Initial coin offerings (ICOs) seem to find their way into almost any conversation I have nowadays. Most of the people that I’ve talked to regarding this matter seem to have an opinion. I’ve found that the word disruption gets thrown around almost always. Nonetheless, when you press people on the issue, you can tell that the understanding of ICOs are, at most, shallow. This shallowness is not because we don’t want to understand it, believe me, we do, it’s because the subject and the underlying technology are so complex that the more you learn about it, the more you find yourself questioning it.
I believe that this lack of understanding has permeated to the regulatory agencies, which are trying to circumscribe a disruptive and new technology into a mainstream and outdated set of rules, hence, the difficulty. As it has been evidenced, regulation has been issued to address specific issues, but there is still a lack of consensus about who, and how, ICOs should be regulated. Regulation is often perceived as a threat to innovation because it has the power to determine its applicability in the market.
So, what are ICOs anyway?
ICOs, also known as network token presales, are often considered analogous to IPOs, initial public offerings because both could be fundraising mechanisms. In an ICO, tokens (also known as app coins or coins) are exchanged for money, and in IPOs, equity shares are traded for money. The token presales help jumpstart a specific initiative by providing early liquidity to participants, and in consequence are very attractive to new businesses and ventures, specifically startups.
Now, it has been evidenced that ICOs are sometimes used by startups to avoid the SEC’s strictly regulated capital-raising process, which has prompted the SEC and other regulators to begin scrutinizing ICOs. Along with the SEC, entities like the Commodities Futures Trading Commission (CFTC) and the Financial Institution Regulatory Authority (FINRA) have started issuing investigations and releases regarding ICOs and digital tokens.
So, how do regulatory agencies define ICOs?
The SEC’s formal regulation of ICOs can be traced to the summer of 2017 when the SEC released an Investor Bulletin with recommendations for companies that wanted to issue tokens through an ICO. The Bulletin was the first formal document in which the SEC advised that it interpreted certain ICOs as offers and sale of securities, therefore requiring the issuers to register the tokens with the SEC (unless they were exempt from doing so).
Since the issuance of this investor bulletin, the SEC has halted several ICOs, like PlexCorps (which had purportedly raised $15 million), Munchee (which wanted to raise $15 million in capital to improve an existing iPhone app centered on restaurant meal reviews), Titanium Blockchain Infrastructure Services Inc. (which had raised $21 million), and Blockvest LLC (that was in pre-ICO sales and falsely claimed SEC approval). Consequently, entities like TokenLot, ICO Superstore, and individual Zachary Coburn have been charged with operating as unregistered broker-dealers.
On December 11th, 2017, Chairman Jay Clayton of the SEC addressed the issue of ICOs and directed it to “main street” investors and market professionals. The statement was filled with skepticism and advised wariness on initial coin offerings and cryptocurrency-related investments. Furthermore, on January 22, 2018, Clayton warned legal advisors on ICOs and highlighted two problematic scenarios that surround them, and that lead to the undertaking of ICOs that don´t comply with applicable securities laws.
“As a crypto-currency exchange and we have trouble figuring out what if something is or is not a security. So, I think right now that’s our first challenge is to get some clarity on that, because once you figure out if something is or is not a security then you can figure out all the different rules and regulations that apply for us”.
– Carla Carriveau, Circle Senior Regulatory Council. CNBC, September 25, 2018
The first problematic scenario is when promoters cryptocurrencies claim unequivocally that the product being offered is not a security even when it may have some of the key features of a securities offering. If the promoters of cryptocurrencies and their counsel mistakenly assert that the ICO is not subject to US securities laws, the ICO might breach applicable securities laws. Similarly, the promoter might undertake an ICO that does not comply with applicable securities laws when advised incorrectly or refuse to take a position on whether the coin or token being offered in an ICO is a security.
In that line of reasoning, in its now notorious speech, Director Hinman of the SEC, with regard to cryptocurrencies stated that “just as in the Howey case, tokens and coins are often touted as assets that have a use in their own right, coupled with a promise that the assets will be cultivated in a way that will cause them to grow in value, to be sold later at a profit,” shedding some light on when ICOs could be treated as the offering of securities. In his speech, he also stressed the fact that many ICO’s relied on the claims made by promoters on the future benefits of the application of their technologies and the networks yet to be established, making the success of the offerings still uncertain.
From another perspective, Hinman’s speech gave some insight on when the offerings of digital assets cannot be considered securities, following the preceding rationale, indicating that “where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts – the assets may not represent an investment contract.”
