No Fraudulent Initial Coin Offering Is Too Small for the SEC

The US Securities and Exchange Commission’s (SEC) Administrative Order titled In the Matter of Tomahawk Exploration LLC and David Thompson Laurance, indicates that the SEC has set its sights on fraudulent initial coin offerings (ICOs).

Between July and September 2017, oil and gas exploration company Tomahawk Exploration LLC, and its founder, David Laurance, held an ICO in which they offered and sold “Tomahawkcoins” or “TOM” in an effort to raise $5 million to fund an oil drilling venture in California. The SEC found that the defendants published fraudulent promotional materials overstating the economic potential of TOM coins and failed to disclose Laurance’s prior criminal convictions. In the corresponding press release, the Chief of the SEC’s Cyber Unit stated, “Investors should be alert to the risk of old-school fraud, like oil and gas schemes, masquerading as innovative blockchain-based ICOs.”

Tomahawk’s promotional materials stated that the drilling project was “capable of producing significant risk adjusted rates of return,” and that the TOM coin was “backed by profits generated by Tomahawk.” The defendants also offered token holders the opportunity to convert TOM into equity and potentially profit from the anticipated oil production. The SEC found that the defendants used inflated projections of oil production and falsely suggested that Tomahawk already possessed drilling leases. Tomahawk also described its managers as “refined successful citizens with flawless backgrounds,” but failed to disclose Laurance’s prior brushes with law enforcement, including a 1993 conviction for fraud, past involvement with companies subject to SEC actions, and personal bankruptcies.

To promote the ICO, the defendants launched a free promotional token giveaway called the “Bounty Program,” in which 80,000 TOM coins were distributed to internet users who promoted the currency on trading platforms, blogs and social media.

The SEC found that the defendants had violated federal law by: (1) selling securities without complying with registration requirements, in violation of Sections 5(a) and 5(c) of the Securities Act of 1933; and (2) making materially false and misleading statements in connection with that sale, in violation of Section 10(b) of the Securities and Exchange Act of 1934 and SEC Rule 10b-5.

In making this determination, the SEC opined that the TOM tokens were “securities” because they represented an investment of money in Tomahawk’s drilling enterprise and could be converted into equity. The SEC also determined that the promotional token giveaway constituted a securities “sale” because it involved “an attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value.”

Significantly, the SEC noted that the “free” nature of a token giveaway “does not mean that there was not a sale or offer for sale” because a “gift of a security is a sale . . . when the donor receives some benefit.” The SEC specifically pointed to the online marketing benefits associated with Tomahawk’s “Bounty Program” giveaway and the creation of a public trading market for TOM, as the value that Tomahawk received in exchange for its Bounty Program distribution. When combined with the misleading statements made in connection with the ICO, such a “sale” of virtual currency violated registration and antifraud rules.

This enforcement action suggests that the SEC is taking a close look at token sales and Bounty Programs and may proceed with investigations and penalties against individuals and entities even in comparatively small-scale operations. Those in the industry should tread carefully, even when dealing with relatively small sums of virtual currency.

We would also like to thank McDermott Partners David L. Taub, Alexandra C. Scheibe and Summer Associate Charlie Wohlberg for their contributions to this article.