On September 30, 2019, the Securities and Exchange Commission announced that blockchain developer Block.one had agreed to pay a $24 million fine to settle charges that it had engaged in an unregistered offering of securities in violation of Section 5 of the Securities Act.  The announcement set off a mini-firestorm of criticism in the crypto community because the $24 million penalty seemed disproportionately small relative to the $4 billion it raised in its ICO and relative to the penalties imposed on other ICO issuers targeted by the Commission in similar cases not involving fraud.  Moreover, Block.one was not hit with any of the non-monetary sanctions imposed in the other cases, namely rescission, registration and bad actor disqualification. The apparent enforcement disconnect has resulted in confusion among ICO issuers, exchanges, lawyers and other players in the space, along with demands for an explanation from the Commission and predictions that the case signals a relaxation of enforcement policy. A closer look at the circumstances of Block.one’s ICO, however, suggests another possibility.

Rescission, Registration and Bad-Actor Disqualification

Before Block.one, Commission sanctions in unregistered offering cases not involving fraud allegations such as Airfox and ParagonCoin included rescission, registration and bad-actor disqualification.

Rescission refers to the process of remedying a securities violation by offering investors the right to rescind their purchase of securities and receive a repayment of their investment. Purchasers who reject the offer lose the right to bring a private action under state securities law, but it is unclear whether federal claims are barred as well. The Commission has taken the position through no-action letters that rescission offers don’t eliminate Federal securities liability to those rejecting the offer, but Federal courts have held the opposite.

The mechanics of the rescission obligation under previous settlement orders begin with the requirement to issue a press release within a certain number of days following the settlement order.  The press release notifies the public of the order and links to the rescission claim form, which also must be posted on the issuer’s website.  The claim form along with a notice is then delivered to all potential claimants informing them of their rescission rights and the deadline for filing the claim form. The issuer then is required to make payments to all claimants properly delivering claim forms, and to provide updates to the Commission to enable the Commission to monitor the rescission process.

A rescission offer is deemed a separate offer of securities which must either be registered or qualify for an offering exemption. This is to ensure that those receiving the offer have sufficient meaningful information on which to base a decision on whether or not to accept the offer. Consequently, the aforementioned pre-Block.one settlement cases also obligate the issuer to register the ICO tokens with the Commission. Specifically, the issuers in the subject settlements were required to register the tokens on Form 10 under the Securities Exchange Act of 1934. See for example ParagonCoin’s Form 10 here. The filing of a Form 10 also triggers the periodic reporting requirements of the Exchange Act, obligating the issuer to file annual reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K.

Finally, the pre-Block.one settlements also include bad actor disqualification from future utilization of the exemptions provided in Regulation A, Regulation CF (crowdfunding) and Regulation D.  Although the settlement orders don’t explicitly provide as much, the disqualification applies because the order requires the issuer to cease and desist from committing or causing any future violations of Section 5 of the Securities Act, and a Commission order to cease and desist from future violations of Section 5 of the Securities Act is one of the disqualifying events under the Commission’s bad actor rules.

Why the Enforcement Disparity?

So what explains the apparent enforcement disparity between Block.one, which involved only a relatively insignificant monetary penalty, and previous non-fraud unregistered offering cases which included rescission, registration, bad-actor disqualification and relatively more significant penalties relative to offering proceeds? Some have suggested that the Block.one settlement order signals a relaxation of enforcement in these cases. Others have justifiably called for the Commission to provide more detail and explain the disparate treatment.

It would certainly be helpful to ICO issuers, exchanges, lawyers and other market participants for the Commission to provide further detail explaining the apparent disparity. In the meantime, some of the details of how the Block.one ICO was conducted may suggest an explanation. The order states that Block.one implemented certain measures to prohibit U.S. persons from participating in the ICO.  First, Block.one’s offering website included certain measures intended to block U.S.-based purchasers from buying the offered digital tokens, including by blocking U.S.-based IP addresses from accessing the website token sale page. Second, Block.one required all token purchasers to sign a token purchase agreement which provided that U.S. persons were prohibited from purchasing the tokens and that any purchase by a U.S. person was unlawful and rendered the token purchase agreement null and void.

So if Block.one took steps to ensure offers and sales were not made to U.S. persons, why was the Block.one ICO of any concern to the Commission? Despite the aforementioned efforts to exclude U.S. persons from purchasing tokens in the ICO, the settlement order implies that some portion of the multi-billion dollar proceeds was raised from U.S. persons. The Commission also implies in the order that whatever U.S. sales did occur may not have been purely accidental. The order states that Block.one did not ascertain from purchasers whether they were in fact U.S.-based persons. Also, a number of U.S. based persons apparently purchased tokens directly through Block.one’s offering website, and received information through that site and various social media and forum posts. Further, the order states that Block.one undertook efforts for the purpose of, or that could reasonably be expected to have the effect of, conditioning the market in the U.S. for the tokens, including by engaging in directed selling efforts. Among other things, Block.one was said to have participated in blockchain conferences in the U.S. where it promoted its ICO.  Its offering website, white paper and other promotional statements were accessible to potential U.S. purchasers. Finally, the order states that the tokens were traded and widely available for purchase on numerous online trading platforms open to U.S.-based purchasers throughout the duration of the ICO, and that Block.one didn’t take any steps to prevent the tokens from being immediately resold to U.S.-based purchasers in secondary market trades.

So in the final analysis, the Commission may have been worried about Block.one’s selling efforts in the U.S. despite the tangible and seemingly reasonable safeguards implemented by it to ensure no sales were made to U.S. persons. But perhaps because the Commission was not ultimately able to prove how much of the offering proceeds were in fact generated in the U.S., and because of the difficulty of ever being able to make such a determination, the Commission may have tried to split the baby by settling with Block.one under terms more relaxed than in previous enforcement actions.

Key Takeaway

The key takeaway here is that ICO issuers that believe they can conduct a successful offering outside the U.S. should implement the safeguards employed by Block.one while avoiding the offering pitfalls that may have undercut its efforts to exclude U.S. persons.  That means blocking U.S.-based IP addresses from accessing the offering website, requiring that all token purchasers sign token purchase agreements prohibiting U.S. persons from purchasing tokens and providing that any purchase by a U.S. person is unlawful and renders the token purchase agreement null and void.  It also means obtaining written representations from purchasers that they are not U.S.-based persons.  It also means refraining from any efforts that could reasonably be expected to have the effect of conditioning the market in the U.S. for tokens, including by engaging in directed selling efforts such as promoting the ICO in U.S. blockchain conferences. Issuers should ensure that their offering website, white paper and other promotional statements are not accessible to potential U.S. purchasers, and that their digital tokens are not available for purchase on online trading platforms open to U.S.-based purchasers.