The Securities and Exchange Commission’s (SEC) new Cyber Unit is moving with ostensible speed.

Earlier this month, the unit launched its first official enforcement action related to an initial coin offering (ICO) when it brought a securities fraud case against PlexCorps, an unincorporated Canadian company. The SEC accuses PlexCorps of “misappropriating investor funds illegally raised through the fraudulent and unregistered offer and sale of securities called ‘PlexCoin’ or ‘PlexCoin Tokens’ in a purported ‘Initial Coin Offering.’”[1]  In announcing the action, Robert Cohen, Chief of the Cyber Unit, stated that the case represents exactly the type of matters his unit will pursue.[2]

“This first Cyber Unit case hits all of the characteristics of a full-fledged cyber scam and is exactly the kind of misconduct the unit will be pursuing. We acted quickly to protect retail investors from this initial coin offering’s false promises.”

– Robert Cohen, Chief of the SEC Cyber Unit, December 2017[3]

As we shared in a recent article, the SEC unveiled its first formal guidance on “digital token” sales earlier this year. This guidance was in connection with a decision not to bring an enforcement action against the DAO, an unincorporated virtual organization created by the German company Slock.it UG. The SEC chose to stand pat despite concluding that the DAO had offered and sold digital tokens that were securities within the meaning of U.S. federal securities laws. In its guidance, the SEC warned that U.S. federal securities laws may apply to certain initial coin offerings (ICOs), or “token sales,” and called for the use of a “principles-based framework” for assessing the applicability of the securities laws to these new types of investment vehicles. The SEC stressed that the unique “facts and circumstances” of each situation will determine whether or not the securities laws apply and recommended that market participants consult with their securities counsel on these issues.[4][5]

“The issue of whether a particular investment opportunity involves the offer or sale of a security – regardless of the terminology or technology used in the transaction – depends on the facts and circumstances, including the economic realities and structure of the enterprise.”

– SEC, Divisions of Corporation Finance and Enforcement, July 2017[6]

SEC Chairman Jay Clayton echoed this sentiment in a public statement on digital token sales. While he refrained from offering a bright line test, Clayton stressed that token sales “being sold on the potential for tokens to increase in value – with the ability to lock in those increases by reselling the tokens on a secondary market – or to otherwise profit from the tokens based on the efforts of others [exhibit] key hallmarks of a security and a securities offering.”[7]

The SEC followed up its July guidance by announcing the creation of a new Cyber Unit to focus the SEC Enforcement Division’s cyber-related expertise on identifying securities law violations involving blockchain or distributed ledger technology and ICOs. The new unit is also focused on targeting market misconduct involving market manipulation schemes using false information spread through electronic and social media, hacking schemes, “dark web” activity, intrusions into retail brokerage accounts, and cyber-related threats to trading platforms and other critical market infrastructure.[8]

What’s particularly interesting is understanding why the SEC chose to bring an enforcement action in the PlexCoin matter, but not in the DAO matter.

The Heart of the Matter

On December 1, the SEC filed a lawsuit[9] against PlexCorps and two associated individuals in federal court in Brooklyn, NY, alleging that PlexCorps (a/k/a and d/b/a PlexCoin and Sidepay.Ca.), along with Dominic Lacroix and Sabrina Paradis-Royer, both residents of Quebec, Canada, violated U.S. federal securities laws in connection with an unregistered ICO.

According to the SEC’s complaint, the defendants raised an estimated $15 million from “thousands of investors,” including investors throughout the United States, via an unregistered and unlawful offering of nonexempt securities. Further, the defendants allegedly made materially false and misleading statements in furtherance of their scheme, including efforts to entice early investors with promises of returns of over 1,000% in under a month. Moreover, the SEC alleges that while PlexCorps indicated that some proceeds from the ICO would go toward the development of PlexCorps products, in truth, the defendants used the proceeds for personal expenses, including home décor projects.

The crux of the SEC’s claims is its determination that the PlexCoin ICO involved the marketing and sale of securities within the meaning of U.S. federal securities laws and that the defendants failed to properly register the ICO. The SEC alleges the defendants violated the securities fraud statutes of the Securities Act of 1933 (Section 17(a)) and the Securities Exchange Act of 1934 (Section 10(b) and Rule 10b-5) and unlawfully marketed and sold unregistered securities (violations of Sections 5(a) and 5(c) of the Securities Act). Additionally, the SEC alleges Lacroix and Paradis-Royer aided and abetted the aforementioned violations.

