What exactly is an Initial Coin Offering (ICO) and why is everyone talking about them? Are they even legal and what is the risk? This article explains the ICO phenomenon, the risks involved, and the current legal landscape.
Initial Coin Offerings, or ICOs for short, come in different flavors, but one common characteristic is the presence of a digital token or "coin" built on Blockchain network (or the promise of one in the future).
But what is Blockchain?
At its most basic, Blockchain is like a massive spreadsheet or ledger distributed to the public that updates itself with every transaction on its network in real-time. This distributed ledger is composed of transactions (or other records) linked and secured using cryptography. Through the use of Blockchain technology, developers can create unique and innovative digital assets and platforms with various characteristics.
What are digital tokens or "coins" and where do they come from?
A token is a digital asset that can be transferred almost instantaneously between two parties over the internet without involving a third party. However, not all tokens are the same. Tokens can serve as a replacement for traditional currency, such as Bitcoin, Ethereum, Litecoin, XRP, or Stellar Lumens. They can be designed to provide the right to a future good or service or even be used to set up and execute smart contracts. Alternatively, tokens can be backed by a particular type of asset, such as gold, silver, or other collateral.
ICOs have raised over $2 Billion in 2017, with some ICOs raising as much as $200 million. Filecoin, for example, raised $257 million over a month of activity. Filecoin aims to provide a decentralized network for digital storage through which users can effectively rent out their spare capacity. In return, those users receive Filecoins as payment.
Another example is Golem, which presents itself as a global, decentralized supercomputer that anyone can access. It is comprised of the combined power of each participating user's machines, from personal computers to data centers. Users who rent out their computing power are compensated with Golem Network Tokens.
The hype: is it a security or not—it depends. . .
The United States Security and Exchange Commission (SEC), which regulates securities, has warned that, depending on the facts and circumstances of any particular ICO, the offering may involve the sale of securities and, therefore, be subject to SEC (and state) regulation. Assuming an offering of such tokens is not a sale of securities just because it involves a blockchain token is fraught with peril. The facts and circumstances that determine whether an ICO is offering a so-called "utility" token or a security are not clear. However, the SEC has reiterated its historical position, that it considers the substance of a transaction over form.
To date, we have three examples from the SEC to work with. These are explained in more detail below. The DAO ICO, PlexCoin ICO, and MUN ICO were each deemed "investment contracts" under securities law.
Just because an ICO is considered a security, however, does not make it illegal. It only means that the ICO must comply with the applicable securities laws. Registration with the SEC and compliance with the applicable regulations, while potentially expensive and time- consuming, may prevent a tremendous headache later on.
What laws should I consider?
At a minimum, you should consider all federal consumer protection and securities laws, including but not limited to the Dodd-Frank Wall Street Reform and Consumer Protection Act's prohibition against unfair, deceptive, and abusive acts, to the Securities Acts of 1933 and 1934, and their implementing regulations (Regulation A, A+ S-K, S-X, Rule 10b-5). In addition, if an ICO should be classified as a security pursuant to federal law, it would likely be necessary to consider all relevant state securities or "Blue Sky" laws.
SEC Investigative Report for the Decentralized Autonomous Organization (DAO)
In July 2017, the SEC issued an Investigative Report on the application of the federal securities laws to the Decentralized Autonomous Organization (DAO) and the blockchain token associated with it (DAO Token). The DAO operated like a venture fund. DAO Token purchasers would vote on a menu of investments to which the DAO would apply portions of the pooled funds. The purchasers would then share in profits from the investments based on their DAO Token holdings. The SEC determined that the DAO Token was a security, requiring registration with the SEC. However, the SEC decided not to bring an enforcement action in that case.
The SEC applied the Howey test to determine whether the DAO Tokens were "investment contracts" under securities law. At its most basic, the Howey test looks to whether an instrument, contract, or scheme consists of the investment of money in a common enterprise with the expectation of profits derived from the efforts of others (Securities and Exchange Commission v. W. J. Howey Co., 328 U.S. 293 (1946)).
In applying the Howey test, the SEC did not declare that all tokens are necessarily securities. Whether a token sale or ICO is a security will depend on the facts and circumstances of each individual ICO.
SEC enforcement action – PlexCoin ICO
The SEC initiated its first enforcement action against an ICO in December 2017. As its initial step, and something often typical for the SEC, it obtained an emergency injunction to halt and freeze the PlexCoin ICO.
According to the SEC, the individuals operating PlexCorps violated securities laws through the fraudulent and unregistered offering of securities called "Plexcoin." The SEC alleges in its complaint that the individuals misled investors by falsely claiming that investments in PlexCoin would yield a 1,354% profit in less than 29 days. In addition, investors in the ICO were promised, among other things, that the returns would stem from the following: (i) the appreciation in value of the PlexCoin Token through investments PlexCorps would make with the proceeds of the PlexCoin ICO and based on the managerial efforts of PlexCorps' team of supposed experts; (ii) the distribution to investors of profits from the PlexCorps enterprise; and (iii) the appreciation in value of the PlexCoin Tokens based on efforts of PlexCorps' "market maintenance" team, which included listing the Token on digital asset exchanges.
PlexCorps raised about $15 million from investors throughout the United States and globally. According to the SEC, however, these funds were misappropriated to fund, among other things, extravagant personal expenditures.
SEC cease-and-desist proceeding - Munchee Inc. (MUN ICO)
Munchee Inc., a blockchain-based food review service, halted its MUN Token ICO after the SEC contacted the company and Munchee Inc., agreed to an order in which the Commission found that the ICO constituted the offer and sale of unregistered securities. According to the order, Munchee Inc. and its promoters represented that investors could expect that efforts by the company would lead to an increase the value of the Tokens. Specifically, that Munchee would develop and enhance its smartphone app and create a MUN "ecosystem" using the proceeds from the sale of MUN Tokens. Additionally, Munchee intended for MUN Tokens to trade on a secondary market, representing in its MUN white paper that it would work to ensure a secondary market for MUN Tokens.
The MUN white paper also indicated that Munchee had done a Howey analysis and found that its utility Token did not pose a significant risk of implicating federal securities laws. The SEC, however, obviously disagreed. Notably, the SEC indicated that even if MUN Tokens had a practical use at the time of the offering, it would not have precluded the Token from being a security.
So you want to consider an ICO:
- These examples provide three unique and different fact patterns that outline what the SEC considers to be the sale of securities. However, there is still a lot of unknown space within this border. While it is unclear exactly where the line will be drawn for when an ICO is deemed an unlawful securities offering, the SEC will expect ICOs apply, and follow, the guidance laid out in these cases.
- While Congress simplified the regulatory structure for some start-ups, it is not clear that ICOs were contemplated. After determining that an ICO is desirable for your business, consult counsel to determine whether your facts get you to where you want to be – whether that is a securities offering or not.
- Finally, the ICO world is certainly not static. As the SEC refines its guidance, and the judicial -- and perhaps legislative – branches become involved, ICOs will receive greater scrutiny under both the SEC and consumer protection laws.