Initial Coin Offering (ICO) Minefields: Anti-Fraud Disclosures, Resale Restrictions and Underwriter Prohibitions

Overview

In the first half of 2018, Initial Coin Offerings (also referred to as “ICOs”) have raised over $5 Billion worldwide. ICOs involving U.S. investors have become a focal point of the Securities Exchange Commission (“SEC”) as public awareness of ICOs continues to grow. The SEC has provided general guidance regarding their position that most ICOs qualify as securities offerings, which would make them subject to extensive state and federal securities laws. For the unwary, the applicable securities law framework is a dangerous minefield. More and more companies are becoming aware that their ICOs likely qualify as securities offerings. Therefore, they  are now making efforts to comply with SEC rules and applicable securities laws. 

All private securities offerings must comply with numerous laws and regulations, including, without limitation, those relating to anti-fraud disclosures, restrictions on resales and prohibition on sales to underwriters.  Securities laws applicable to private securities offerings are complex, and those attempting to conduct ICOs may not be aware of the many dangers of conducting illegal securities offerings.  Among them are (i) not providing the proper anti-fraud disclosures to potential investors while using white papers upon which investors make their investment decisions; and (ii) not informing potential investors of applicable resale restrictions and/or unwittingly selling securities to investors who qualify as “underwriters” under applicable securities laws. These are just some of the lesser known dangers inherent in ICOs and other securities offerings, including Security Token Offerings (STOs) that are growing in popularity in the cryptocurrency space.  Failing to properly address these and other securities law compliance issues  can result in ICO issuers and their promoters personally being required to return all invested capital to investors and can even result in criminal prosecution and prison time.

 Anti-Fraud Disclosure Requirements

White papers have become the standard document used by companies conducting ICOs. As well-written as many ICO white papers may be, most were not written to comply with securities laws; thus, they are insufficient as disclosure documents for securities law purposes.  Among applicable laws that apply to securities offerings is the SEC’s Rule 10-b(5) (the “Disclosure Rule”). Of special note is clause (b) of the Disclosure Rule, which states: “(It shall be unlawful for any person)…to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.” 

The Disclosure Rule requires issuers to state any “material fact” that would be material to an investor making his or her investment decision, and an omission breaks the rule just as much as a misrepresentation.  According to the Supreme Court, a fact is material “…if there is a substantial likelihood that a reasonable shareholder would consider it important…”  Whenever there is a question about whether a fact is material or not, it is always best to disclose it. Not surprisingly, there is no precise way to determine when one is in danger of violating anti-fraud rules (outside of the obvious intentional deceit). Indeed, materiality is a mixed question of law and fact, which means that it will be based on individual circumstances relevant to the issuer, its offering, and other factors. White papers are not designed to comply with the Disclosure Rule, and any company relying on a white paper as their only   offering document is vulnerable to potential securities fraud claims in the future. Such a risk jeopardizes the future of the company and personal freedom of the company’s officers, directors and other ICO promoters. 

Resale Restrictions – Underwriter Prohibition

a.      Resale Restrictions

The Securities Act of 1933, as amended (the “Securities Act”) states that a security may not be sold or transferred unless it is either registered or exempt from registration.  ICOs typically do not register their coins or tokens with the SEC. Instead, ICOs conducted pursuant to the Securities Act offer coins or tokens pursuant to an exemption from registration provided by Section 4(a)(2) of the Securities Act, principally Regulation D, Rule 506(c). Such coins or tokens are deemed to be “restricted” securities, and may be re-sold only pursuant to certain other exemptions provided by the Securities Act. Among these exemptions are “private sales” made pursuant to Section 4(a)(1) of the Securities Act and sales made pursuant to Rule 144. The private sale exemption allows a holder of restricted stock to sell the stock in a “private sale” which is completed in a manner similar to a private sale made by the issuer under Section 4(a)(2).

Inherent in ICOs is the issue of investors acquiring coins or tokens with the intent of reselling them on a cryptocurrency exchange. If the coins or tokens purchased in an ICO are securities (as they most likely are as the SEC as postulated), any resale would be illegal except if such resale qualifies for an exemption (which a public sale on an exchange within the first 1-2 years of purchasing likely will not).   Speculators often participate in ICOs to make a quick flip and a quick profit, unaware of the securities laws that may apply.  

b.     Underwriter Prohibition

Securities regulations applicable to private offerings prohibit the issuer from selling securities to anyone who is not purchasing for his own account but who has the intent to resale or distribute the securities. These investors may be deemed “underwriters.” Section 4(a)(1) of the Securities Act exempts from registration “transactions by any person other than an issuer, underwriter, or dealer.” Generally, a person is an “underwriter” if he acquires securities with a view to “distribution” or is participating in a “distribution,” which generally means an offering that is not a private offering.  

Conclusion

If an issuer of tokens or coins in an ICO (or an STO) relies solely on a white paper that does not satisfy applicable state and federal anti-fraud disclosure rules, the issuer and the individual promoters (officers, directors and outside third parties) risk being charged with securities fraud. Securities fraud is a criminal offense which may result in prison time for ICO promoters.

If investors in ICOs (or STOs) are not made aware by the issuer of the applicable resale restrictions and illegally resell them on an exchange (or otherwise), the issuer of the coins or tokens may be deemed by the SEC to have conducted an illegal securities offering which would disqualify the issuer from its SEC registration exemption. If investors acquire tokens or coins in an ICO (or an STO) are deemed to be “underwriters” under the Securities Act, selling to such persons may implicate the issuer in an illegal securities offering and disqualify the issuer from its SEC registration exemption. Consequently, all investment funds may be ordered returned to the investors and the individual promoters of the illegal ICO (or STO) may be held personally liable for the return of investment funds.  In light of the severe consequences that may be imposed by the SEC for non-compliance with applicable securities laws, all ICOs and STOs should be conducted with the assistance of experienced securities counsel. 

This article does not address tokens/coins sold via ICOs or STOs using SAFTs (Simple Agreements For Future Tokens). Despite the position taken by some that tokens/coins received pursuant to SAFTs are utility tokens/coins and not securities, such tokens/coins may arguably constitute securities (since the SAFT itself is a security).  As of the time of this writing, please note that the SEC has not addressed this specific issue related to SAFTs and the tokens/coins issued pursuant to them.

Disclaimer: This article is not intended to be comprehensive, but is intended to provide a high-level overview of certain issues that may be missed when conducting ICOs and STOs if not properly conducted with the assistance of experienced securities counsel.  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 securities attorney in your community.