In its complaint, the SEC states that it considers the PlexCoin ICO to be a “general solicitation” made through statements that were posted and/or disseminated on the Internet and on social media. The SEC refers to PlexCorps’ “whitepaper,”[10]  which was issued in connection with the ICO, along with postings on webpages and Facebook accounts registered in the names of Lacroix and Paradis-Royer, as materials containing such statements. Additionally, the SEC refers to various online payment services accounts and cryptocurrency addresses allegedly used by the defendants to collect investor funds.

On the topic of whether or not the PlexCoin Tokens are securities within the meaning of U.S. federal securities laws, the SEC draws a distinction between digital assets that constitute securities (so-called cryptosecurities) and digital assets that do not constitute securities (so-called cryptocurrencies).

“To skirt the registration requirements of the federal securities laws, Lacroix has attempted to refashion the PlexCoin Tokens as a ‘cryptocurrency’ and likened them to Bitcoin. In reality, PlexCoin Tokens are securities within the meaning of the U.S. federal securities laws.”

The SEC’s complaint further states:

“An ICO is a fundraising event in which an entity offers participants a unique ‘coin’ or ‘token’ in exchange for consideration (often in the form of crypto or fiat currency). The tokens are issued on a ‘blockchain’ or cryptographically secured ledger. Generally, coins or tokens may entitle holders to certain rights related to a venture underlying the ICO, such as rights to profits, shares of assets, rights to use certain services provided by the issuer, and/or voting rights. These coins or tokens may also be listed on online platforms, often called virtual currency exchanges, and tradable for crypto or fiat currency.”

Repeat Offenders

According to the SEC, the defendants marketed the PlexCoin Token as a “tokenized currency,” promising early investors “outlandish” returns on investment, and made a number of materially false or misleading statements with regard to PlexCorps and the PlexCoin Token in furtherance of their scheme. For example, the company represented that there were over 40 experts working on the project throughout the world and that the principal place of business was Singapore. However, only a handful of individuals were involved in the project, and all of them were located in Quebec according to the SEC. Defendants also allegedly refused to disclose to investors the identity of PlexCorps’ principal executive, Lacroix, citing competition and privacy concerns, when, in truth, the nondisclosure was meant to hide Lacroix’s history as a known “recidivist securities law violator.”

According to the SEC’s complaint, Lacroix is a repeat offender of securities laws in Canada. In 2011, the Autorité des Marchés Financiers, Quebec’s financial markets authority, charged Lacroix with offering unregistered investments in a company he controlled known as Micro-Prêts (or “Small-Loans” in French), in violation of the Quebec Securities Act. The Quebec Financial Markets Administrative Tribunal (Quebec Tribunal) then issued an ex parte order enjoining Lacroix and Micro-Prêts from further violations. Later that year, Lacroix and Micro-Prêts signed an undertaking representing that they would not conduct any further securities transactions, including through the use of the Internet.

In 2013, Lacroix and Micro-Prêts pled guilty to making materially false statements in connection with the offer and sale of securities, before a Quebec tribunal, and was ordered to pay over C$25,000 in criminal penalties. Three and a half years later, the Quebec Tribunal issued another order (in June of this year) against Lacroix and three companies (DL Innov, Gestio, and Micro-Prêts) after finding evidence that Lacroix and the companies had raised over $2 million from investors in Micro-Prêts, and again enjoined him from further securities-related activities. Finally, the Quebec Tribunal issued another order this July to stop activity in connection with PlexCorps and the PlexCoin ICO after it found sufficient evidence that PlexCoin Tokens are securities within the meaning of the laws of Quebec. The Superior Court of Quebec subsequently held Lacroix in contempt of this order, and sanctions are pending.

Scrutiny of Whitepaper and Other Materials

The defendants reportedly used a variety of means to market PlexCoin and gather investor funds, including making postings on Facebook and other webpages and using accounts held at online payment processors such as PayPal, Square, Shopify, and Stripe. In mid- to late-June 2017, Lacroix announced an “ICO presale launch” scheduled for August on a Facebook page with the address @plexcoin, describing PlexCoin as “the next decentralized worldwide cryptocurrency based on the Ethereum structure.” The next month, Lacroix and PlexCorps launched another Facebook page with the address @plexcorps on which posts were made regarding PlexCorps’ supposed group of more than 40 independent experts, including programmers, engineers and cryptocurrency specialists. A number of Internet websites were also registered and launched related to PlexCorps and PlexCoin around this time.

