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SEC Targets ICO Fraud

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  • Posted on: Oct 16 2017

The SEC recently announced that fraud charges were being brought against the creator of two Initial Coin Offerings (“ICOs”). The complaint alleges that Maksim Zaslavskiy (“Zaslavskiy”) defrauded investors with two ICOs, the REcoin Group Foundation, LLC (“REcoin”) and the DRC World, Inc. (also known as the Diamond Reserve Club) (“DRC”), that were said to be backed by investments in real estate and diamonds.

What is an ICO?

ICOs are a way for startups to raise money by issuing their own cryptocurrencies through the use of blockchain cloud-ledger technology pioneered by Bitcoin. These entities sell “digital tokens” that are purported to be the equivalent of company shares. Currently, ICOs are under enhanced regulatory scrutiny because they are being used to raise quick cash without disclosing substantive information to investors.

The Scheme to Defraud

Both REcoin and DRC were pitched as real companies with staff, attorneys, and retail relationships from which investors could expect sizeable returns. However, neither company had any real operations. According to the SEC, these shell companies never made investments on behalf of token-buyers and the digital tokens they claimed to be selling did not actually exist. In other words, REcoin and DRC were not even running blockchains, and so were not bona fide ICOs.

In particular, the SEC alleged that Zaslavskiy and REcoin misrepresented that ICO proceeds would be invested in real estate. They also claimed that between $2 million and $4 million had been raised from investors when the actual amount was about $300,000.

The DRC scheme centered on investments in diamonds. According to the SEC, DRC purportedly invested in diamonds and obtained discounts with product retailers for individuals who purchased “memberships” in the company. Despite their representations, Zaslavskiy and DRC did not purchase any diamonds and did not engage in any business operations. Yet they continued to solicit investors and raise funds.

This is the first time the SEC has brought charges related to assets pitched as an ICO. However, the securities watchdog is said to be taking a measured approach to weeding out fraud in the nascent ICO market. Some observers tout the positives of ICO technology, such as the ability to raise funds quickly on a global level, however, the infrastructure linking digital tokens to offline assets in the broader marketplace is a work in progress.

The SEC’s action comes on the heels of an investor alert issued in July (here) that ICOs would be subject to regulatory scrutiny and that digital tokens may be deemed securities. 

“Investors should be wary of companies touting ICOs as a way to generate outsized returns,” said Andrew M. Calamari, Director of the SEC’s New York Regional Office. “As alleged in our complaint, Zaslavskiy lured investors with false promises of sizeable returns from novel technology.”

The SEC charged Zaslavskiy, REcoin, and DRC with violations of the antifraud and registration provisions of the applicable federal securities laws. The SEC is seeking permanent injunctions and disgorgement, as well as an officer and director bar for Zaslavskiy.

The SEC’s complaint can be found here.

The Takeaway

Many agree there is great potential for the application of blockchain technology in financial services, supply chain, logistics, healthcare, agriculture, real estate, biotech, data, retail and government operations. Nonetheless, this case highlights how bad actors are seeking to gain entry into the ICO sector. Ultimately protecting investors in these novel technologies will require the joint efforts of regulators and experienced securities fraud attorneys.

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