In 1946, the Supreme Court heard a case SEC v. Howey Co., 328 U.S. 293 (1946), setting forth a four-prong test -the Howey test- to determine whether an instrument meets the definition of an investment contract and thereby a security. The importance of determining whether an investment is a security lies in the registration requirements this investment will be subject to if deemed a security.
Only with a few exceptions, all securities offered in the U.S. must be registered with the Securities and Exchange Commission (SEC). According to the Howey test, an investment is a security if:
- The scheme involves an investment of money;
- There is an expectation of profits from the investment;
- The investment of money is in a common enterprise;
Any profit comes solely from the efforts of others (e.g. a promoter or third party).
So, what about the CFTC and FINRA?
The CFTC has designated virtual currencies as commodities. Therefore, ICOs may fall under its jurisdiction. Fraud and manipulation involving cryptocurrencies traded in interstate commerce are appropriately within the purview of the CFTC, as is the regulation of commodity futures tied directly to cryptocurrencies. That said, products linked to the value of underlying digital assets may be structured as securities products subject to registration under the Securities Act of 1933 or the Investment Company Act of 1940.
Different from the SEC, the CFTC has been mostly quiet in its handling of fraudulent activities regarding ICOs. Nonetheless, the increasing use of ICOs for fraud has prompted them to issue a customer advisory to alert customers to exercise caution and conduct extensive research before purchasing digital coins or tokens.
In its advisory, the CFTC indicates that several studies and news reports show that many ICOs are fraudulent or the underlying products or services fail to live up to their promises. Estimates of fraud range from 5 percent to more than 80 percent of ICOs. One report also identified nearly 300 offers that contained plagiarized investment documents, promises of guaranteed returns or fake executive teams. Another report indicates that after one year from their ICO, almost half of all the projects or companies have failed or shut down.
These grim studies and statistics may prompt the CFTC to take a more proactive approach when dealing with ICOs. This approach is expected to be in line with the SEC’s position, as both entities have regularly complemented each other when regulating ICOs. In January, SEC Chairman Clayton, CFTC Chairman J. Christopher Giancarlo issued a joint statement and indicated that the CFTC and SEC will work together to bring transparency and integrity to cryptocurrency markets, expressing the agencies’ commitment to deter and prosecute fraud and abuse.
As per FINRA’s president Robert Cook, it looks like the entity will align itself with the course set by the SEC and the CFTC. For now, FINRA has said that it will continue to monitor regulatory developments around virtual currencies, and where certain digital assets “are securities or where an ICO involves the offer and sale of securities, FINRA may review the mechanisms firms have put in place to ensure compliance with relevant federal securities laws and regulations and FINRA rules.”
So, what do the courts say about this?
On September 11, 2018, the US District Court for the Eastern District of New York (EDNY) found that US Securities Laws May Apply to ICOs. The ruling, made regarding the ICOs of RECoin and Diamond, was made after it was found that the ICOs were likely a fraud scheme. The defendants said that real estate and diamonds backed the tokens, but after investigation, it was concluded that there was no support to these claims. In its ruling, the court found that the Howey test would apply, and that indictment was constitutionally sound and that the Exchange Act and SEC Rule 10b-5, under which the defendant was charged, were not unconstitutionally vague as applied to the case. The court based part of its ruling on the previously explained position of the SEC. In consequence, there seems to be a willingness by the courts to uphold the regulatory intent of these entities. Nonetheless, the court left the question of whether the virtual currencies are securities to be decided at trial.
We find ourselves in an era where we tend to speak a lot about subjects that we don’t fully understand, and ICOs are no different, especially considering its complex technology and niche vocabulary. Until a clear regulatory framework is developed, the questions of legality and skepticism surrounding ICOs will linger. Nonetheless, as evidenced by Forbes, ICOs were 45% of IPOs In Q2 2018 which leads us to conclude that cryptocurrencies are here to stay, and ICOs will continue to raise more and more money.
Written By: Jorge Juan Ballen Saldarriaga
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- SEC.gov | Statement on Cryptocurrencies and Initial Coin… https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11
- CFTC.gov | Customer Advisory: Use Caution When Buying Digital Coins… https://www.cftc.gov/sites/default/files/2018-07/customeradvisory_tokens0718.pdf
- Forbes, ICOs Were 45% Of IPOs In Q2 2018, As Cryptos Disrupt Investment Banks, https://www.forbes.com/sites/caitlinlong/2018/07/22/icos-were-45-of-ipos-in-q2-2018-as-cryptos-disrupt-investment-banks/#f46ad36794c2