On Friday, November 16, 2018, the U.S. Securities and Exchange Commission (SEC) announced that it settled two cases against digital token issuers. The settlements, one with CarrierEQ Inc. (AirFox) and the other with Paragon Coin Inc. (Paragon), are the first time that the SEC has imposed civil penalties on companies solely for offering digital tokens in an initial coin offering (ICO) that allegedly violates the securities laws. In addition to agreeing to pay civil fines of $250,000 each, both companies agreed in the settlements to allow certain token purchasers to elect to receive a refund. The settlement agreements also require both companies to pursue registration of their digital tokens as a class of securities under section 12(g) of the Securities Exchange Act of 1934 by filing a Form 10.

In each case, the SEC’s enforcement action was grounded on the sale of unregistered securities. There were no assertions of fraudulent statements having been made in connection with the ICOs.

AirFox ICO. AirFox conducted its ICO in October 2017, promoting a mobile application that would allow users to earn AirTokens by interacting with advertisements. Users were told they could exchange AirTokens for free or discounted mobile data and, eventually, other goods. AirFox raised $15 million in its ICO.

The SEC found, inter alia, that AirToken was a security because a purchaser in the AirFox ICO “would have had a reasonable expectation of obtaining a future profit based upon AirFox’s efforts, including AirFox revising its app, creating an ‘ecosystem,’ and adding new functionality to the platform using the proceeds from the sale of AirTokens.” The SEC also cited AirFox’s efforts to ensure that AirFox would be listed and traded on the secondary market – an intention that was broadcast to prospective investors prior to the ICO.

The SEC concluded that the AirToken is a security despite the clause in AirFox’s token purchase contract that “purported to require purchasers to agree that they were buying AirTokens for their utility as a medium of exchange for mobile airtime, and not as an investment or a security.” The SEC concluded that AirFox had engaged in an unregistered offering of securities without an exemption from registration.

Paragon ICO. The Paragon project (see discussion in more detail in other posts) raised $12 million in its ICO of (PRG) tokens. Paragon asserted that its coin represented a way to “offer payment for [marijuana] industry-related services and supplies” and allowed users to “quickly and easily verifiably transfer funds—business to business, business to consumer, and/or consumer to consumer.” As with AirFox, the SEC found that PRG constituted a security and that Paragon had conducted an unregistered offering of securities without an exemption from registration.

In arriving at that conclusion, the SEC cited, inter alia, Paragon’s promotional efforts to whet investor expectations through Paragon’s website, its White Paper, and other message boards, blogs, and social media outlets that claimed Paragon would build an “ecosystem” that would create demand and increase the value of PRG tokens. The SEC also noted other evidence of Paragon’s intention to use its efforts to increase the value of PRG for investors, including through the use of a so-called deflation algorithm intended to decrease supply of PRG tokens by “burn[ing] tokens that were not sold by the end of the offering”; and by “‘listing’ PRG tokens on ‘major exchanges’ within one month of the closing of the offering.”[¹]

Takeaways. These settlements evidence the SEC’s policy of enforcing the securities laws applicable to the sales of digital currencies. The SEC’s explicit references in its findings to the so-called Howey Test make it abundantly clear that nearly all token issuances must comply with and are subject to traditional securities laws, rules, and precedents. Paragon itself expressed enthusiasm about the settlement, with Paragon CEO Jessica VerSteeg saying the company was “making history” through an “important settlement,” and calling the deal a “very positive agreement.”[²]

The SEC noted in a public statement issued on the same day as the settlements, “[t]hese two matters demonstrate that there is a path to compliance with the federal securities laws going forward, even where issuers have conducted an illegal unregistered offering of digital asset securities.”[³]

These settlements may also signal the SEC’s next enforcement priority. Companies contemplating an ICO, and those that have already sold tokens, should take note of these settlements and seek legal counsel to help understand the full impact of these decisions.

Read the AirFox settlement.

Read the Paragon settlement.


[¹] Paragon’s civil penalty comes amidst ongoing civil litigation by a class of purchasers of PRG. See Davy v. Paragon Coin, Inc., et al., Case No. 18-cv-00671 (N.D. Cal. 2018). The parties in the civil action currently await a decision on Paragon’s motion to compel arbitration or in the alternative to dismiss, wherein Paragon argues that its token is not a security.

[²] Green Market Report, “Paragon Reaches Settlement with the U.S. Securities and Exchange Commission” (Nov. 16, 2018).

[³] Securities and Exchange Commission, “Statement on Digital Asset Securities Issuance and Trading” (Nov. 16, 2018)