Initial Coin Offerings, or “ICOs” are growing in frequency and popularity, and that has SEC Chairman Jay Clayton worried. So worried that, in the last two months, the Chairman has issued repeated and direct warnings to attorneys assisting businesses with ICOs. He has asserted that these attorneys may be violating their professional obligations and assisting others to commit securities law violations.

ICOs are quickly emerging as a hot new means of raising capital. ICOs generally rely on the same “distributed ledger” technology as Bitcoin and other cryptocurrencies. Instead of issuing digital units to be used as a means of exchange as with cryptocurrencies, ICOs issue digital coins or tokens as a means of raising private capital for investment or operational expenses. This distinction may be subject to future challenge, but the SEC has left no doubt that it is focused on ICOs used to raise capital, and particularly on the lawyers who provide advice on securities law issues attendant to these offerings.

Rising Tide of Warnings

Chairman Clayton's first warnings to ICO attorneys came in a Dec. 11, 2017 public statement, with a section specifically addressed to gatekeepers, including lawyers and other market professionals. He highlighted the Commission's Section 21(a) Report from July 2017 that concluded the crypto-tokens issued by a type of entity known as a “Decentralized Autonomous Organization” met the statutory definition of “securities,” and therefore should have been registered. He warned lawyers and other gatekeepers to focus on their responsibilities to uphold investor protection and said that the large majority of the ICOs he had reviewed involved the offer and sale of securities.

The Chairman's rhetoric hit a new peak in a speech on Jan. 22, 2018. He warned ICO attorneys that they needed to act responsibly and called out two scenarios he found troubling. In the first scenario, attorneys assisted businesses with ICOs that had many similarities to securities offerings. In these cases, the attorneys provided assurances to the business that the crypto-tokens issued were not securities. In the second scenario, attorneys provided inconclusive advice to businesses about conducting an ICO—telling clients “it depends,” rather than cautioning that the securities laws likely would require registration of the offering. Many of these businesses accepted the risk and proceeded with their ICOs. Chairman Clayton closed with the warning: “I have instructed the SEC staff to be on high alert for approaches to ICOs that may be contrary to the spirit of our securities laws and the professional obligations of the U.S. securities bar.”

In his Feb. 6, 2018 testimony before the Senate Committee on Banking, Housing, and Urban Development, Chairman Clayton escalated the tone yet again—he warned market professionals that they were in the “crosshairs” of the Enforcement Division. He said that the Commission expected gatekeepers to do their job and act responsibly. Recently, the head of the SEC's new Cyber Unit, Rob Cohen, confirmed active ICO investigations, and noted an increased frequency in the involvement of outside lawyers in counseling ICO companies on registration issues, as compared to earlier, when such decisions apparently were made by non-lawyer company officials.

History of Pursuing Attorneys

Chairman Clayton's remarks are not idle threats. The SEC has a long history of pursuing attorneys who violate the securities laws, and often works in parallel with criminal authorities. One example of such cases is the “reverse merger” stock scheme, which frequently relies on the assistance of attorneys for its execution. In these schemes, a promoter collects the outstanding stock of an existing, publicly-listed shell company with no operations or assets. Then, the promoter “reverse” merges a private company into the public shell company so that the publicly-listed entity survives. The promoter often seeks an opinion letter from securities counsel to confirm there are no trading restrictions for the public stock. The promoter thereafter engages in various means of generating public interest in the “new” public company, often by circulating false market information and/or generating artificial trading to increase the price of the otherwise worthless stock. The promoter's goal is achieved when he sells his stock at artificially inflated prices. Historically, in some of these cases, attorneys participate in every phase of the scheme as a co-conspirator of the promoter. In others, attorneys participate only in two critical roles: creating publicly traded shell companies and issuing opinion letters on whether previously-restricted shares are now free-trading. The SEC and criminal authorities have investigated and charged this version of the pump-and-dump scam since the 1950s and 1960s.

In the 1970s, the Honorable Stanley Sporkin, former Director of Enforcement at the SEC, articulated the reasoning behind the SEC's pursuit of cases against attorneys as the “access theory,” an early form of gatekeeper liability—that attorneys and other professionals provided security-issuing principals with access to America's public securities markets. Because of this privileged role, these professionals had a responsibility to exercise good judgment and to act reasonably in providing legal advice because their failures would be felt throughout the securities markets.

Federal judges have also been equally vigilant in scrutinizing the role of securities counsel. Renowned Second Circuit Judge Henry Friendly confirmed more than 50 years ago that attorneys and other professionals had special roles that came with additional responsibility:

In our complex society the accountant's certificate and the lawyer's opinion can be instruments for inflicting pecuniary loss more potent than the chisel or the crowbar. Of course, Congress did not mean that any mistake of law or misstatement of fact should subject an attorney or an accountant to criminal liability simply because more skillful practitioners would not have made them. But Congress equally could not have intended that men holding themselves out as members of these ancient professions should be able to escape criminal liability on a plea of ignorance when they have shut their eyes to what was plainly to be seen or have represented a knowledge they knew they did not possess.

