Cryptocurrency fraud

Blockchain, Cryptocurrency and Initial Coin Offering (ICO) Fraud and SEC Whistleblower Program

Though blockchain technology and cryptocurrencies can help prevent fraud, they can also be used to perpetrate fraud. As the SEC warned in a recent investor bulletin, “[f]raudsters often use innovations and new technologies to perpetrate fraudulent investment schemes” and “it is relatively easy for anyone to use blockchain technology to create an ICO that looks impressive, even though it might actually be a scam.” The CFTC has also warned about virtual currency fraud in a new CFTC Whistleblower Alert.

Under the SEC Whistleblower Program, the SEC will issue whistleblower rewards to individuals who provide original information about wrongdoing that leads to successful enforcement actions with total monetary sanctions in excess of $1 million. In exchange for the valuable information, the SEC will pay the whistleblower 10 to 30 percent of the total monetary sanctions collected as an award. Since 2011, the SEC has paid nearly $1 billion in awards to whistleblowers. The largest SEC whistleblower award to date is $114 million.

ICO and Digital Currency Violations

The most common securities law violations that the SEC warns about with ICOs and digital currencies are:

Theft and misuse of investor funds;
A failure to register the coins/tokens as securities, e.g., SEC v. Kik Interactive, Inc.;
Market manipulation schemes, such as pump-and-dump virtual currency schemes;
A failure to maintain adequate internal controls; and
A failure to disclose risks associated with these investments.

The digital asset market is growing exponentially and there no sign that it will slow down soon. As such, the SEC Office of Compliance Inspections and Examinations listed “Cryptocurrency, Initial Coin Offerings, Secondary Market Trading, and Blockchain” as examination priorities for 2018 and 2019. The SEC indicates that its areas of focus will include:

Whether financial professionals maintain adequate controls and safeguards to protect these assets from theft or misappropriation; and
Whether financial professionals are providing investors with disclosure about the risks associated with these investments, including the risk of investment losses, liquidity risks, price volatility, and potential fraud.

Many Initial Coin Offerings (ICOs) and Digital Assets are Securities and Therefore Subject to Rules Prohibiting Offering Fraud

U.S. federal securities laws apply to ICOs and digital assets when they have the characteristics of an “investment contract.” According to the U.S. Supreme Court’s 1946 Howey decision, an “investment contract” exists when:

A person invests money
In a common enterprise
With a reasonable expectation of profits derived solely from the efforts of others.

On April 3, 2019, the SEC released its Framework for ‘Investment Contract’ Analysis of Digital Assets, which explains the application of Howey to digital assets. Using this test, many ICOs and digital assets will be considered securities – but not all – in which case, whistleblowers disclosing fraud or other violations of the federal securities laws in connection with the ICOs or digital currencies may be eligible for SEC whistleblower awards.

Token sales, also known as initial coin offerings or ICOs, have become an important source of funding for cryptocurrency projects and have raised significant capital in the past few years. According to Smith + Crown, a crypto finance research firm, “ICOs provide a way for cryptocurrency project creators to raise money for their operations” and “[m]ost ICOs raise money in Bitcoin or other cryptocurrencies.” The SEC warns that certain tokens, coins or other digital assets issued on a blockchain may be considered an offer or sale of securities, and thus subject to regulation under federal securities laws, depending on the “economic realities” of the particular transaction..

In July 2017, the SEC issued an investigative report concluding that digital tokens offered and sold by a “virtual” organization known as “The DAO,” for decentralized autonomous organization, were securities and therefore subject to the federal securities laws. The DAO had used blockchain technology to raise about $150 million in 2016. The SEC said it would not take any enforcement action against the organization, but clarified that it could have as the organization’s tokens were sold online to U.S. investors and legally qualified as securities.

While the report only represents the SEC’s evaluation of one coin offering, it nonetheless confirms that issuers of distributed ledger or blockchain technology-based securities must register offers and sales of such securities unless a valid exemption applies. Indeed, the SEC warned that registration “requirements apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology.”

Initial Coin Offering “Pump and Dump” and Market Manipulation Schemes

The SEC also warns that companies claiming to be related to, or asserting that they are engaging in, ICOs may be attempting scam investors by fraudulently manipulating the market. In one market manipulation scheme, known as the “pump and dump” scheme, fraudsters seek to boost a company’s stock by issuing false or misleading statements to the marketplace. After “pumping” up the stock through these false or misleading statements, the fraudster will then “dump” their shares to quickly profit from the misinformation.

In August 2017, the SEC issued an investor alert related to public companies making ICO-related claims. The investor alert was issued after the SEC suspended the trading of four companies’ shares for making “claims regarding their investments in ICOs or touted coin/token related news.” The companies affected by trading suspensions include First Bitcoin Capital Corp., CIAO Group, Strategic Global, and Sunshine Capital.

