Recently, the SEC has charged the gamut of ICO players with violating the securities laws, including companies raising money with ICOs, an exchange, and people promoting ICOs. None of the recent cases contained allegations of fraud and in some cases, the companies attempted to comply with the law.
In the most recent case, the SEC charged CoinAlpha LLC (“CoinAlpha”), managing partner of a crypto investment fund for violating the securities laws. Unlike other companies that the SEC charged, CoinAlpha made a concerted effort to comply with the law, including by filing with the SEC. This case is significant because it illustrates that even if you try to comply with the law, you can still get in trouble if you make a mistake.
Facts Leading to the CoinAlpha Enforcement Action
CoinAlpha Creates a Crypto Fund
CoinAlpha created an investment fund called, CoinAlpha Falcon LP (the “Fund”) to invest in crypto assets. LP stands for “limited partnership.” In a limited partnership, there is one managing partner and one or more limited partners.
The managing partner’s role is to manage the fund, while the limited partners are responsible for contributing money to the fund. They have no management powers and are merely passive investors, so these limited partnership interests are securities.
Under U.S. securities laws, the offer and sale of securities must be registered unless it is exempt from registration.
CoinAlpha Raises Money for the Fund
CoinAlpha served as the managing partner of the Fund. It decided to raise money for the Fund by CoinAlpha soliciting investors to buy limited partner partnership interests. Between October 2017 and August 2018, CoinAlpha sold $600,000 worth of limited partnership interests to 22 investors. They knew 13 of these investors and found the remaining 9 investors by posting on their blog, pitching at conferences, and giving media interviews.
CoinAlpha Makes a Good Faith Attempt at Complying with U.S. Securities Laws
When CoinAlpha began raising money for the Fund, they filed a Form D with the SEC indicating that they were raising money under Rule 506(b). In addition, they gave their investors questionnaires and had them self-certify as to their accreditation status before selling them partnership interests in the Fund. All of the investors certified that they were accredited.
How a Small, Preventable Mistake Lead to an SEC Enforcement Action
The Rule 506 Exemptions
Rule 506(b), the exemption that CoinAlpha purported to rely upon is one of the exemptions under Regulation D that allows a company to raise money without registering with the SEC. Other exemptions under Regulation D include Rule 504 and Rule 506(c).
Rule 506 is the most popular exemption because it allows a company to raise an unlimited amount of money and the qualifications for a Rule 506 offering are relatively straightforward. Under Rule 506 are two distinct and separate exemptions, Rule 506(b) and Rule 506(c). Both rules allow a company to raise an unlimited amount of money without any required disclosures as long as all investors are accredited investors. In addition, both rules require a company to file a Form D within 15 days of the first sale.
Rule 506(b)
Under Rule 506(b), a company can raise an unlimited amount of money from accredited investors and up to 35 non-accredited investors. Rule 506(b) prohibits general solicitation and advertising. One of the ways to show you did not engage in general solicitation and advertising is to have a pre-existing, substantive relationship with your potential investors before offering them an investment opportunity.
Rule 506(c)
Rule 506(c), on the other hand, allows general solicitation and advertising. Unlike a Rule 506(b) offering, non-accredited investors cannot invest in a Rule 506(c) offering. In addition, a company relying on Rule 506(c) must take reasonable steps to verify the accreditation status of their investors.
Whether the steps taken are “reasonable” is based a facts and circumstances analysis. Rule 506(c) contains a list of verification methods that are considered “reasonable,” but a company is not limited to using the list contained in Rule 506(c). This includes reviewing a potential investor’s tax returns, bank statements and brokerage statements, obtaining verification from the investor’s attorney or CPA, or relying upon an investor’s self-certification if that investor had previously invested in the company’s Rule 506(b) offering before September 23, 2013, and remains an investor in that company.
Where CoinAlpha Went Wrong
Because CoinAlpha posted on their blog, went to conferences, and participated in media interviews to promote the opportunity to invest in the Fund, they generally solicited and advertised their offering. This means they were not able to rely on Rule 506(b). They were required to rely on Rule 506(c).
Rule 506(c) requires a company to take reasonable steps to verify the accreditation status of investors. CoinAlpha may have believed that providing investors with a questionnaire to self-certify their accreditation status sufficed as a “reasonable step.” However, the SEC disagreed based on the fact that CoinAlpha did not have pre-existing, substantive relationships with 9 of their investors and only found them because they generally solicited and advertised their offering to these investors.
CoinAlpha Failed to Qualify for Any Exemption Because of a Small, Easily Preventable Mistake
When the SEC contacted CoinAlpha, it engaged a third party to verify the accreditation status of its investors. As it turned out, all 22 of CoinAlpha’s investors were in fact, accredited. Unfortunately for CoinAlpha, it was already too late.
Because they did not take reasonable steps to verify the accreditation status of their investors, CoinAlpha violated the registration requirements of the securities laws because it did not register with the SEC nor did it qualify for an exemption.
To appease the SEC, they unwound their fund and refunded investors, in the amount invested and in management fees.
CoinAlpha attempted to qualify for an exemption to registration but failed to do so because of an easily preventable mistake. Because of this, they were in violation of the U.S. securities laws.
Despite CoinAlpha’s attempt to comply after the SEC contacted them by engaging a third party to verify the accreditation status of investors and even taking additional steps to show cooperation and protect investors, the SEC charged them with violating the securities laws and fined CoinAlpha $50,000.
In addition, CoinAlpha lost their investment fund.
CoinAlpha Illustrates That U.S. Securities Laws Can Be Easily Violated and that Such Violations Are Easily Preventable
The CoinAlpha case demonstrates the importance of ensuring compliance with the U.S. securities laws if you plan to raise money for your company. Even if you attempt to comply with the law in good faith, the SEC can and will still enforce the law against you even if you act in good faith, but make a small and easily preventable mistake.
CoinAlpha mistakenly believed that having their investors certify their own accreditation status would suffice. They could have avoided an SEC enforcement action if they had been advised that they needed to take an additional step to verify the accreditation status of their investors, for example, by hiring a third party to verify the accreditation status of their investors–which they ultimately ended up doing. This simple step would have shielded them from the SEC, preventing the collapse of their business, the hefty fine from the SEC, and an enforcement action on their record.
Onki Kwan is a partner at Vanguardium Legal LLP, a San Francisco-based law firm that advises blockchain and technology startups. Her expertise includes entity formation, capital-raising, blockchain-related securities and regulation issues, commercial transactions, and employment, technology, product, marketing, consumer protection, and privacy-related matters. In her previous role as a senior attorney and director at a public interest law firm, she launched and managed an SEC and FINRA compliant JOBS Act funding portal.