This article looks at what ICOs are and why the SEC is leaning towards viewing them as securities.
Initial coin offerings (“ICOs”) are similar to initial public offerings (“IPOs”) in that they are a type of fundraising campaign in which investors buy into a new venture. In contrast to IPOs, however, ICO investors receive “tokens” or “coins” instead of stock in the company. These virtual tokens vary in what they afford their holders; some are essentially cryptocurrencies, while others function more like securities. ICOs’ novelty and heterogeneity have contributed to a lack of their regulation, with regulators opting to assess their legality on a case-by-case basis.
Pros and Cons of ICOs
Entrepreneurs like this new method of fundraising because it allows them to raise capital for their companies without giving up decision-making power to venture capitalists or surrendering any equity to them. In an interview with the Wall Street Journal, Spencer Bogart, managing director and head of research at Blockchain Capital, gave his opinion of ICOs from a startup’s point-of-view: “You can raise a venture round or raise 10 times as much with an ICO and give up no control.”
Investors are attracted to ICOs because they give them the opportunity to buy into a company at a much earlier stage of its development, which affords them the possibility to receive a high rate of return on their investment. Additionally, investors of traditional startups tend to wait several years for a company to become acquired or go through an IPO, while investors who buy tokens ahead of their public sale can usually expect the ICO to happen within a year-freeing up their initial investment sooner than traditional ventures.
The potential for high reward, however, is accompanied with a high level of risk. Investing in a relatively immature company is inherently risky; however, ICOs include their own set of additional risks. Their lack of regulation, for one, means that many ICOs are unregistered with the U.S. Securities and Exchange Commission (“SEC”). Additionally, the novelty and complexity of the blockchain technology at the heart of ICOs can confuse investors, and the unscrupulous are using this to their advantage. As the SEC’s Office of Investor Education warned investors in an investor alert published in August, “fraudsters often try to use the lure of new and emerging technologies to convince potential victims to invest their money in scams.” The SEC also advised investors to be wary of ICO-related fraud in an investment bulletin published in January. They stated that potential investors should be wary of people who use high-pressure or jargon-laden sales pitches when selling ICOs, and also those who promise “guaranteed” high investment returns.
Regulatory Response to ICOs
Raising over $3.7 billion so far in 2017, ICOs have grabbed the attention of U.S. federal regulators. Since there currently is no specified legal framework for them, however, they currently operate in a legal grey area. Regulators have stated, though, that for now at least, ICOs will be regulated to the extent that they fall within existing legislation. For example, in July, the SEC issued a bulletin stating that, “depending on the facts and circumstances of each individual ICO, the virtual coins or tokens that are offered or sold may be securities. If they are securities, the offer and sale of these virtual coins or tokens in an ICO are subject to the federal securities laws.” Additionally, in “Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO” (“The DAO Report”), released by the SEC in July, the SEC determined that DAO Tokens are considered securities under federal securities laws. However, the SEC determined not to pursue an enforcement action in the matter.
The U.S. Commodity Futures Trading Commission (“CFTC”) has also taken notice of ICOs, and is prepared to regulate them should they be considered commodities, as determined on a case-by-case basis. In “A CFTC Primer on Virtual Currencies” released in October, the CFTC stated that virtual tokens (such as those offered in ICOs) may be commodities or derivative contracts depending on the particular facts and circumstances. They also stated that there is no inconsistency between the SEC’s analysis in “The DAO Report” that the tokens in that case were considered securities and their own stance that tokens can be considered commodities. The CFTC noted that cryptocurrencies, such as Bitcoin, have been considered commodities since 2015.
Initial coin offerings offer some unique benefits for both entrepreneurs and investors in comparison to IPOs. However, their current lack of regulation and the potentially confusing nature of their underlying technology make them attractive to fraudsters and scam artists-leaving unwary investors in a precarious position. While taking a relatively measured and cautious approach to regulating ICOs, the SEC has issued multiple warnings to potential investors in order to try to protect them from fraud. In an investor bulletin published in July, the SEC offered investors the following advice: “if the investment sounds too good to be true, it probably is.”
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