On or about August 4, 2017, PlexCoin’s whitepaper was posted on the Internet. It specified that the “presale” would run from August 7 through September 5 and the “launch” date for secondary trading would be September 10. PlexCoin began trading under the symbol PXN on the digital exchange platform Etherdelta at this time. According to the SEC, PlexCoin’s whitepaper indicated that the company was seeking to raise nearly $250 million from the ICO, and profits from the enterprise would be distributed to investors using PlexCoin Tokens, including profits from the presale. The SEC notes that the whitepaper contained a range of financial forecasts, starting at approximately $77 million in profits for the fifth year under a “conservative” view to nearly $6 billion in profits for the fifth year under an “optimistic” view. Investors were directed to purchase PlexCoin Tokens using U.S. dollars, Canadian dollarts, euros, Bitcoin, Ether, or Litecoin.

Furthermore, the SEC noted that the whitepaper promoted PlexCoin as a “profit-making opportunity” and touted “enormous” ROI targets. The SEC also highlighted language from the whitepaper indicating that the PlexCorps team would use a portion of the proceeds from the presale to prop up the value of PlexCoin, if necessary:

“The PlexCoin Whitepaper explained that the 70% reference to market maintenance meant that a ‘team will remain on the lookout for PlexCoin’s value fluctuations when it will be launched’ and ‘will limit the value decreases by buying if the value drops,’ such that they ‘will thus guarantee a rather steady increase of PlexCoin's value.’”

These concerns appear to parallel the issues highlighted above from the chairman’s recent public statement.

According to the SEC, the defendants’ statements regarding the estimated worth of a PlexCoin Token, as well as the expected returns and uses of funds, were materially false or misleading. Further, the SEC alleges that the defendants’ statements regarding PlexCorps’ team of experts and corporate locations were also materially false or misleading.

Movement and Use of Proceeds

Lacroix originally accepted payments through a PayPal account starting in early August 2017, but the payments were eventually reversed, and the account was flagged for suspicious activity. The defendants then opened an account at Shopify and announced the new payment system on PlexCoin’s Facebook page. Investors were instructed to remit payments through the portal “Sidepay.ca.” Based on the HTML source code, Sidepay.ca was simply a cover for the Shopify account. The Shopify account had been opened in Paradis-Royer’s name using Lacroix’s personal email address and was associated with bank accounts held by Paradis-Royer. In early September, Shopify placed a hold on the account, but the defendants opened another bank account shortly thereafter in an attempt to avoid the hold.

In addition, the defendants also accepted investor funds through the online payment services provider Stripe. The defendants allegedly opened three accounts with Stripe to collect euro, U.S. dollar and Canadian dollar payments. The accounts currently hold over $800,000 as of the date of the SEC’s complaint:

• Stripe euro account – Received payments totaling approximately €262,000 (or $311,000), all of which remains in the account due to a 90-day administrative hold by Stripe that was set to expire in December.
• Stripe U.S. dollar account – Received payments totaling over $1 million, and approximately $900,000 was transferred out to one of the defendants’ bank accounts. Approximately $211,492 remains in the account.
• Stripe Canadian dollar account – Received payments totaling over $322,000, and more than C$372,000 (or $290,000) remains in the account under an administrative hold by Stripe that was set to expire in December.

In the aggregate, the SEC estimates that the defendants’ sales of PlexCoin Tokens generated proceeds in excess of $15 million (based on PlexCoin’s stated offering price), and that the defendants currently control “unknown amounts” of Bitcoin, Ether, or Litecoin cryptocurrencies that they obtained in exchange for PlexCoin Tokens.

According to the SEC, Defendants have already misappropriated or attempted to misappropriate at least $200,000 of this amount to pay for home improvement and other personal expenditures, including lawn services, painting services, electricians, ceramic work, and aluminum work. On the same day it filed its complaint, the SEC obtained an emergency restraining order from the federal court to temporarily freeze the defendants’ assets. In addition to the $200,000, the SEC expressed concerns that the couple would soon gain access to another $800,000 held in online bank accounts. The remainder of the ICO proceeds are believed to be held in Bitcoin or other blockchain addresses or wallets under the control of the defendants. These amounts have yet to be traced as of the date of the SEC’s complaint.

