Bridgett Bauer – Beginning in 2017, cryptocurrency experienced an unfathomable boom, paving the way for unconventional methods of funding. Initial Coin Offerings (“ICOs”) have quickly dominated the emerging market for virtual assets, while also coming under extreme scrutiny. Sharing features of initial public offerings (“IPOs”) and crowdfunding campaigns, ICOs provide an unregulated mechanism for funding start-up companies. Similar to an IPO where an investor receives stock in exchange for their monies, the investor in an ICO receives a crypto token from the underlying project in exchange for their virtual monies (more commonly traded virtual currency like bitcoin or ether). ICOs are becoming increasingly popular as a way to participate in investment opportunities or raise capital, though they pose many perils. While the new block chain technology presents potential for greater efficiency in financial markets, the virtual assets themselves come with a price tag. ICOs put investors at greater risk for fraud and manipulation due to the lack of regulations and inability to recover investment monies.
At the core of federal securities laws stands the requirement for disclosure. This statutory objective provides investors with means to make informed investment decisions and spot potential risks. As such, the SEC has regulated securities by implementing disclosure requirements as well as reporting standards. Innovative issuers have attempted to bypass the standard venture-capital process and federal securities laws with the use of ICOs. While the definition of a “security” is carved out in the Securities Act of 1933 and the Exchange Act of 1934, it has left room for speculation as to whether the new age of digital assets qualify under this broad classification.
During the SEC’s Atlanta Town Hall Meeting on June 13th, SEC Chairman Jay Clayton clarified the agencies position on whether tokens and digital assets used in ICOs are securities, stating “A token, a digital asset, where I give you my money and you go off and make a venture, and in return for giving you my money I say ‘you can get a return’ that is a security and we regulate that… We regulate the offering of that security and regulate the trading of that security.” The SECs assessment of ICOs as securities may very well be one of the factors contributing to the downward trend for the digital asset transactions.
In determining whether digital asset transactions like ICOs are securities the focus is the economic substance of the transaction rather than the form, and the Howey test is applied. This four-factor test pronounces the scope of the term “investment contract” which falls under the definition of a security and requires an investment of money be made into a common enterprise with an expectation of profit to be derived solely from the efforts of others.
Does an ICO really fall within the delineated analysis proscribed by this test? At a closer glance an ICO is an investment of money, investors exchange tangible money for virtual currency and invest into a common enterprise which is the enticing online project. ICO issuers tout potential investors with the opportunity to make “big money” and receive a return on their investment should the ICO turn out to be successful. This leads investors to reasonably believe that efforts will be undertaken and may result in a return on their investment in the digital asset. Lastly, those who fall victim to investing into these dicey financing schemes have no control over their investments and instead sit by passively, as others like the issuer play a significant role in the development and maintenance of the asset.
What are the consequences of classifying ICOs as securities? Despite the gray area and need for further guidance from regulators, the SEC has cautioned that those who offer and sell digital securities must comply with the federal securities laws. By classifying ICOs as securities the SEC can charge issuers of the virtual tokens with acting as an unregistered broker-dealer, since Section 5 of the Securities Act of 1933 mandates registration as a requirement to offering and selling securities. What this means for the those partaking in these virtual ventures is that they must tread lightly; the SEC has already begun investigations leading to penalties against virtual token issuers in ICOs. Filing a registration statement with the SEC is costly and requires due diligence on behalf of the issuers, but is nonetheless something that must be done.
In a public statement released in May of 2018 the agency announced that the enforcement division would be targeting fraudulent ICOs and Crypto- asset investment products in an effort to more effectively protect investors. In the most recent ICO controversy, the SEC charged “ICO superstore” TokenLot LLC with operating as unregistered broker-dealers, marking the first case since the agency issued the 2017 DAO Report where it cautioned ICO issuers to comply with federal securities laws. The agency is delivering a clear message in their crack downs; for ICOs to stay off the radar of regulators, virtual asset issuers should take steps to either register the securities or find private placement exemptions to comply with.
