The SEC ramps up its efforts to combat digital fraud.

By Wick Sollers, Dan Sale, Christina Kung, and Kelli Gulite (https://www.americanbar.org/groups/litigation/committees/criminal/practice/2019/cryptocurrency-crackdown/)

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On November 2, 2018, the Enforcement Division of U.S. Securities and Exchange Commission (SEC) issued its annual report. The report described the division’s enforcement actions and policy initiatives over the past year, highlighting the SEC’s enforcement efforts in several areas, including retail investors, the Foreign Corrupt Practices Act, and securities offerings. However, some of the more interesting statistics within the report outline recent efforts to combat scams in the cryptocurrency market.

According to the report, the SEC brought 20 stand-alone actions and opened dozens of investigations involving digital assets this year. This is particularly significant because the agency did not even mention cryptocurrencies in its 2016 annual report. The 2018 report also notes that the SEC has shifted resources to pursue investigations in the cryptocurrency market. Part of those resources will undoubtedly be steered toward the division’s Cyber Unit, which was formed at the end of 2017 to tackle cyber-related threats and misconduct. The Cyber Unit currently has over 225 ongoing investigations.

Most of the SEC’s efforts to combat digital fraud this year were focused on initial coin offerings (ICOs). ICOs are a recent phenomenon and can be thought of as the digital-market equivalent of an initial public offering (IPO). Instead of fundraising by selling shares, companies accept money or digital currencies such as bitcoin in exchange for “tokens” specific to the company. Tokens can take many forms but are, essentially, credits in the company.

Despite regulators’ increasing interest in the ICO market, some large corporations want to capitalize on this new technology. In 2018, Kodak launched an ICO for KODAKCoin, a currency used to buy photo rights on Kodak’s digital photography platform, KodakOne. Kodak’s stock price tripled after it announced its plans to issue an ICO. And Overstock.com raised $134 million dollars in an ICO that launched in late 2017. At the same time, other corporations are distancing themselves from the cryptocurrency market, likely due to the increased government scrutiny. For example, Google and Facebook recently banned all advertisements for ICOs from their platforms.

While corporations are uncertain about the future of digital currencies, the SEC has clearly demonstrated its intention to rein in the market for ICOs. A few weeks after the report was published, the SEC announced that professional boxer Floyd Mayweather Jr. and music producer DJ Khaled settled claims that they failed to disclose payments received for promoting investments in ICOs. In addition to investigating and prosecuting high-profile cases, the SEC has also engaged in non-conventional methods to signal that it is serious about ICO fraud. In May 2018, for example, the agency launched a mock website selling “HoweyCoins” to draw attention to the problem of ICO fraud and show how easily fraudsters can set-up a scam ICO.

The SEC has not been the only regulator to launch investigations into the digital-currency market. State attorneys general from Alabama, Colorado, Maryland, Massachusetts, Texas, Missouri, North Carolina, and New Jersey all issued cease-and-desist orders to ICOs this year. The Financial Industry Regulatory Authority (FINRA) also brought its first disciplinary action related to cryptocurrency in September. Additionally, the Department of Justice (DOJ) announced that it would develop a comprehensive strategy to combat cryptocurrency fraud next year.

The DOJ also scored a big win in a cryptocurrency case in 2018 in United States v. Zaslavskiy. Maksim Zaslavskiy pled guilty to ICO fraud when he initiated two ICOs that he falsely claimed were backed by investments in real estate and diamonds. While the presiding district judge said the indictment “charges a straightforward scam,” the case created monumental precedent. Before Zaslavskiy pled guilty, the court ruled that ICOs are considered securities and must comply with the registration and fraud provisions of the securities laws. As such, agencies will have the full weight of these laws to prosecute future ICO misconduct.

While it remains to be seen how receptive other courts will be to criminal cases involving cryptocurrency fraud, more investigations into the digital assets market can be expected in 2019. In fact, the Wall Street Journal recently published a comprehensive study [login required] that showed that 16 percent of the ICOs examined (513 companies) used deceptive and fraudulent tactics. Considering the rate of ICO fraud, this crackdown may only escalate the tension between crypto proponents and federal regulators.