Initial coin offerings

Initial coin offerings (ICOs) are a recent phenomenon used for funding companies that are developing new digital currencies and associated technologies. However, companies offering ICOs are often eager to skirt securities regulations and disclosure requirements, leaving potential investors with vague or misleading information — and fraudsters with new opportunities.

Imagine a company gives an opportunity to pre-purchase a new kind of digital token that’s similar to bitcoin. It doesn’t actually exist yet, but the company will use the money raised from early investors to finance its ongoing development. Also, because the token doesn’t exist there’s no economic use for it. The company’s hope is that once it releases the token, people will adopt it to purchase various goods and services. The company releases a 20-page white paper primarily comprised of vague promises regarding its revolutionary potential. It doesn’t divulge much information about the proposed business model, the background of the company’s employees or the company’s financial health. Do you have any concerns?

This hypothetical is a simplified, though not inaccurate, portrait of an initial coin offering (ICO). Largely due to the rising interest in cryptocurrencies among investors, ICOs (also called coin/token sales) enjoyed a notable swell in popularity during 2017. While ICOs are a novel way for tech-focused startups to raise money, they’re also fraught with fraud risks.

What’s an ICO?

Startups use ICOs to raise funds to support their businesses and to generate excitement about their proposed products or services. During an ICO, a company sells the underlying cryptocurrency to investors in exchange for other, more established cryptocurrencies like bitcoin and ether. By selling these tokens during a specially designated window, a company ensures that it has a built-in userbase for its eventual product. Unlike an initial public offering (IPO), ICO investors aren’t purchasing shares of a company. Instead, they’re purchasing a virtual product offered by the company with the hope that it will materialize and appreciate in value.

Types of digital tokens

There are many different token types sold during ICOs. One of the most common are tokens designed to pay for or buy specific services. For example, the largest ICO of 2017, Filecoin, aims to create a decentralized digital storage market in which users can rent out their unused hard drive space in exchange for filecoins. These coins can then be exchanged for other currencies. Filecoin raised more than $257 million in a sale that was limited to accredited investors, which exempts a company from registering securities with the U.S. Securities and Exchange Commission (SEC). (See $257 Million: Filecoin Breaks All-Time Record for ICO Funding, by Stan Higgins, CoinDesk, Sept. 7, 2017, and Is FileCoin’s $200m ICO the first SEC-compliant token sale? by Edward Beard, Lexology, Aug. 29, 2017.)

Similarly — and in a recursive twist — a company called Token Report recently launched an ICO, Token Clarity, for a token that can be used to access a specialized database that tracks ICOs.

Other tokens are intended to trade like a general-purpose currency that can be used anywhere they’re accepted. These tokens often advertise some kind of upgrade or benefit over other cryptocurrencies (e.g. quicker transaction times, lower transaction costs, upgraded security features).

Types of coin sales

There are two common formats for coin sales. In the first, the company running the ICO distributes the tokens immediately after or during the sale. More common, however, is a “presale.” Presales are similar to a Kickstarter (a global crowdfunding platform), in which the product isn’t actually ready for deployment and often requires an extended gestation period. In this case, the tokens are promised to be distributed at a later date once the appropriate infrastructure is in place. The two largest ICOs of 2017, Filecoin and Tezos, were presales. Both companies raised more than $200 million largely on the hype surrounding their projects. (See Here Are The Biggest ICOs of 2017, October 2017, Bitcoin IRA.)

Blockchain technology

The companies behind ICOs are generally pursuing novel uses of blockchain technology — the application of which extends far beyond the realm of cryptocurrencies. A blockchain is a digital, decentralized ledger distributed among all users of a specific computer network. Whenever a transaction occurs on the network it’s verified against previous transactions and the ledger is updated for all users. Blockchains are designed to be virtually immutable, preventing any single user from making unilateral alterations.

One of the most innovative uses of blockchain is happening in Estonia, where the government is using the technology to streamline its bureaucracy. A new network allows Estonians to view and control access to their medical records, vote, challenge parking tickets and access other government services from their personal computers using their identification cards. And, because this network is decentralized, it’s less susceptible to a major data breach. (See Estonia, The Digital Republic, by Nathan Heller, The New Yorker, Dec. 18 and 25, 2017.)

Why have ICOs become so popular?

Interest in cryptocurrencies and blockchain reached a point of near-hysteria in 2017. This frenzy was most clearly demonstrated when a publicly traded beverage company, Long Island Iced Tea Corp., changed its name to Long Blockchain Corp. and announced plans to invest in bitcoin. Its stock soared nearly 200 percent overnight. This excitement was related to the surging price of bitcoin and other established cryptocurrencies. In 2017, bitcoin went from trading for less than $900 in January to hitting a high of more than $19,000 in December. (See Long Island Iced Tea Soars After Changing Its Name to Long Blockchain, by Arie Shapira and Kailey Leinz, Bloomberg, Dec. 21, 2017.)

