to structure their funding in a way that will keep them out of trouble. The safest way to do it is to lawyer up. Unfortunately that option is extremely expensive and therefore out of reach for most pre-ICO and non-venture backed startups.

We’ve created an infographic to better explain this idea to you:

Another way to build regulation friendly tokens is by choosing to launch on an ICO platform that has the relevant features built-in and makes regulatory compliance easy. One example is Mobu.

Mobu is an ICO platform designed specifically to launch regulatory friendly tokens, especially securities tokens. The company’s idea is to partner with startups that are running an ICO to help them navigate the challenges of complying with securities law. Those tasks include:

Banking partnerships to keep bank accounts open when cryptocurrency is involved

A new token standard, MOB20, that can limit transactions only to accredited investors

Having KYC providers on the platform available to approve investors (for a fee)

Milestone based Post-ICO escrow service, so investors can exit an ICO on a pro-rata basis if the roadmap isn’t followed

The last two points are very important but might be overlooked. Many securities can only be lawfully sold to accredited investors. It’s difficult enough to manage this during an ICO, let alone in the secondary market. Crypto-Lawyer Gregory Rigano also brings this up in the interview we looked at earlier, saying there is “significant potential that exchanges have the highest liability, because they could potentially be listing unregistered securities, and then each time a trade happens, that’s a violation.”

Mobu has a unique way of solving this problem. MOB20 Tokens on the Mobu platform can be intrinsically restricted via a smart contract to be tradable only to addresses verified by a KYC provider on the Mobu platform. This means the issuers, investors, and exchanges can be confident that all participants and token holders are authorized investors. As the restriction is built-in on the code level, it even works for trades on decentralized exchanges.

By launching on a platform like Mobu (instead of say, Ethereum), the challenges of building a compliant securities token are baked in at the code and platform level. This makes the process easy and may keep the SEC at bay.

The Prepared Will Thrive

Open hunting season on investors for ICOs is quickly coming to a close. Regulatory bodies in the US, Canada, and Europe have already started cracking down on the most rotten apples of the ICO world. It’s not just the scammers that need to beware though. The findings and charges made so far hint that many more legitimate ICOs could also be operating in regulated legal space without realizing it. It’s likely many of them will get caught out.

Now is the time to start preparing for a more regulated ICO industry. For startups, it means getting legal support and structuring the ICO in a way that’s regulation-friendly. For investors, it means choosing companies that understand this. Early stage startups already face enough risk of failure. Adding the potential of asset freezes, fines, and jail sentences for the founders makes things even worse.

Those that are most prepared will thrive in the new environment, and they’ll also be safely at the bottom of the SEC’s hitlist.

All materials on this site are for informational purposes only. None of the material should be interpreted as investment advice.