On January 22, 2018, the Chairman of the U.S. Securities and Exchange Commission (SEC), Jay Clayton, gave opening remarks at the Securities Regulation Institute during which he took the opportunity to warn market professionals to “act responsibly and hold themselves to high standards” with respect to token sales, also known as initial coin offerings (ICOs).[1] [2]

Chairman Clayton’s speech reiterates the SEC’s clear pronouncements regarding ICOs, including its plan to continue bringing enforcement actions against ICOs conducted in violation of the U.S. securities laws, and to monitor all ICO market participants (i.e., not only issuers, but also finders, promoters, broker-dealers, investment advisers, exchanges, lawyers, accountants, and others).

In his remarks, Chairman Clayton urged ICO market professionals to “do better” and “bring expertise, judgment, and a healthy dose of skepticism to their work.”

Despite his previously fired warning shot—“I have yet to see an ICO that doesn't have a sufficient number of hallmarks of a security[3]—some market participants are still taking risks and conducting tokens sales without complying with the registration requirements of the U.S. federal securities laws or relying on an applicable exemption.

Chairman Clayton emphasized that he has instructed the SEC staff to be on “high alert for approaches to ICOs that may be contrary to the spirit of our securities laws and the professional obligations of the U.S. securities bar.

These warnings are consistent with the SEC’s guidance provided to ICO market participants over the past year:

  • On July 25, 2017, in connection with the DAO Report[4], the SEC reiterated that “Whether or not a particular transaction involves the offer and sale of a security—regardless of the terminology used—will depend on the facts and circumstances, including the economic realities of the transaction,” and confirmed that token sales would be analyzed under the facts-and-circumstances test outlined in SEC v. W.J. Howey Co.[5]
  • On August 24, 2017, following a request for information from the SEC, Protostarr, a blockchain based startup, canceled its ICO and refunded its investors.[6]
  • On September 25, 2017, the SEC announced the creation of a Cyber Unit to address cyber-related misconduct, including, among others, “violations involving distributed ledger technology and initial coin offerings.[7]
  • On November 1, 2017, the SEC warned that endorsements of ICOs may be unlawful if they do not disclose the nature, source, and amount of any compensation paid, directly or indirectly, by the company in exchange for such endorsement.[8]
  • On December 4, 2017, the SEC obtained an emergency asset freeze to halt the ICO of Quebec-based PlexCorps for falsely promising a 13-fold profit in less than a month.[9]
  • On December 11, 2017, the SEC ordered Munchee Inc. (“Munchee”)[10] to cease and desist its ongoing token sale. Although Munchee’s white paper had stated that it had conducted a “Howey analysis” and concluded that its tokens were not securities, the SEC disagreed and stated that even if Munchee’s tokens “had a practical use at the time of the offering, it would not preclude the token from being a security” and reiterated that: “Determining whether a transaction involves a security does not turn on labelling—such as characterizing an ICO as involving a “utility token”—but instead requires an assessment of “the economic realities underlying a transaction.
  • On January 30, 2018, the SEC obtained a court order to halt the ICO of Dallas-based AriseBank for allegedly conducting a fraudulent ICO that targeted retail investors to fund what it claimed to be the world’s first “decentralized bank.”[11] According to the SEC, AriseBank “used social media, a celebrity endorsement, and other wide dissemination tactics to raise what it claims to be $600 million of its $1 billion goal in just two months.”

On a more positive note, the SEC also acknowledged that “it is possible to conduct an ICO without triggering the SEC’s registration requirements,[12] providing the example of a private placement conducted in reliance on Regulation D of the Securities Act. Indeed, several judicious market participants have structured token sales in reliance on an exemption from the registration requirements of the U.S. federal securities laws and in compliance with other applicable laws. In this regard, several token sales have been conducted in reliance on Rule 506(c) of Regulation D of the Securities Act (including Filecoin’s $257 million ICO[13]). Additionally, in light of most market participants’ desire to establish a trading market and offer liquidity for their investors, we expect to see an increasing number of token sales to be conducted in reliance on Tier 2 of “Regulation A+” of the Securities Act.

Below is a summary comparison of the main features of these two exempt offering alternatives.[14]

Exempt Offering Alternative

Maximum Size of Offering

Prohibition on General Solicitation or Advertisement

Type of Investors

Filing or Reporting Requirements

Restricted Securities

Rule 506(c)

Unlimited.

No, provided that all purchasers are accredited investors.

All purchasers must be accredited investors.

Issuer must take reasonable steps to verify accredited investor status.

Yes. File Form D with the SEC not later than 15 days after first sale.

No ongoing reporting requirements.

Yes. Purchasers cannot freely resell restricted securities to the public without an available registration exemption.

Tier 2 “Regulation A+”

Up to $50 million over a 12-month period.

No.

The offering need not be limited to accredited investors.

Offering documents must be filed with, reviewed by and “qualified” by the SEC.

Issuer is subject to ongoing reporting requirements.

No.

Purchasers can freely resell to the public.

While this alert is focused on compliance with the Securities Act in connection with an ICO, if a token is a security, market participants also must consider SEC regulations related to broker-dealer registration and operation of a secondary market trading platform as well as other potential regulations.

There is certainly “no one size fits all” structure. However, as the blockchain industry matures, we hope that all market participants will conduct token sales in compliance with all applicable laws, offer investors the protection of our securities laws, and continue to drive innovation for years to come.