This remarkable run prompted what could be described as a digital gold rush. On one hand, people rushed to “mine” cryptocurrencies — creating shortages of some high-end computer components in the process. On the other, investors rushed to catch the rising wave, which included buying into established cryptocurrencies and seeking out new, extremely speculative opportunities.

According to CoinSchedule, a website that tracks ICOs, 235 ICOs raised more than $3.7 billion in 2017. Most of this funding occurred between April and November, when news about cryptocurrencies began to heat up. For comparison, in 2016, 46 ICOs raised about $96 million.

ICOs are popular with startups because they’re an easier and cheaper way to raise money than traditional means. This is because coin sales are a way to bypass the scrutiny and regulations that apply to venture capital funding. Companies can also raise money much quicker through an ICO than through traditional means.

The popularity of specific ICOs is often driven by the promise of the underlying technology, rather than the actual token being offered. For example, Filecoin offers a potentially revolutionary advancement in digital storage that could monetize vast swathes of otherwise unused hard-drive space. Many companies want to use blockchain to disrupt existing industries such as finance, health care, gambling and real estate. Other companies are pursuing the development of new, more advanced blockchain networks that could serve as the foundation for other enterprises.

Thus, coin sales offer a way for both novice and sophisticated investors to back potentially groundbreaking advancements.

How can ICOs be used to perpetuate fraud?

Last year, both China and South Korea banned coin sales due to concerns that they’re overly speculative and could be used for financial scams. However, few other countries have taken such definitive steps towards regulation. Most regulatory authorities have opted for a reactive, rather than proactive, approach.

For example, in July 2017, the SEC noted that federal securities laws might apply to ICOs. This depends on whether a specific ICO meets the definition of a security as established by SEC v. W. J. Howey Co., a Supreme Court case from 1946. This announcement indicated that the SEC would continue business as usual and apply existing laws to ICOs as necessary. It was also a reminder to companies that calling a token a “currency” doesn’t insulate it from securities laws.

The companies behind ICOs are eager to avoid securities regulations because they would incur compliance costs and be required to make significant public disclosures. Unsurprisingly, not a single ICO was registered with the SEC during 2017. Many companies have made half-hearted attempts to exclude U.S. investors from their ICOs in an effort to mitigate the possibility of SEC interference.

Lack of information

Companies running ICOs are rarely forthcoming with internal information. Typically, an ICO is launched alongside a 20- to 40-page white paper that provides an overview of the project. In terms of details, these white papers pale in comparison to a Form S-1 (an SEC filing required for companies launching IPOs) which can run for hundreds of pages and contain extensive information about a company’s management, finances and proposed business model.

Because so little information is expected from ICOs, it’s easy for fraudsters to produce a slick website and vague white paper for a product that doesn’t exist. Then they can aggressively promote the ICO through social media — potentially using spam accounts. And because cryptocurrencies rely on cutting-edge and often esoteric technology, a fraudster could easily hide a project’s illusory nature behind technical, though insubstantial, jargon. These factors make it easy for an individual to run an ICO and then disappear with the money.

Pump-and-dump schemes

The ease with which ICOs can be manipulated also makes them vulnerable to pump-and-dump schemes. In fact, in 2017 the SEC issued trading suspensions for several companies that made claims about ICO or cryptocurrency investments. The SEC expressed concern that companies might be using ICO-related announcements to drive up their stock prices. (See the SEC Investor Alert, Public Companies Making ICO-Related Claims, Aug. 28, 2017.)

Pyramid and Ponzi schemes

ICOs could also possibly be used to facilitate pyramid or Ponzi schemes. Some ICOs promise seemingly outlandish returns and provide incentives for investors to refer other users. Because investors expect an actual product, such a scheme would be difficult to sustain for more than a short period of time. However, a short-lived ICO scheme would require a relatively modest amount of work while promising a potentially astronomical return.

Money laundering

Some regulatory authorities believe that ICOs (and cryptocurrencies in general) are attractive vehicles for money laundering and terrorist financing. This concern is because of  the anonymous nature of cryptocurrency transactions and the companies’ abilities to raise large sums of money within short periods of time. Additionally, it’s likely that the companies running ICOs lack the tools and expertise to mitigate money-laundering risks.

The REcoin and Diamond Reserve Club schemes

In September 2017, the SEC filed a complaint alleging that Maksim Zaslavskiy and his two companies, REcoin Group Foundation and Diamond Reserve Club, had defrauded investors and illegally issued unregistered securities in connection with two ICOs. (See the SEC complaint.)

Zaslavskiy promoted REcoin as the first cryptocurrency to be backed by real estate. He advertised REcoin Group Foundation as a company comprised of lawyers, accountants and brokers who would invest the proceeds from the REcoin ICO in real estate. However, the company didn’t purchase any real estate during or after the ICO. Likewise, Zaslavskiy testified that he never consulted nor hired any experts. Lastly, the company made statements that it had raised nearly $4 million, but it had only raised approximately $300,000.

