Federal Court Finds ICOs May Be Securities for Purposes of Criminal ProsecutionOn September 28, 2018 by Schnader in Criminal Defense
For the first time, a federal court has determined that initial coin offerings (“ICOs”) may be considered investment contracts for the purposes of a criminal securities fraud prosecution by the Department of Justice. The case, United States v. Zaslavskiy, represents a potentially groundbreaking decision about the jurisdiction of U.S. agencies in the fight against cryptocurrency related fraud.
The heart of this decision is the court’s conclusion that, “Stripped of the 21st-century jargon, including the Defendant’s own characterization of the offered investment opportunities, the challenged Indictment charges a straightforward scam, replete with the common characteristics of many financial frauds.” The Justice Department argued that Zaslavskiy never produced any coins or operated a true ICO, and instead conned investors out of significant sums based on fraudulent misrepresentations. The court noted that a discussion of whether the ICOs constituted an investment contract was premature. The trier of fact will be tasked with determining whether the ICOs qualify as securities based on the Howey test. The outcome of that determination could have monumental effects on the characterization of ICOs, and potentially cryptocurrencies.
In his Motion to Dismiss, Defendant Maksim Zaslavskiy argued that the allegedly fraudulent ICOs, REcoin and Diamond, were not securities but rather currencies, and therefore the case should be dismissed because securities laws do not apply. Zaslavskiy also argued that the securities laws are unconstitutionally vague as applied to his cryptocurrency operations. Judge Raymond J. Dearie of the Eastern District of New York disagreed, and denied the Motion to Dismiss, finding that the economic realities of the transactions supported the Justice Department’s argument that the ICOs should be characterized as investment contracts. If the Justice Department is successful at trial, the outcome may support government efforts to treat ICOs (and potentially cryptocurrencies) as securities subject to government regulation.
At trial the critical issues will be: (1) whether Zaslavskiy made materially false statements to investors to entice them into investing significant funds into the ICO scheme; and (2) whether the ICOs were investment contracts and therefore, securities. A finding that ICOs are securities could prompt SEC rulemaking efforts to promote further regulation of ICOs.
 The Securities and Exchange Commission (“SEC”) has also brought a civil case against Zaslavskiy, but those proceedings have been stayed pending the outcome of the criminal case by the Justice Department.
 In the U.S. Supreme Court case, SEC v. Howey, the Court set out a test for determining whether an agreement is an investment contract, which is a type of security under securities laws. The Howey test provides that a transaction is an investment contract if: (i) It is an investment of money (or investments of other assets in certain contexts); (ii) There is an expectation of profits from the investment; (iii) The investment of money is in a common enterprise; and (iv) Any profit comes from the efforts of a promoter or third party.