Cryptocurrency Initial Coin Offerings (ICOs): SEC Provides Warnings and Guidance

By: Bernard H. Coleman, Esq.

Overview

In 2017, Initial Coin Offerings (also referred to as “ICOs”) raised over $4 Billion worldwide, hitting the radars of the Securities Exchange Commission (“SEC”) and other government regulators around the world. Many cryptocurrency entrepreneurs assert that their cryptocurrencies are not securities, and thus, they are beyond the regulatory oversight of the SEC. Unfortunately, many are wrong. The SEC has launched and will continue to launch investigations into ICOs that may be deemed illegal securities offerings. Such SEC investigations may result in these entrepreneurs having an obligation to return the proceeds of their offerings to investors and/or face criminal charges and possible jail time. The stakes are high, so before placing any bets by launching an ICO for U.S. resident participation, it is recommended that cryptocurrency entrepreneurs secure the guidance of experienced legal counsel. The fact than an “ICO” (Initial Coin Offering) sounds so much like an “IPO” (Initial Public Offering) has only heightened regulatory concerns. However, no matter what ICOs are called, a facts and circumstances test will govern how they are treated under the law.

Cryptocurrencies Offered in ICOs

Cryptocurrencies offered in ICOs may be for assets that qualify as “coins” built upon their own blockchain platforms (such as Bitcoin, Ethereum or Litecoin) or “tokens” created using an existing blockchain platform (such as Tether, EOS or Augur’s REP).   Crypto coins and tokens offered for sale in ICOs are designed to have inherent value (such as a currency like the U.S. Dollar or a commodity like oil). They are also designed to enable coin and token owners to make purchases, sales and other financial transactions utilizing blockchain technology. ICOs are often conducted pre-launch -- before the actual development or launch of the networks in which the coin or token will be utilized. ICOs may also occur post-launch -- where the networks exist for functional use of the coin or token immediately upon purchase. In either case, whether or not an ICO constitutes an offering of a security is a pressing issue that the SEC has just recently started to publicly address.

ICOs and U.S. Securities Laws

Many cryptocurrency entrepreneurs have attempted to avoid the jurisdiction of the SEC by conducting ICOs that offer “utility tokens” to purchasers via crowdfunding pre-sales. Many of these purchasers never intend to use the tokens acquired in these ICOs. They invest in them with the intent of buying low and selling them at a higher price on a cryptocurrency exchange (such as Coinbase or Kraken). These cryptocurrency exchanges facilitate secondary market trading (similar to a stock exchange), which have also caught the interest of the SEC.  Unfortunately, merely calling a coin or token a “utility” or structuring the coin or token to provide some utility does not prevent it from being a deemed a “security” under U.S. securities laws.

The SEC issued an investigative report on July 25, 2017 regarding its investigation of a 2016 ICO known as “The DAO” which was built on top of the Ethereum blockchain. The SEC cautioned those who have conducted or who plan to conduct ICOs, stating that the offer and sale of digital assets by “virtual” organizations are subject to the requirements of the federal securities laws. The SEC took the position that whether a particular ICO involves the offer or sale of a security (despite what the offering or cryptocurrency asset is called) will depend on the facts and circumstances, including the economic realities of the transaction.

The 4-Prong Howey Test

The starting point for determining whether an ICO (or any offering) qualifies as a securities offering begins with what is referred to as the “Howey Test.” The term “securities” is broadly defined in the Securities Act of 1933 (the “Securities Act”), to include stocks, notes and even investment contracts in a transaction or a series of transactions.  The Howey Test is centered around the following questions:

1)     Does the transaction involve an investment of money?

2)     Is there an expectation of profits from the investment?

3)     Is the investment of money in a common enterprise?

4)     Will any profits come from the efforts of a promoter or third party?

If the answer is “yes” to these questions (as it is for many ICOs), the ICO may qualify as a securities offering under the Securities Act.  Although some ICOs may not qualify as securities as defined by the Securities Act, it will be based on the facts and circumstances of each case.  Until the SEC clarifies its position regarding ICOs, sponsors of and participants in ICOs should proceed with an abundance of caution and seek securities counsel to assess the complexities of the state and federal securities laws that may apply. 

Conclusion

As of December 2017, the SEC Chairman urged traders and investors in ICOs to stay ‘especially wary’ of ICOs and individuals claiming to be fully legitimate, clarifying that no exchange-traded products “holding cryptocurrencies or assets related to cryptocurrencies” had been listed or approved for listing with the SEC.  Until Congress passes new laws and the SEC creates new regulations applicable to ICOs, sponsors and participants will be forced to make judgments based on the current legal frameworks that may apply, including the Securities Act.  

According to a Notice of Exempt Offering of Securities filed with the SEC on February 13, 2018, the much-hyped Telegram ICO for the development of the Telegram Open Network (TON) has raised $850 million pursuant to a Securities Act private placement exemption.  The Telegram ICO may represent a new era for ICOs to be conducted in the United States, whereby ICO issuers choose to comply with the Securities Act instead of attempting to circumvent it with different creative names and structures. Pre-launch ICOs are especially at risk for SEC investigation.  However, all ICO issuers and participants should beware of the SEC’s position and be aware of the Securities Act that may apply.  

Disclaimer: This article should only be used for informational purposes. It does not constitute legal advice, and it does not create an attorney-client relationship with anyone. If you need legal advice, please feel free to contact me at 404-419-6571 or bcoleman@tclfirm.com or consult an experienced attorney in your community.