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ICOs Involving Non-Issued Cryptocurrency May Be  Prosecuted Under Federal Securities Laws
September 19, 2018

ICOs Involving Non-Issued Cryptocurrency May Be Prosecuted Under Federal Securities Laws

By: Jeffrey Hamlin

This week, a federal district court in New York was the first to decide that federal securities laws may be used to prosecute fraud involving cryptocurrencies. In United States v. Zaslavskiy, Eastern District Judge Raymond Dearie held that the Securities Exchange Act of 1933 (“Exchange Act”) and Securities Act of 1933 (“Securities Act”) are broad enough to cover representations made in connection with virtual currency investment schemes and related Initial Coin Offerings (“ICOs”). Although the decision breaks new ground, it is limited. The court held only that prosecutors should have the chance to prove that acts alleged in the indictment amount to criminal violations of federal securities laws. The court did not hold that all virtual currencies are “securities” under federal law or that the Securities and Exchange Commission (“SEC” or the “Commission”) has jurisdiction over all ICOs.

In November 2017, a grand jury in Brooklyn charged Maksim Zaslavskiy with conspiracy to commit securities fraud and two substantive counts of securities fraud—one involving his company REcoin Group Foundation, LLC (“REcoin”) and the other involving his company DRC World, Inc. a.k.a. Diamond Reserve Club (“DRC”). According to the Indictment, Zaslavskiy formed REcoin in July 2017 as a vehicle for real estate investing and the development of real estate “smart contracts,” i.e., contracts that are executed by computer when certain triggering conditions are met. Two months later, he allegedly formed DRC as a vehicle for investing in diamonds and obtaining discounts from diamond retailers on behalf of DRC members. From January to October 2017, Zaslavskiy allegedly raised capital for both companies by offering virtual currency in exchange for investment funds. Zaslavskiy told investors that REcoin (i) was uniquely valuable because it was backed by real estate investments, (ii) provided a platform for converting savings into real estate-backed currency with potential for high returns; and (iii) had some of the highest potential returns. A related white paper stated that REcoin was led by an experienced team of brokers, lawyers, and developers. According to prosecutors, these promises were fraudulent because REcoin never purchased real estate, staffed its team of professionals, or developed the cryptocurrency.

After the REcoin ICO purportedly concluded, Zaslavskiy started the DRC ICO. Allegedly, Zaslavskiy encouraged REcoin investors to convert their REcoin into DRC tokens at a discounted rate. Investors purportedly were told that DRC cryptocurrency was hedged by diamonds that were fully insured and stored securely in the United States. A related white paper forecasted minimum growth of 10% to 15% per year. Prosecutors contend that the offering was fraudulent because DRC never purchased diamonds, took out insurance on diamonds, or conducted the ICO.

Zaslavskiy asked the court to dismiss the charges on grounds that the alleged ICOs did not involve “securities” so were not subject to federal securities laws. The argument was not far-fetched. Under the Exchange Act, the word “securities” is defined to include “investment contracts,” but explicitly excludes “currency,” which is regulated as a commodity.

The court was not persuaded. Judge Dearie explained that Zaslavskiy’s promise of non-issued cryptocurrency was insufficient to defeat the SEC’s jurisdiction over investment opportunities that he marketed to investors on behalf of REcoin and DCR. The facts alleged in the charging document, if proven, would support a jury finding that Zaslavskiy made false statements to potential investors so they would enter “investment contracts.”

Under the Supreme Court’s Howey test, an “investment contract” exists when there is a contract, transaction or scheme whereby a person (i) invests his money (ii) in a common enterprise and (iii) is led to expect profits from the efforts of the promoter or third party. Judge Dearie applied that test and found that facts alleged in the indictment, if proved, would be sufficient to meet each element. First, a reasonable jury could conclude that individuals invested money in the REcoin and DCR investment schemes. Moreover, accepted as true, the allegations would support a jury finding that both REcoin and DCR constituted a common enterprise—i.e., that each was a common venture that tied each individual investor’s fortune to the fortunes of other investors in the investing pool. Finally, a reasonable jury could conclude that investors were led to believe that any profits in REcoin and DCR would be derived solely from the managerial efforts of Zaslavskiy and his co-conspirators. The court concluded that, since the indictment was facially sufficient, prosecutors should have the chance to prove their case at trial.

The facts of this case seemed to present a strong test case for the SEC. We will be watching closely to see whether and how other district courts apply federal securities laws to offerings involving cryptocurrencies.