Editor’s note: John Eisenman and Subash Mandanapu also contributed to this blog post.
As Initial Coin Offerings (ICOs) brought in $1.7 billion over the past two years, investors and startup founders weren’t the only ones taking notice. Regulators also want to know more about how ICOs are being used, and they’re forming legal opinions about how ICOs and tokens should be treated. In the U.S., some key signals have been provided by the Securities and Exchange Commission (SEC), and future bulletins are likely to have an impact on activity as perspectives and markets mature.
Outside of the SEC, token issuers and investors will need to remain watchful. Access to capital through the sale of coins may seduce entrepreneurs and their management teams to enter the ICO market, but selling tokens and trading them on the secondary market currently face limited regulatory oversight. Some market observers have considered ICOs to be the “Wild West” of capital raising.
One key question is whether or not tokens will be defined as securities and whether ICOs will be considered offerings of securities. In the U.S., marketing and selling securities to the public requires registration with and jurisdiction from the SEC unless sales take place under an exemption. In particular, securities offerings are subject to the requirements of the Securities Act of 1933 (to ensure transparency in financial statements to investors and prohibit misrepresentation) and the Securities Exchange Act of 1934 (to govern securities transactions on the secondary market). For example, in an initial public offering (IPO), an issuer must complete the SEC’s Form S-1 as the initial registration form for new securities. Filing an S-1 must be completed before shares can be sold to the public and listed on an exchange.
In an ICO, marketing and releasing information occurs on a company’s website and through cryptocurrency news websites and online forums. In fact, companies conducting ICOs have sought to avoid U.S. securities regulation by registering in foreign jurisdictions such as Singapore and Switzerland. Other ICO issuers have structured offerings to fit within U.S. securities law exemptions such as Reg D for accredited investors. The creators of Filecoin structured its ICO to be available only to so-called accredited investors, which allows the sale to be exempt from certain SEC regulations that are intended to protect smaller investors.
Over 70 years ago, the U.S. Supreme Court first articulated a legal test to determine whether an asset is a security. Known as the “Howey Test,” the parameters for an offering to be considered a security include a three-prong review:
i) there is an investment of money
ii) that the investment is in a common enterprise
iii) that buyers expect to profit from the efforts of others
Whether some tokens will be considered securities or not, and as a result fall under the purview of the SEC, remains to be seen. In July, the SEC released a Report of Investigation and found that tokens offered and sold by “The DAO” — a project that raised nearly $150 million in 2016 before being hacked — were indeed securities and therefore subject to federal securities law. While the SEC did not pursue charges, it cautioned as part of its July communication that “…federal securities laws apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology.”
The continued development of the ICO market will hinge on regulatory clarity. Recently, the Canadian Securities Administration and the Monetary Authority of Singapore have both warned of applying a similar framework as the SEC. The opaque nature of certain offerings has left some investors involved in fraudulent scams with limited recourse against the token, project, or company. It should be noted that the secondary market for these tokens are limited as well as the market is very still small. Notwithstanding the slew of questions raised due around disclosure and governance, investors should be reminded that they are not shareholders and thus have no ability to vote or control a company’s operating assets.
If ICOs become a long-term success story, they may do so despite these inherent limitations. If that happens, traditional investors will face new challenges to existing paradigms as ICO standards evolve. By that point, the value of their strengths should become clear.