Cleary Discusses SEC’s Freeze of Allegedly Fraudulent “Decentralized Bank” ICO

On January 30, 2018, the U.S. Securities and Exchange Commission (SEC) announced[1] that it had obtained an order from a U.S. District Court in Dallas, Texas, halting an allegedly fraudulent initial coin offering scheme.  The SEC’s complaint alleges that defendants AriseBank and AriseBank founders Jared Rice Sr. and Stanley Ford violated the anti-fraud and registration provisions of the U.S. federal securities laws, including by falsely claiming that AriseBank’s customers’ accounts and transactions were FDIC insured, falsely claiming that AriseBank’s customers could spend 700 different virtual currencies using AriseBank’s Visa card, and failing to disclose the criminal history of two of AriseBank’s officers.  Among other relief, the district court has granted the SEC’s request to freeze the defendants’ assets, and for the first time in a cryptocurrency enforcement case has appointed a receiver over those assets, including the cryptocurrencies purportedly held by AriseBank.

ICOs and the SEC

Initial coin offerings (ICOs) or token sales are a form of crowdfunding in which participants contribute funds to a blockchain-based project, often in the form of a cryptocurrency like bitcoin or ether, and in return receive cryptographic coins or tokens.  Tokens currently in circulation aim to serve myriad functions, including as currency, betting or prediction mechanisms, and to capture advertising revenue.  In some cases, tokens replace traditional securities, for example representing shares in a company.  Tokens issued in token sales also typically trade on secondary cryptocurrency markets.

In the latter half of 2017, in the midst of an ICO boom that raised more than $3.6 billion, the SEC began to take aim at what it alleged were fraudulent ICOs.  In September the SEC created a Cyber Unit focusing on cyber-related misconduct, including involving blockchain and ICOs, and brought its first action to halt an allegedly fraudulent ICO against Maksim Zaslavskiy and two companies he controlled, REcoin Group and Diamond Reserve Club.  In December, as we previously discussed in a prior blog post[2], the SEC filed a similar action against Dominic Lacroix, his partner Paradis-Royer, and their company PlexCorps, which the SEC alleges defrauded investors of as much as $15 million.

The SEC has made clear that, as with other transactions, the analysis of whether a specific cryptocurrency offering or transaction is governed by U.S. securities laws will turn on the characteristics of a token and the circumstances of its issuance, irrespective of how the transactions are labeled or whether investors contribute funds in the form of cryptocurrencies.

AriseBank

According to the SEC’s complaint against AriseBank and its founders, the defendants marketed and, through an ICO, offered a security token called AriseCoin.  The defendants claimed AriseCoin would work with AriseBank, the world’s first “decentralized bank,” and that a proprietary automated algorithmic cryptocurrency trading application would generate returns for investors by trading among different cryptocurrency pairs.  As AriseBank accounts rose in value, additional AriseCoin tokens would be “minted daily” and distributed to investors, along with eACO, a second token that would expire if unspent, a feature purportedly designed to encourage circulation of the currency to buoy AriseCoin and the AriseBank platform.

The SEC claims that the defendants’ ICO was an unregistered securities offering and that the defendants made materially false and misleading statements and omissions in the course of marketing the ICO, AriseBank, and AriseCoin.

First, the SEC alleges that the AriseCoin ICO was an unregistered offer and sale of securities that, lacking registration with the SEC or qualification for an exemption, violated the securities laws.  The complaint does not analyze AriseCoin under the Howey test, but notes that the defendants, in what they referred to as “a statement on our fight with the SEC,” themselves equated their tokens with stock in a company before incorrectly stating that the SEC lacks jurisdiction over a private company’s issuance of private stock to the investors of its choosing.

Second, the SEC alleges that, separate and apart from the defendants’ failure to register the AriseCoin ICO with the SEC, the defendants made a series of materially false statements.  These false statements included the claim that AriseBank had acquired a 100-year-old FDIC-insured bank, which would allow AriseBank to “offer its customers FDIC-insured accounts and transactions,” and that AriseBank would offer customers a Visa card permitting the spending of over 700 cryptocurrencies through its partnership with a service called Marqeta.  According to the complaint, the FDIC has no record of insuring AriseBank or the bank it acquired, and AriseBank has no relationship Marqeta (indeed, Marqeta sent AriseBank a cease-and-desist letter when it learned of the claims).  The SEC also alleges that the defendants failed to disclose the criminal history of certain of AriseBank’s officers, including felony theft, tampering with government records, and felony robbery.

The complaint seeks preliminary and permanent injunctions, disgorgement, and civil penalties, as well as an order prohibiting the individual defendants from serving as officers or directors of a public company or offering security tokens in the future.  As a preliminary matter, the court has granted the SEC’s request to freeze the defendants’ assets and has appointed a receiver, including over AriseBank’s cryptocurrency holdings—which the SEC alleges include bitcoin, litecoin, BitShares, dogecoin, and BitUSD—to preserve the court’s ability to order, if necessary, disgorgement and the payment of civil penalties.

Implications

Consistent with the enforcement actions the SEC has brought in the last year, the SEC in AriseBank appears to be continuing to target clear cases of fraud—in a statement, Stephanie Avakian, Co-Director of the SEC’s Enforcement Division, called the AriseCoin ICO “an outright scam.”  This approach, while important to the SEC’s mission to protect investors, provides little guidance with respect to more difficult questions, including the potential viability of utility tokens.  The SEC’s complaint takes as a given that AriseCoin is a security, simply stating as much rather than addressing each of the elements Howey test.  AriseBank reiterates that the mere invocation of terms like blockchain or cryptocurrency will not on its own remove what are otherwise securities from the purview of the securities laws, and the SEC will continue to consider the facts and circumstances of each case.

Notably, in AriseBank, the SEC sought and obtained for the first time in an ICO enforcement action the appointment of a receiver, in this case to take control of and protect AriseBank’s assets.  Among other duties, a court-appointed receiver may be tasked with distributing misappropriated funds to defrauded investors, and the SEC may seek appointment of a receiver[3] in cases where the risk of corporate property or assets disappearing is higher.  Dissipation of assets is a concern common to many securities fraud cases, but may be particularly acute where cryptocurrencies are involved.

In the PlexCorps case, for example, the SEC argued that the decentralized nature of the cryptocurrency funds allegedly received from investors required immediate discovery regarding the status of those funds as “there exists no central authority (like with respect to Defendants’ bank accounts) on which the Commission may serve freeze orders for cryptocurrencies.”  Similarly, in a lawsuit alleging that the cryptocurrency trading platform BitConnect was “both a pyramid and a Ponzi scheme,” a federal district judge in the Western District of Kentucky on January 30, 2018, issued a temporary restraining order that, among other things, requires BitConnect to disclose all cryptocurrency wallet addresses it controls “so that these assets may be monitored and traced.”  The legal analysis of the alleged fraud in these cases may be traditional, but remedies and enforcement may prove more complicated as the SEC and the courts confront a technology touted by some proponents for its anonymity and ability to evade government scrutiny and control.

ENDNOTES

[1] [link: https://www.sec.gov/news/press-release/2018-8%5D

[2] [link: https://www.clearycyberwatch.com/2017/12/newly-created-sec-cyber-unit-takes-first-action-allegedly-fraudulent-ico/%5D

[3] [link: https://www.sec.gov/oiea/investor-alerts-bulletins/ib_receivers.html%5D

This post comes to us from Cleary Gottlieb Steen & Hamilton LLP. It is based on the firm’s blog post, “SEC Freezes Allegedly Fraudulent ‘Decentralized Bank’ ICO,” dated February 2, 2018, and available here.