Home Markets Crypto Crackdown: SEC Busts “Manual” Digital Ponzi Scheme | Morrison & Foerster LLP

Crypto Crackdown: SEC Busts “Manual” Digital Ponzi Scheme | Morrison & Foerster LLP

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Crypto Crackdown: SEC Busts “Manual” Digital Ponzi Scheme |  Morrison & Foerster LLP

In the 1920s, a new form of investment fraud appeared in the markets with the advent of the Ponzi scheme. Last week, the Securities and Exchange Commission (SEC) filed a complaint captioned SEC c. Okhotnikov et al. in U.S. District Court for the Northern District of Illinois, alleging that 11 crypto founders and promoters are using the same illegal moneymaking tactics employed by Charles Ponzi a century ago.[1] SEC alleges defendants used a ‘textbook pyramid and Ponzi scheme’, fraudulently raising over $300 million from millions of retail investors worldwide, in connection with crypto platform Forsage . This action continues the SEC’s wave of aggressive enforcement in the crypto space.

Key points to remember

  • The Forsage complaint makes clear that the SEC continues to find that “smart contracts” that run on blockchain applications and enable transactions of digital assets are securities, under the Supreme Court. Howey test.[2] This is consistent with the SEC’s previous application of “smart contracts”.[3]
  • The SEC continues to aggressively pursue what it sees as fraudulent crypto schemes, even when the main defendants are foreign nationals and the agency will no doubt face challenges in collecting civil penalties or other relief. monetary. In the Forsage complaint, for example, four of the 11 defendants are Russian nationals and are said to reside in Russia, Georgia and Indonesia. The SEC July 2022 Complaint regarding alleged insider trading on the Coinbase platform accuses two Indian nationals.[4]
  • The SEC is heavy meticulous examination of the crypto markets is here to stay. In May 2022the SEC nearly doubled the number of attorneys in the Division of Enforcement’s Crypto Assets and Cyber ​​Unit, which since its inception in 2017 has filed more than 80 enforcement actions in the crypto space.[5] We expect this trend of aggressive crypto enforcement to continue.

Forsage Complaint: An Alleged “Paper Pyramid and Ponzi Scheme” Where Investors Profited from Rookie Participation

According to the SEC complaint, Forsage was started in January 2020 by four Russian nationals who “aggressively” marketed crypto investments online to U.S. and foreign investors. In addition to the four Russian founders, the SEC also sued seven US nationals and residents who allegedly promoted the program using YouTube channels and social media platforms. The SEC alleges that investors were tricked into entering into crypto transactions through “smart contracts” that operated on the Ethereum, Tron, and Binance blockchains. According to the complaint, each platform contained at least three “smart contracts” that had “slots” available for purchase by investors. These ‘slots’ could then be sold to other people, who have been recruited by the investors, as a way for the investors to earn compensation.[6]

Fittingly, the SEC began by analyzing whether smart contract “slots” were securities under the Supreme Court’s ruling in Howey.[7] The SEC alleges that these “slot machines”, and investors’ right to receive compensation on sales of “slot machines”, were securities because “[i]The investors invested money – using Ethereum, Tron or Binance tokens – in a joint venture from which they were made to expect profits solely from the efforts of the defendants or third parties.[8] Because the “slot machines” were not registered with the SEC and did not qualify for an exemption from registration under the Securities Act of 1933 (the “Securities Act”), the SEC alleges that the defendants violated Section 5 of the Securities Act.

Regarding the workings of the fraud, the SEC alleges that Forsage was not providing a bona fide investment opportunity to its investors, but rather was a pyramid scheme whereby “[t]The main way for investors to make money with Forsage was to recruit other people into the program.[9] The SEC alleges that “all payments to previous investors were made using funds received from subsequent investors” – the hallmark of a classic Ponzi scheme.[10] Investors in Forsage would also participate in “profit sharing in the form of spinoff payments from other investors in the wider Forsage network.”[11] These “indirect payments” were linked to the number of “slots” bought or sold; more “slots” bought or sold resulted in more revenue for the Forsage investor pool in accordance with the applicable “smart contract”.[12] Despite defendants’ “aggressive promotion of Forsage as an income-generating opportunity”, the SEC alleges that the significant level of income touted by defendants “was simply not achievable for most investors given that Forsage worked like a pyramid scheme.[13] Accordingly, the SEC alleges that the defendants violated Section 17(a) of the Securities Act, and Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934. The SEC requested the court to order the defendants further violations of federal securities laws, including their engagement in this alleged scheme, as well as reimbursement, civil monetary penalties and other relief.

Interestingly, the SEC is not the first regulator to challenge this “scheme.” In September 2020 and March 2021, the Philippines Securities and Exchange Commission and Montana Securities and Insurance Commissioner, respectively, issued cease and desist actions against Forsage for “acting like a fraud”.[14]

Conclusion

The SEC continues to aggressively pursue potential violations of federal securities laws in the crypto world, even where there may be a low probability of recovery for investors due to the residency of the alleged perpetrators and presumably the location of ill-gotten gains outside the United States. We expect the SEC to continue to flex its muscles in the crypto space, and those involved in the supply and lending of crypto should watch these developments closely.

[1] Complaint, SEC c. Okhotnikov et al.No. 1:22-cv-03978 (ND Ill. Aug. 1, 2022) (“Forsage Complaint”).

[2] See SEC c. WJ Howey Co.328 US 293 (1946).

[3] See Press Release, SEC, SEC Charges EtherDelta Founder to Operate Unregistered Exchange (8 November 2018), https://www.sec.gov/news/press-release/2018-258.

[4] Press Release, SEC, SEC Charges Former Coinbase Director, Two Others in Crypto Asset Insider Trading Lawsuit (July 21, 2022), https://www.sec.gov/news/press-release/2022-127.

[5] Press Release, SEC, SEC Nearly Doubles Size of Crypto Assets and Enforcement Cyber ​​Unit (May 3, 2022), https://www.sec.gov/news/press-release/2022-78.

[6] Complaint by Forsage at 11–12.

[7] Howey328 United States 293.

[8] Complaint Forsage at 4.

[9] Identifier. at 3.

[10] Identifier. at 3.

[11] Identifier. at 12.

[12] Identifier. at 12–13.

[13] Identifier. at 26 years old.

[14] News Release, SEC, SEC Charges Eleven People in $300 Million Crypto Pyramid Scheme (August 1, 2022), https://www.sec.gov/news/press-release/2022-134.

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