United States v. Benjamin, 328 F.2d 854, 863 (2d Cir. 1964).

In the early 2000s, following Enron, WorldCom, and other major accounting frauds, this narrative was relabeled—the SEC was focused on “gatekeepers.” If anything, these more recent cases only increased the SEC's appetite for pursuing attorneys who committed securities law violations. Since then, the list of SEC actions against attorneys is extensive.

Prezioso Framework

In April 2005, Giovanni Prezioso, then SEC General Counsel, gave a speech on attorney enforcement actions that created a clear and helpful paradigm for understanding these cases. Prezioso first observed that if certain conduct would create securities law liability for a layperson, a lawyer engaging in the same conduct would not be absolved because they were acting as a lawyer. Although the Commission generally disfavors bringing enforcement actions against securities counsel, it clearly believes there are circumstances where charges are warranted. For example, when a lawyer drafts disclosure that she or he knows to contain a misstatement that will be relied upon in the purchase or sale of a security, the lawyer is likely to be charged with a securities law violation.

In borderline cases, Prezioso listed three important factors that influence when the Commission will pursue an attorney in an enforcement action:

• First, the Commission considers a lawyer's role in making any key decisions that caused the securities violation. If the lawyer was responsible for the decision that led to a securities law violation, or if the lawyer withheld key information that caused a violation, it is more likely that the lawyer will be held responsible. By contrast, where an attorney gives his or her client “a balanced legal view” and the client makes the decision resulting in a violation, it is less likely the attorney would be charged.

• Second, the Commission considers the difficulty (or simplicity) of the legal issue involved in the violation. Where reasonable securities lawyers could disagree, an enforcement action is not likely.

• Third, the SEC disfavors actions against attorneys defending clients in enforcement proceedings because the Commission is sensitive to avoid creating a chilling effect that could impact zealous advocacy for clients.

Chairman Clayton's recent warnings to ICO attorneys are consistent with this framework. He singled out attorneys advising clients that ICO tokens are not securities. Since he has said that virtually every ICO he has reviewed involved the issuance of securities, presumably he does not see this question as one where reasonable securities lawyers could disagree. Chairman Clayton also warned that attorneys who deliberately advised clients that the law was equivocal on whether crypto-tokens issued in ICOs were securities—when, in his view, the answer is obvious—could face liability for withholding key information needed by the client to make an informed decision. Thus, attorneys who provide their clients with securities law advice on ICOs must be aware of the warnings issued by the SEC and should be communicating those warnings to their clients.

ICO Enforcement Priorities

In the last six months, the SEC has brought four enforcement actions in connection with unregistered ICOs, three of which included fraud allegations and more than $600 million in potential proceeds. The outlier was a settled action against Munchee, Inc., in which the company promptly halted its ICO when contacted by SEC staff and subsequently returned all investor funds. In the settled order, Munchee agreed to cease any further violation of the securities laws, but paid no fine.

Some have concluded that these actions signal that only large, fraudulent ICOs will be an enforcement priority, and suggested that ICOs for legitimate businesses will escape scrutiny. In light of Chairman Clayton's sharp escalation of warnings to ICO gatekeepers, this view is unrealistic. Given the increasing popularity of ICOs and the Commission's clear priority to ensure they are properly regulated, we do not expect the Commission to limit its enforcement program to major frauds.

The settled order in Munchee, Inc. is consistent with this approach given the factors favoring leniency in that case. At the time, there may have been some legitimate doubt about whether the particular ICO tokens the company was issuing were, in fact, securities. Since that time, this doubt has been removed (or at least diminished) by further guidance from the Chairman and SEC staff. Additionally, Munchee was able to terminate its ICO and return all investor funds. Not all businesses, even otherwise legitimate ones, will be able to do that.

Practical Tips for ICO Attorneys

Given the gestation period for Commission enforcement actions, we expect that matters involving the role of attorneys in ICOs are already under investigation. But going forward, there are two key steps that ICO attorneys can take when counseling clients:

• Keep careful records of the advice you provide, including details of your legal basis for that advice. Note the sources and authorities you consulted before reaching a conclusion.

• Keep careful records of the factual information provided by your client, including records of your due diligence efforts to understand the client's ICO and operations. The failure to ask obvious questions and follow up on open issues could lead to a charge of recklessness.

Conclusion

Chairman Clayton's warnings to gatekeepers are not unprecedented—the SEC has issued such warnings before. But those warnings have teeth because of the Commission's consistent history of following warnings with enforcement actions against attorneys and other gatekeepers. Only time will tell, but attorneys and other gatekeepers would do themselves and their clients well to be familiar with Chairman Clayton's warnings and the Prezioso framework for how the SEC decides to bring charges against lawyers, and to make and keep good records of the advice they provide to clients on ICO issues.

William F. Johnson is a partner in the special matters and government investigations practice group at King & Spalding. Jacob Gerber, an associate in the group, assisted in the preparation of this article.