Zaslavskiy carried out a similar scheme with Diamond Reserve Club, a company that launched an ICO purportedly backed by diamonds. As with REcoin, the company made no purchases of diamonds and didn’t appear to employ anyone besides Zaslavskiy. Neither REcoin nor Diamond Reserve Club issued digital tokens to investors following their ICOs.

The PlexCoin scheme

On Dec 1, 2017, the SEC filed an emergency action to freeze the funds raised by the ICO for PlexCoin. The SEC alleges that the ICO was an illegal sale of unregistered securities, and the defendants made materially false and misleading statements. Further, the funds raised in the ICO allegedly weren’t used to develop PlexCoin but were diverted for personal use, including several hundred thousand dollars spent on home improvements. (See the SEC complaint.)

PlexCorps launched the PlexCoin ICO in August 2017 and purportedly raised $15 million. The PlexCoin website advertises the cryptocurrency as an open-source, global currency similar to bitcoin. The accompanying white paper states that PlexCoin “could become the main exchange cryptocurrency and the most used one in the world.” Beyond this rather ambitious statement, the paper advertises a potential return on investment “after 29 days or less” of anywhere from 200 percent to 1,354 percent. It also states that, compared to other cryptocurrencies, these are “conservative” estimates.

The SEC alleges that this promise was only one of many misleading statements made by the defendants. Despite representations by the defendants that PlexCorps is comprised of 53 experts in various fields — none of whom are actually named — there are apparently only a handful of employees in Quebec. (The PlexCoin white paper states that PlexCorps is based in “the heart of Singapore.”)

Likewise, the white paper includes a personal message from the CEO of PlexCorps without identifying this individual. The SEC alleges that this information was withheld because the CEO, Dominic Lacroix, is a recidivist securities law violator in Canada.

Because of his criminal background, Lacroix and his partner took steps to conceal Lacroix’s involvement by registering domains and accounts under fake names. Additionally, when an individual on a cryptocurrency forum discovered evidence linking Lacroix to PlexCoin, Lacroix instructed associates to deny his involvement through social media channels. (See U.S. SEC’s cyber unit files charges in alleged initial coin offering fraud, by Michelle Price, Reuters, Dec. 4, 2017.)

Perhaps most significantly, in July 2017, the Quebec Financial Markets Administrative Tribunal ruled that PlexCoin were securities under Quebec’s laws and issued an injunction enjoining Lacroix, PlexCorps and other companies he controlled from participating in the ICO. In October 2017, the Superior Court of Quebec issued an order holding Lacroix in contempt for failing to obey this injunction and later sentenced him to two months in jail. (See Quebec’s regulator demands prison sentence for founder of virtual currency scam PlexCoin, by Maria Nikolova, FinanceFeeds, Nov. 17, 2017.)

How ICOs entice investors

Beyond touting the innovative features of their projects or the possibility of high returns, companies frequently offer incentives like bonuses or discounts to ensnare early investors. PlexCoin, REcoin and Diamond Reserve Club each offered discounts for early purchases. PlexCoin was sold in four different stages at progressively higher price points — from 13 cents to 88 cents per token. Likewise, REcoin and Diamond Reserve Club frauds offered 15 percent discounts during the initial stages of their coin sales.

The websites for ICOs often feature prominent countdowns that indicate when discounts will end. This setup encourages investors to act quickly (or impulsively), because the discounted tokens provide the greatest potential for return.

Another common incentive is using affiliate programs. These programs reward investors who encourage associates to invest in the ICO. These programs reward both the referred and the referring investor with a bonus (e.g. 2 percent extra tokens for each referral). This incentivizes individuals to advocate for a particular ICO on social media and elsewhere. It also creates a chain of new investors because the referred investors can also partake in the affiliate program.

Companies also enlist celebrities or social media “influencers” to promote ICOs. Paris Hilton, Floyd Mayweather and Jamie Foxx each endorsed specific coin sales using their respective social media accounts. This became widespread enough for the SEC to issue a statement reminding the promoters of securities (which at least some ICOs are) that they must disclose details regarding any compensation they received in exchange for their endorsement. (See the SEC public statement.)

Teaching an old dog new tricks

Most ICOs aren’t fraudulent. However, their newness and the possibility of outsized returns makes them an attractive vehicle for criminals. While the complexity of ICOs can be intimidating, it’s important to remember that they’re new tools fraudsters can use to perpetuate old schemes. As in the PlexCoin, REcoin and Diamond Reserve Club schemes, this could involve false or misleading statements, misappropriating investor funds or simply selling unregistered securities.

Additionally, as the news of fraudulent coin sales continues to trickle out, it’s likely that companies running ICOs will face increased scrutiny and louder demands for compliance and transparency.

Jordan Underhill, J.D., CFE, is an ACFE legal writer. His email address is: junderhill@ACFE.com.

To learn more about ICOs, check out the ACFE podcast, “Buyer Beware: Are Initial Coin Offerings the Newest Investment Vehicle or the ‘Biggest Scam Ever’?” with host Emily Primeaux, CFE, associate editor of Fraud Magazine.