The temporary order was set to expire on December 15, and late last week, U.S. District Judge Carol Bagley Amon (Eastern District of New York) granted a preliminary injunction, extending the asset freeze and restraining the company from destroying, altering, or concealing evidence related to the allegations set forth in the SEC’s complaint.[11]

Howey Test

In its complaint, the SEC notes that the Quebec Tribunal relied in part on the U.S. Supreme Court Howey[12] decision, in determining that the PlexCoin Tokens are considered securities within the meaning of the laws of Quebec. In fact, the SEC referred to this case, and the “Howey test,” in its guidance on digital assets released earlier this year.[13] The Howey case arose out of a dispute over the offer and sale of units of a citrus grove development and a related service contract, which was deemed to be an “investment contract” within the meaning of U.S. federal securities laws.[14]

Under the Howey test, a transaction is a security (or investment contract) if the following are true:[15]

1. It involves an investment of money
2. The investment of money is in a common enterprise
3. There is an expectation of profits from the investment
4. Any profits come solely from the (managerial) efforts of others

Back in 2016, the Howey test was suggested as a framework for digital assets by Peter Van Valkenburgh of Coin Center.[16]  Later that year, Coinbase, in collaboration with Coin Center, Union Square Ventures, and Consensys, introduced the “Blockchain Token Securities Law Framework,” along with a “Framework Tool” for developers and users of blockchain tokens. The framework was created with contributions by securities law attorneys with the law firms Debevoise & Plimpton LLP and Cooley LLP,[17]  and the tool may be a useful guide for market participants in ICOs.[18]

SEC Ready to Respond

As evidenced by the speed with which the SEC reacted to the PlexCorps matter, the SEC looks to be moving quickly to respond to potential misconduct or fraudulent activities involving emerging technologies and the rapidly evolving ICO marketplace. As the SEC’s Cyber Unit brings additional enforcement actions, we will watch for further insights into the SEC’s stance on important questions regarding digital assets and the ICO markets.

1. Securities and Exchange Commission Complaint, SEC v. PIexCorps a/k/a and d/b/a PlexCoin and Sidepay.ca, et al., No. 17 Civ. 7007 (CBA). December 1, 2017. Information in the remainder of this article regarding the PlexCorps matter are taken from the SEC complaint, unless otherwise noted.
2. Press Release, “SEC Emergency Action Halts ICO Scam,” December 4, 2017.
3. Ibid.
4. “Investor Bulletin: Initial Coin Offerings,” Securities and Exchange Commission, July 25, 2017.
5. Public Statement, “Statement by the Divisions of Corporation Finance and Enforcement on the Report of Investigation on The DAO,” Divisions of Corporation Finance and Enforcement, July 25, 2017, Emerging Technologies and the Federal Securities Laws; and Securities and Exchange Commission, Securities Exchange Act of 1934, Release No. 81207 / July 25, 2017, “Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO.”
6. Ibid.
7. Public Statement, “Statement on Cryptocurrencies and Initial Coin Offerings,” SEC Chairman Jay Clayton, December 11, 2017.
8. Press Release, “SEC Announces Enforcement Initiatives to Combat Cyber-Based Threats and Protect Retail Investors,” September 25, 2017.
9. Securities and Exchange Commission Complaint, SEC v. PIexCorps a/k/a and d/b/a PlexCoin and Sidepay.ca, et al., No. 17 Civ. 7007 (CBA). December 1, 2017.
10. Generally, the proponents of an ICO will release a “whitepaper” in anticipation of the launch, which describes their project and the terms of the ICO. Whitepapers are essentially sales and marketing documents in which the proponents highlight the features of their product, service, or technology connected with the ICO.
11. “Order Granting Preliminary Injunction, Asset Freeze, and Other Interim Relief” in SEC v. PIexCorps a/k/a and d/b/a PlexCoin and Sidepay.ca, et al.; No. 17 Civ. 7007 (CBA).
12. Securities and Exchange Commission v. W. J. Howey Co., 328 U.S. 293, May 27, 1946.
13. Securities and Exchange Commission, Securities Exchange Act of 1934, Release No. 81207 / July 25, 2017, “Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO.”
14. Securities and Exchange Commission v. W. J. Howey Co., 328 U.S. 293, May 27, 1946.
15. Ibid.
16. Peter Van Valkenburgh, “Framework for Securities Regulation of Cryptocurrencies v1,” Coin Center Report, January 4, 2017.
17. “A Securities Law Framework for Blockchain Tokens,” Joint initiative of Coinbase, Coin Center, Union Square Ventures, and Consensys, last updated December 7, 2016.
18. The authors of the framework caution: “The Howey test has not yet been directly applied by the courts to any digital currency or blockchain token. The Howey test as applied by the courts does not involve any points-based calculation. The points system is intended as a guide – to highlight the characteristics of a token which are relevant to the securities law analysis. This Framework should be read together with the full legal analysis. This Framework and the full legal analysis may be updated in the future as the law in this area develops.”