SEC v. Crowd Machine, Inc. was a lawsuit that the United States Securities and Exchange Commission brought against Crowd Machine Inc. (“CMI”), and others, for CMI’s making materially false and misleading statements in connection with an initial coin offering of Crowd Machine Compute Tokens (CMCTs). Rather than using the ICO proceeds for the stated purpose, Defendants diverted more than $5.8 million in ICO proceeds to gold mining entities in South Africa. The SEC also alleged that Crowd Machine and its principal did not register their offers and sales of CMCT tokens with the Commission and knowingly sold CMCTs to “ICO pools”—groups of investors, including individuals in the U.S.—without determining whether the underlying investors were accredited.
On January 11, 2022, with Defendants’ consent, the court entered judgment against Defendants for violations of, among other things, Section 10(b)(5) of the Securities Exchange Act of 1934. The judgment ordered Defendants to pay disgorgement of ill-gotten gains. On December 5, 2023 the district court issued an Order in connection with a proceeding to determine the amount of the judgment. Under Supreme Court precedent, such awards are limited to the net profits from a defendant’s wrongdoing, defined as “the gain made upon any business or investment, when both the receipts and payments are taken into the account.”
Defendants received $33,499,206 from the ICO token sale. The SEC argued that this entire token sale was fraudulent, noting that Defendants misrepresented the state of the technology and failed to notify investors about its eventual use of funds, which included the $5.8 million loan to a gold mining operation. Thus, according to the SEC, because all of Defendants’ gross revenue derived from this fraudulent sale, no deductions were warranted.
Defendants argued that disgorgement was not appropriate because they did not profit from the scheme. But, the court said, this was inconsistent with Ninth Circuit precedent. In Defendants’ favor, however, the court noted that it was undisputed that Defendants’ business was not a complete sham. Although Defendants derived nearly $33.5 million from an unregistered token sale infected by fraud, the business otherwise incurred significant operating expenses that did not “fuel” or “further” the token sale. The court therefore decided that it would be proper to deduct certain expenses.
Defendants sought to deduct various expenses in marketing the token sale and retaining consultants to advise on the sale. The court agreed with the SEC that costs incurred to initiate the unlawful and unregistered sale of securities, such as marketing and consulting costs to further the sale, did not have any value “independent of fueling a fraudulent scheme.” These expenses furthered an unregistered sale of securities that Defendants knew at the time to be subject to fraudulent misrepresentations. The court therefore did not deduct them.
Defendants claimed that expenses related to minting tokens for the sale should be deducted as legitimate, pointing to case law deducting “transaction costs” such as brokerage fees incurred in processing fraudulent transactions. The court disagreed because, unlike brokerage expenses, the creation of these tokens was at the heart of the violations at issue; Defendants minted the tokens to sell in an unregistered offering that was itself infected by fraud.
Defendants also sought to deduct certain legal fees. The Court agreed with the SEC that it would be inequitable to deduct fees related to defending against a private arbitration brought by an investor, and against this enforcement action—in other words, defending the fraud itself after the fact. It was different, however, for outside general counsel advice, which included advice on Form D filing, as well as advice regarding whether the CMCTs were securities subject to SEC regulation. The court found this expense to be legitimate and deductible because holding otherwise would dis-incentivize good faith practices in seeking legal advice. Moreover, investors understood that part of their investment would be spent on legal fees.
Defendants received nearly $33.5 million in cryptocurrency from the ICO but claimed that the cryptocurrency depreciated in value by the time Defendants liquidated the assets and sought this depreciation as a deductible business expense. The court agreed with the SEC that such a loss did not amount to a deductible expense. The court noted that it could disgorge the full amount Defendants raised in the token sale because it was derived from fraud, but, exercising caution, the court deducted expenses incurred by the business that did not further the fraudulent nature of the token sale. But treating depreciation of an asset class as a legitimate business was a step too far—let alone depreciation of assets taken by fraud.
The court also addressed the issue of the amount of the civil penalty. Under the statute, there are three tiers of penalties. Tier I penalties are available for all violations, and the amount of the penalty “shall be determined by the Court in light of the facts and circumstances.” Tier II penalties require fraud, deceit, manipulation, or a deliberate or reckless disregard of regulatory requirements, and Tier III penalties require Tier II elements, plus substantial losses or significant risk of substantial losses to other persons.
The SEC requested the maximum third-tier statutory penalty of $1,116,140. The court found that a third-tier penalty was appropriate because Defendants admitted to fraudulent behavior and a deliberate (or at least reckless) disregard for regulatory requirements that resulted in substantial losses to investors. One of the factors for a court to consider in determining the amount of the penalty is scienter. That issue was not straightforward on whether Defendants knew that the tokens were securities. Although the SEC had issued guidance urging cryptocurrency sellers to ensure compliance with securities laws, this guidance did not definitively establish which digital assets qualified as securities. While this means that Defendants were on notice of the potential consequences of an unregistered sale, Defendants conducted the sale after consulting with counsel, who advised that CMCTs likely were not subject to registration as securities. These facts “somewhat mitigated” wrongful intent. The court ultimately issued a penalty of $600,000, about 52 percent of the amount sought by the SEC.