The Securities and Exchange Commission (SEC) today announced a settlement with cybersecurity company, Gladius Network LLC. From October through December of 2017, Gladius conducted an ICO that raised around $12.7 million in ETH. Like many other companies that conducted ICOs in recent years, Gladius did not register this offering with the SEC. However, unlike other recent enforcement actions against such companies, this time the SEC did not assess fines against Gladius. Let’s talk about what this means.
How NOT to run an ICO: The Story of AirFox (and Paragon kinda)
At the time AirFox got mixed up with the SEC it was working on a pretty interesting mobile business. AirFox had a plan of offering prepaid mobile phone service and offering customers free or discounted data and airtime if they engaged with ads. Of course to make the system work, AirFox would need some kind of credit system to track the amount of ads a user viewed as well as the amount of data they used. AirFox decided to create their own cryptocurrency token to do this call “AirTokens.”
AirTokens wouldn’t stop at just that however. AirFox planned on enabling users to transfer AirTokens amongst themselves. So, for example, if one user engaged with a bunch of ads and had a surplus of AirTokens, they could lend them to another user. Maybe eventually users, could use these AirTokens to buy goods and services beyond just airtime and data.
This was all well and good, but AirFox had to build this whole wonderful system out and gain customers. In a normal startup, the founders would take out a loan, or sell shares of the company to raise the necessary capital. AirFox instead decided to sell AirTokens to the public. This was the basis of AirFox’s Initial Coin Offering (ICO) that they conducted in the fall of 2017.
AirFox completed their ICO in October, 2017 and raised around $15,000,000 by selling 1.06 billion AirTokens. The company said they’d use the money from the ICO as follows.
| Purpose | Percent of Capital Used |
| Engineering & Research | 50% |
| Sales & Marketing | 20% |
| Mobile Data Purchases | 13% |
| Admin and Legal | 12% |
| Reserved for Company | 5% |
According to the SEC, AirFox told investors that they could expect AirTokens in increase in value over time. Investors would also be able to sell AirTokens on an open market. At this point, you may ask, what is the difference between an AirToken and a stock (or similar security)? Turns out the SEC was asking the same question of AirFox and a host of companies conducting similar ICOs.
There were several public policy problems with this situation. Most importantly, there is a real danger that companies could be saying all kinds of untrue things about their “tokens.” The classic pump-and-dump scheme would be for a company to release all kinds of news about how great their business and token is doing, pumping up the price, selling all kinds of worthless tokens for real cash. Then taking the money and running for the hills. The SEC works to regulate this with securities by requiring all kinds of extensive disclosures by companies offering securities. Companies doing ICOs basically made the following argument:
AirFox: “These aren’t securities. They’re blockchain tokens. Totally different. Stop bothering us SEC. Your rules don’t apply.”
SEC: “Looks like a duck, walks like a duck, quacks like a duck…”
SEC Brings Down the Hammer
In November, 2018 the SEC had finally had enough of these IPOs and brought an enforcement action against AirFox.
- AirFox had to officially register AirTokens as a security with the SEC.
- AirFox had to tell everyone who bought an AirToken that they had a right to sue for their money back with interest and send a properly formatted claim form to each person facilitating this.
- AirFox had to provide a monthly progress report to the SEC regarding their efforts with #2 (and a bunch of other reports and promptly respond to any SEC requests for information on these matters).
- AirFox had to pay a find of $250,000 to the SEC.
Basically, would be out the $15,000,000 they raised via the ICO. They’d also owe interest on that money. They also had to pay $250,000 on top of that. And finally there would be a lot of administrative and legal costs the company would encounter to fulfill all of their registration and reporting requirements.
The same day the SEC announced the resolution of the issue with AirFox, it also announced a similar resolution with another company called Paragon. You can read the details of the Paragon deal in the filing documents below, but it’s basically the same story as AirFox. Instead of mobile phone airtime however, Paragon was involved in a ICO that would bring blockchain tech to cannabis cultivation (because you can never annoy too many government agencies). Paragon’s ICO in the fall of 2017 raised around $12 million and the SEC administered roughly the same punishment to them.
That’s the Stick, What About the Carrot?
The problem for the SEC however, is that AirFox and Paragon represented two of the roughly 2,100 ICOs that occurred in 2017 and 2018. Or from another angle the two companies represented less than $30 million of the approximately $14 billion dollars raised in those two years. It will take the SEC forever to pursue cases against all of these companies. And some of these companies raised hundreds of millions of dollars in their ICOs. While they may seem like ripe targets, those millions also buy you incredible resources to engage in protracted legal fights. The SEC needed a way to incentivize companies to come into compliance on their own. This is where the Gladius deal comes in.
Gladius raised around $12.7 (in ETH) in the fall of 2017. But Gladius self-reported to the SEC and while they have to offer investors the opportunity to get their money back, they will avoid any additional civil penalty. With the orders provided by the SEC regarding AirFox, Paragon, and Gladius the SEC has provided a clear roadmap for companies that want to clean up their potential ICO legal issues by self reporting.
[None of the above should be taken as legal advice and is based on my understandings of the SEC orders. If you want more details (and perhaps even more accurate details) please check out the actual SEC orders below.
