Slaying the Dragon: Lessons from an SEC Crypto-Enforcement Action

Slaying the Dragon: Lessons from an SEC Crypto-Enforcement Action
12/01/2022

This blog was written in partnership with our legal team at FinTech Law. FinTech Law's services range from legal guidance to Registered Funds, cryptocurrency law, and intellectual property rights.

Understanding the Dragon

In SEC v. Dragonchain, the SEC brought an action against three Dragonchain entities controlled by John Roets, which collectively raised $16.5 million from about 5,000 investors in “unregistered’ crypto asset securities offerings. Dragonchain was set up as an investment club that offered discounted tokens in a pre-sale campaign and an initial coin offering (“ICO”). The SEC alleged in its complaint that the tokens, referred to by the symbol DRGNs, were “securities” that needed to be registered with the SEC because no exemption applied. In its complaint, the SEC cites Howey specifically, arguing the Dragonchain token offering was a security offering because it is a scheme devised to seek the use of the money of others on the promise of profits.

The case is a good example of the SEC’s policy on digital offerings that may be security offerings and illustrates some key takeaways that founders and entrepreneurs should consider when launching blockchain companies or pivoting from one business plan to another.

From Utility Token to Investment Scheme

Dragonchain was created on the Walt Disney open-source blockchain to create a turnkey platform that would allow businesses to introduce blockchain technology into their daily activities. Dragonchain used the Ethereum blockchain to raise capital to fund the company’s development efforts. Initially, Dragonchain told investors that DRGNs were “utility” tokens that would be used to purchase features on the Dragonchain platform, but that the native platform did not require DRGNs to be used as the medium of exchange. Rather, the platform users could purchase DRGNs with fiat currency.

Further, Dragonchain did not market DRGNs to native platform users. Rather, beginning in 2017, it sold DRGNs to non-platform users in the crypto investor community, including “crypto influencers” as part of a referral campaign. These influencers received DRGNs at pre-sale discounts and the value of their DRGNs increased as more users purchased the tokens. Nearly all the statements made by the DRGN influencers referred to the token’s value as an investment scheme, and not the underlying native platform. Dragonchain owners and employees also referred to the investment benefits of DRGNs, including their investment liquidity over traditional assets and the availability of secondary trading markets. After the ICO, Dragonchain focused on getting DRGNs listed on crypto trading exchanges and promoting the value of the token as an investment. Within 12 months of the ICO, about 56% of the DRGNs purchased in the pre-sale and ICO were sold in crypto markets.

Deployment of Capital

Dragonchain owned about 45% of all DRGNs after the pre-sale. As the value of the tokens increased, Dragonchain used the tokens to pay for third-party services such as operations, marketing, customer support, product development, and advisory services; these payments equaled more than $2 million. It also used the capital to invest in CoinMe Inc., another blockchain company. Dragonchain used about $500,000 of its fund-raising proceeds to invest in CoinMe.

Securities Designation

In January 2021, Dragonchain entered into a consent order with the Washington state’s Department of Financial Institutions, which found that DRGNs were securities. Despite this designation, Dragonchain continued to sell the tokens on the open market to pay for third-party services.

The SEC’s complaint provides its standard roadmap for bringing crypto-related enforcement actions. Despite Congress’ weak attempts to give the CFTC jurisdiction over cryptocurrencies, the SEC continues to treat many crypto offerings as securities offerings, subject to the disclosure and anti-fraud provisions of the Securities Act of 1933 (the “Securities Act”). The SEC has repeatedly stated that such offerings must be registered under the Securities Act unless an exemption applies. The most common exemptions are for private securities offerings to accredited or other sophisticated investors. Since most crypto-currency firms offer their tokens or coins publicly, their offerings generally don’t meet any exemptions under the Securities Act.

Participants in the blockchain community should beware that the SEC will treat any publicly offered cryptocurrency, virtual currency, digital coin, or digital token as a securities offering because such assets are “investment contracts.” This means blockchain issuers should “take appropriate steps to ensure compliance with the U.S. federal securities laws.

Key Takeaways

Like many of the SEC’s recent enforcement actions, the activities at issue occurred more than a few years ago, before the Commission’s agenda around cryptocurrencies was set by now Chairman Gary Gensler. Entrepreneurs in the crypto space need to be aware of activities that create regulatory risk under SEC enforcement. Here are the key takeaways from the SEC’s policy.

  1. Utility versus Security. Using blockchain technology for utility or other operational purposes will avoid SEC scrutiny. For example, using Ethereum to create smart contracts or processes that leverage the benefits of blockchain technology is outside the scope of SEC policy. But if the purpose of the technology is to raise assets for business funding, replace traditional equity securities, or create an ecosystem for trading, then business may be crossing the regulatory Rubicon.

  2. Fast Money is Dangerous Money. Founders need to remember that accessing public markets, even though autonomous cryptocurrencies, is very different than raising capital privately. A founder that used private offerings to fund a prior venture may be unaware of the pitfalls and other dangers of entering public markets. Generally, startups cannot publicly raise capital, although there are some limited exceptions to this rule. Before raising capital for a startup or pivot, founders should consult with legal counsel to evaluate regulatory requirements related to the capital raise.

  3. Entrepreneurism is Not a License to Avoid Regulation. The crypto and blockchain industry is chock-full of entrepreneurs from the technology industry, a lightly regulated industry compared to the securities industry. These founders are not familiar with the regulatory burdens imposed on financial services firms. If you are going to play in the fintech space, then you need to be aware of regulations that can impact your business plan. Regulatory risk should be a major point of discussion before marketing, building, or launching a product.

  4. Dangerous Pivots. Founders and their boards should discuss any potential regulatory issues when pivoting from one business model to another. Often during these times, companies are under financial or other stressful conditions. A failed product launch and high burn rate can cause founders to focus solely on the financial viability of a company without any consideration of whether a pivot is creating regulatory issues. Founders need to consider whether a change in the business model will create a regulatory risk that could expose the founder and others to personal liability.

As we’ve seen in both recent and past events, the waters of cryptocurrency and decentralized finance (DeFi) are deep if not murky. Regulations are continuously being developed, designed, and evolving as investors and regulators determine how best to navigate this new, technologically advanced financial ecosystem. There are many potential pitfalls that can be easily avoided with the right regulatory and legal knowledge and corporate governance structure. If you are looking to dive into this wild world of crypto and DeFi, make sure you have the right team backing you and keeping your investment safe. Contact the team at FinTech Law and Joot for legal and compliance help.