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United States

SEC settles complaint against self-reporting ICO

Ruling could be problematic for fraudsters of 2017 and 2018

The Securities and Exchange Commission charged Gladius Network LLC with conducting an unregistered initial coin offering (ICO), even after the company self-reported themselves to the commission. Companies that fund through an ICO must register the coins as securities, the SEC clarified on Wednesday. Gladius will have to offer speculators a refund.

Gladius conducted an ICO in late 2017, shortly after the Commission had warned ICOs in its report about Decentralized Autonomous Organizations. Washington, DC-based Galdius had raised approximately $12.7 million worth of digital assets to finance its planned network for renting spare computer bandwidth to defend against cyberattacks and enhance delivery speed. Gladius did not register its ICO under federal securities laws, and the ICO did not qualify for an exemption from registration requirements.

In the summer of 2018, Gladius self-reported to the SEC’s enforcement staff. According to the SEC, they “expressed an interest in taking prompt remedial steps and cooperated with the investigation.” For this reason, the SEC did not impose a penalty because the company self-reported the conduct, agreed to compensate investors, and register the tokens as a class of securities. The case followed the Commission’s two recent ICO registration cases in which companies agreed to pay penalties for similar registration violations and agreed to similar undertakings.

In both of those instances, the SEC charged violators with a $250,000 fine. Gladius won’t have to pay that, but they will have to offer some speculators a refund.  “We have made it clear that companies that issue securities through ICOs are required to comply with existing statutes and rules governing the registration of securities,” said Stephanie Avakian, Co-Director of the SEC’s Enforcement Division.  “These cases tell those who are considering taking similar actions that we continue to be on the lookout for violations of the federal securities laws with respect to digital assets.”

This could be good news for the fraud-prone ICO markets. The SEC has a duty to regulate any tradable financial asset—basically, anything a reasonable person could buy and expect to sell later for a better price can be considered a security. Many ICOs have tried to skirt these regulations in the past, but this ruling was made with coin-buyers in mind, more to protect them from fraud than to prohibit sales.

Most importantly, the SEC solidified its position that all ICOs are considered securities and not utility tokens. The SEC’s report on investigation in July 2017 had already ruled that all ICOs are securities. This differers from the approaches taken in Europe and Asia.

According to a report issued by Swiss consulting firm PwC, this puts the U.S. markets at odds with those in Switzerland and Singapore:

“The US uses a centralized system in which all tokens offered by ICO are traded as securities. In Europe, on the other hand, a differentiated regulation prevails. [Swiss Financial Market Supervisory Authority] FINMA, for example, classifies tokens into three sub-types: asset, payment and utility tokens, which do not constitute an actual investment but allow the buyer direct access to the product or service of the ICO. Finally, in Asia, regulation is very heterogeneous, ranging from strict prohibition to active promotion of ICO projects.”

“The SEC is studying the effects of distributed ledger and other innovative technologies and encourages market participants to engage with us,” SEC Chairman Jay Clayton said in early 2017. Way before “We seek to foster innovative and beneficial ways to raise capital, while ensuring—first and foremost—that investors and our markets are protected.”

“The SEC has been clear that companies must comply with the securities laws when issuing digital tokens that are securities,” said Robert A. Cohen, chief of the SEC’s cyber unit. “Today’s case shows the benefit of self-reporting and taking proactive steps to remediate unregistered offerings.”

As part of the “remedial steps” Gladius will have to honor refunds to any investors who may have been lead to believe that they were purchasing registered securities. Normally an ICO relies heavily on hype and the price of other digital assets on the day of launch to realize any growth. Usually this leaves ICO speculators holding the bag. July 2018’s much-hyped Ternio coin, for example, traded at first for $0.10. Earlier this week, it fell below $0.01.

This means that if future price drop are found to be related to not registering as a security, ICO firms could be required to issue costly refunds.

“Pursuant to the order, Gladius undertakes to return funds to those investors who purchased tokens in the ICO and request a return of funds, and register its tokens as securities pursuant to the Securities Exchange Act of 1934,” the SEC said on Wednesday. “Gladius also will file required periodic reports with the Commission.”

While all tradable assets should be subject to simple oversight, Wednesday’s actions by the SEC could upend the crypto markets. The market for ICOs doubled between 2017 and 2018. But were all of those registered securities? If not, then some of 2018’s big shot blockchain companies might find themselves owing early speculators a refund.

One of the biggest problems in crypto is just that there is little reward for a good idea and plenty to reward a bad idea. Crypto companies mint these coins as a way to sell future services. It’s as if all of these companies have started out by selling “Forever Stamps” to start their own post office. To make matters worse, most ICO speculators aren’t trying to get “Forever Stamps” at a discount. They’re just trying to make a quick and dirty profit however they can.

This SEC ruling isn’t even a slap on the wrist, but it does show that the SEC is actively trying to keep up with the times as securities move into the 21st century. While most financial institutions have written off crypto as faddish, the SEC has taken seriously their duty to help people know where their money is going. After all, unregistered ICOs are just as dangerous to the public as uninsured savings accounts.

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Brendan Sullivan is a writer, producer, and author of the memoir Rivington Was Ours: Lady Gaga, the Lower East Side, and the Prime of Our Lives. Disclosure: he owns cryptocurrencies. Follow him on Twitter.