On January 30, 2018, dissatisfied crypto token purchasers filed a class action lawsuit against Paragon Coin, Inc. (“Paragon”) and founders Jessica VerSteeg and Egor Lavrov, alleging that the Paragon initial coin offering (“ICO”) violated the federal securities laws.[1]  This lawsuit follows those filed by plaintiffs against Centra, Tezos, ATBCoin, BitConnect, and Xunlei in connection with their ICOs in recent months.  One of the more high profile class action defendants is BitConnect, which is defending two class action lawsuits alleging that it sold unregistered securities and operated a Ponzi scheme.[2]  BitConnect allegedly led purchasers to believe that they would receive a 3,000% return on their investment over the course of a year.

The Securities and Exchange Commission (“SEC”) has brought a number of enforcement actions against companies and individuals for selling crypto tokens to the public without registering the sale with the SEC and for engaging in securities fraud.  All such actions have either settled outside of court or remain pending.  Now, the private plaintiffs’ bar is moving in as well and filing claims.  As these cases make their way through the courts, federal judges may soon be faced with the challenging task of running numerous  novel “utility” token products through the rigors of the Howey test analysis to determine if such products must be offered in compliance with the securities laws.[3]

Paragon raised over $70 million in their ICO, which involved both a pre-sale where Paragon sold Paragon Coins (“PRG”) to private purchasers at a discount and a public sale where it sold PRG to purchasers at a price that ascended by $.05 each day.  It promoted the offering through, among other things, a white paper, described in the complaint as “overly ambitious, vague, and impractical.”  The white paper stated that PRG would “offer payment for [marijuana] industry related services and supplies” and allow users to “quickly and easily verifiably transfer funds—business to business, business to consumer, and / or consumer to consumer.”

In a recent enforcement action against Munchee Inc., the SEC argued that crypto tokens may qualify as securities even if they have a use case or utility if they are sold as an investment. The Paragon complaint similarly focuses primarily on Paragon’s manner of sale in its characterization of the PRG as a security, despite its apparent “utility” as a marijuana-related payments vehicle.  Paragon relied on celebrity endorsements from rapper “The Game” and its own founder, former Miss Iowa Jessica VerSteeg.  The SEC recently issued a warning concerning celebrity endorsements, which may violate section 17(b) of the Securities Act of 1933 if they omit necessary disclosures.[4]

In particular, the Paragon white paper characterized the PRG as a crypto token that would increase in value due to a future reduction of supply and an increase in demand.  It stated that “PRG is designed to appreciate in value as our solutions are adopted throughout the cannabis industry and around the world.”  In a video published on Paragon’s Facebook page, VerSteeg explained that persons can purchase PRG as “an investment” and exchange it for traditional currency.

Notably, the Paragon white paper contained customary risk disclosures, but the plaintiffs cite them as support for their argument that PRG are securities because the disclosures portray PRG as an investment that can decline in value.

The Paragon complaint flags a number of important considerations for crypto token offerors. Even if the SEC itself decides not to pursue crypto tokens that have an apparent use case or utility, token offerors must consider that plaintiff’s attorneys may nevertheless present as formidable of a threat.  It is important that token offerors carefully plan out their manner of sale in consultation with legal counsel.  Celebrity endorsers, social media, marketing statements, and inadequate disclaimer language and disclosures can raise unique issues for token offerors.  Market participants should pay close attention to these and other cases where plaintiffs and the SEC challenge “utility” token offerors.

[1] Complaint, Davy v. Paragon Coin, Inc., et al., Case No. 18-cv-00671 (N.D. Cal. 2018), available at courthousenews.com.

[2] An article discussing the class actions is available at coindesk.com.

[3] A Reed Smith client alert on the SEC’s Howey test as applied to crypto tokens is available at reedsmith.com.

[4] A Reed Smith client alert on celebrity endorsements of ICOs is available at reedsmith.com