With an Order Instituting Administrative Proceedings (“Order”) dated August 14, 2018, and a corresponding press release, the SEC renewed its position that there is no such thing as a “free” offering of securities. While we have previously cautioned here that airdrops and other token giveaways should be structured in a manner compliant with the Securities Act, this enforcement action against Tomahawk Exploration LLC (“Tomahawk”) marks the first public action the SEC has taken against issuers distributing tokens to participants in a company’s bounty program.
If you wonder what a typical bounty program is, here is a helpful blog post that summarizes ICO bounty programs. ICO bounty programs have become ubiquitous in the ICO deals. Terms vary, but typically participants receive tokens in exchange for reviewing the code, and marketing and promoting the ICO.
The enforcement action against Tomahawk lays a clear groundwork that the SEC may apply when investigating bounty programs in the future. From July through September 2017, Tomahawk, an oil and gas exploration company, and its founder, David Laurance (who had previously served a prison sentence for securities-related fraud), offered and attempted to sell digital assets in the form of “Tomahawkcoins” or “TOMs” in an ICO. They sought to raise $5 million to fund oil drilling in California. Tomahawk’s website and white paper touted the tokens’ potential for substantial long-term profits based on fraudulent estimations of Tomahawk’s anticipated oil production. Promotional materials also represented that investors could trade their tokens for potential profits on a token trading platform, and that they would could convert their tokens into Tomahawk equity at a 1:1 ratio on a future date.
The SEC noted that, although Tomahawk failed to raise money through the ICO, Tomahawk did issue TOMs as part of a “Bounty Program” in exchange for online promotional and marketing services. Tomahawk featured the Bounty Program prominently on the ICO website, offering TOMs in exchange for actions such as (i) listing of TOMs on token trading platforms, (ii) promoting TOMs on blogs and social networking websites, and (iii) creating promotional materials for the offering. Under this program, Tomahawk issued more than 80,000 TOMs to approximately 40 wallet holders on a decentralized platform. In exchange, Tomahawk received online promotions that targeted potential investors to Tomahawk’s offering materials.
The SEC concluded that the TOMs constituted securities as both “investment contracts” (acquired by investors with expectation of future increase in value) and because the tokens were convertible into equity securities, thereby representing a right to an equity share of the company. Additionally, the SEC concluded that TOMs were “penny stock” because they did not meet any of the exceptions from the definition of “penny stock” found in Section 3(a)(51) of the Exchange Act and Rule 3a51-1 thereunder. This is the first time that the SEC has concluded that tokens could be “penny stock” (which is interesting given that no TOMs were actually sold in the ICO and none ever traded on an exchange). Penny stock carries additional risks, such as difficulty to accurately price the stock due to infrequent trading. Typically, penny stock investments are speculative in nature, and therefore are regulated.
Further, the SEC determined that distributing the coins pursuant to the Bounty Program was a sale under Section 2(a)(3) of the Securities Act despite the lack of monetary consideration. It is a long-standing SEC position that goes back to the 1999 SEC release that “gifting” securities constitutes a “sale” when the donor receives a “real benefit.” The SEC therefore determined that Tomahawk had “sold” the tokens in exchange for value in the form of online marketing promotion and increased liquidity in the securities of the company.
Although the situation with Tomahawk was a clearly fraudulent 21st century reinterpretation of an oil and gas scheme, issuers conducting bounty programs should heed the warning and ask themselves if they are “giving” away tokens in exchange for “value.” If the SEC Order is taken at face-value, almost any action that has a benefit for an issuer, no more how marginal, may be construed as “value.” Careful issuers should make sure that their bounty programs are compliant with an exemption from the registration requirements of the Securities Act or risk the SEC scrutiny.