CFTC Warns of “Pump and Dump” Schemes in Digital Currency Offerings

In February 2018, the CFTC issued a Customer Protection Advisory warning of pump-and-dump schemes that can occur in cryptocurrency.

The warning notes the use of social media to scam victims:

“Customers should avoid purchasing virtual currency or tokens based on tips shared over social media. The organizers of the scheme will commonly spread rumors and urge immediate buying. Victims will commonly react to the currency’s or token’s rising prices, and not verify the rumors. Then the dump begins. The price falls and victims are left with currency or tokens that are worth much less than what they expected. From beginning to end, these scams can be over in just a few minutes.”

SEC Files Emergency Actions to Enjoin Cryptocurrency Fraud

In late September 2017, the SEC sought an emergency order to freeze the assets of Maksim Zaslavskiy and his companies for selling digital tokens or coins that do not really exist. Zaslavskiy touted REcoin as “The First Ever Cryptocurrency Backed by Real Estate” and claimed that he raised $2 million and $4 million from investors when the actual amount is approximately $300,000, Click here to read the complaint. The SEC alleges that Zaslavskiy engaged in securities fraud and engaged in the unlawful sale and offer to sell unregistered securities.

SEC Seeks to Enjoin $15M Fraudulent Initial Coin Offering

On December 1, 2017, the SEC filled an emergency action to stop a fraudulent and unregistered coin offering known as PlexCoin. The defendants raised approximately $15 million from investors through false and misleading statements, including, according to the SEC’s complaint, “promises that if all 400 million PlexCoin tokens for sale were sold, the early investors would reap outlandish rewards of 1,354% in 29 days or less (the supposed period of the PlexCoin ICO), and by comparing the supposed returns to those in other ICOs or investments in cryptocurrencies—returns as high as 88,000%”

The SEC is seeking an injunction barring PlexCorps and individual defendants from participating in any offerings of unregistered securities, an asset freeze, civil penalties, and disgorgement of ill-gotten gains. Click here to see the SEC complaint.

On April 2, 2018, the SEC brought a complaint alleging that the co-founders of Centra Tech. Inc. offered and sold unregistered investments through a “CTR Token.” The company falsely promised investors that the offering would be used to create the “Centra Line” of products — a financial services system that would enable holders of various hard-to-spend “cryptocurrencies” to convert their assets easily into legal tender. In addition, the co-founders represented to investors that the “Centra Token Rewards Program” entitled investors to “rewards” of 0.8% of the total revenue that Centra earned from Centra Card transactions. The offering raised $32 million.

SEC Halts ICO

On December 11, 2017, the SEC halted an unregistered ICO for a blockchain-based food review service. In a consent cease-and-desist order halting the ICO, the SEC identified key aspects of the offering that required registration:

“MUN token purchasers had a reasonable expectation of profits from their investment in the Munchee enterprise. The proceeds of the MUN token offering were intended to be used by Munchee to build an “ecosystem” that would create demand for MUN tokens and make MUN tokens more valuable.”
“Investors’ profits were to be derived from the significant entrepreneurial and managerial efforts of others – specifically Munchee and its agents – who were to revise the Munchee App, create the “ecosystem” that would increase the value of MUN (through both an increased demand for MUN tokens by users and Munchee’s specific efforts to cause appreciation in value, such as by burning MUN tokens), and support secondary markets.”
The offeror (Munchee) made public statements or endorsed other people’s public statements that touted the opportunity to profit. For example, Munchee created a public posting on Facebook, linked to a third-party YouTube video, and wrote “199% GAINS on MUN token at ICO price! Sign up for PRE-SALE NOW!”

SEC Warns About Initial Coin Offerings

The SEC’s Office of Investor Education and Advocacy recently issued an investor bulletin warning investors about the risks of investing in ICOs. According to the bulletin, investors should be alert to the following warning signs:

“Guaranteed” high investment returns.
Unsolicited offers.
Sounds too good to be true.
Pressure to buy RIGHT NOW.
Unlicensed sellers.

For more information about risks related to investing in virtual currencies, see these SEC resources:

ICO/Cryptocurrency Whistleblowers Can Qualify for SEC Whistleblower Awards

Whistleblowers who voluntarily provide original information to the SEC about a securities violation, such as an unregistered offering, may receive anywhere from 10 percent to 30 percent of the monetary sanctions collected in actions brought by the SEC.

The timing of a whistleblower’s tip is a significant factor that the SEC considers in determining whether, and how much, to award a whistleblower. Whistleblowers who wait to report information, therefore, risk being ineligible for an award because someone else might submit the same information to the SEC first.

The SEC whistleblower reward program has been effective in protecting investors, and indeed whistleblower tips have enabled the SEC to recover nearly $2.7 billion in monetary sanctions.