Initial coin offerings (ICOs) have seen incredible growth in the last year, largely outside of regulatory oversight and without the investor protection and disclosure requirements that typically apply to traditional securities or investment offerings. Blockchain startups raised five times more capital through ICOs than through traditional equity financing in 2017 and in the first few months of 2018, ICOs have raised more than $1.7 billion in capital for startups. Many individuals that invest in ICOs do so because they believe that the tokens themselves will have value, either as a currency or on a platform that is created or will be created, but with the steep rise in the value of cryptocurrencies over the past year, a significant number of purchasers of tokens do seem to be simply hoping for a jump in the trading price of the token. It clearly looks like we’re in a cryptocurrency bubble right now and the question is, with regulators taking notice, ‘is the bubble going to burst?’
We previously discussed ICOs and the Securities and Exchange Commission’s (SEC) Report of Investigation on the DAO. But there are still open questions about other types of ICOs, where it may not be squarely an investment, but instead the token has some use other than just providing a return to the holders. That’s where the SEC’s Munchee case in December gave us some more color and in our recent QuickLaunch University webinar on the future of ICOs and cryptocurrencies, we discussed this case and other developments and offer a few key takeaways if you are invested in or planning to launch an ICO:
1. Every offering of securities needs to be registered or exempt. Munchee violated Section 5 of the ’33 Act, which requires every securities offering to be either registered with the SEC or made under an exemption from registration. Interestingly—and the SEC pointed this out in the order—Munchee claimed to have done the Howey analysis, but had determined that there was not a significant risk of the token being a security. The SEC did not agree. The offering materials for this ICO described the way that the tokens would increase in value, which was key to the case. Also key was the fact that the offering material told the potential purchasers that the tokens would be traded on secondary markets. At the time of the sale, Munchee had developed its app, but buyers were not able to buy any goods or services on the ecosystem. Many in this market have proceeded under the impression that a token that has some utility will not be a security, but this case makes it clear that in the SEC’s view, that’s not enough. A token can have some utility, but if the real reason people are buying it is because they are expecting to share in the upside of the business, you need to look harder at that analysis.
2. The SEC is focusing more on ICOs, and getting it right is important as SEC pressure continues. The SEC Chairman has been very vocal in speeches and testimony and has said more than once that just about every ICO he’s seen has looked like a securities offering, which makes us look at these deals very carefully as we move forward. The SEC has also warned securities lawyers that it’s our role to act as gatekeepers, so you will find that the legal analysis will be rigorous to try to keep issuers and investors out of trouble.
3. It appears there will be serious enforcement activity in this space in the coming year. It’s important to pay attention to the recent reports of subpoenas that are being issued to startup companies and their advisors. Most entrepreneurs have not had to interact with the SEC before. Take it seriously. If you do hear from the SEC, don’t destroy any documents. If you get a subpoena, you should also immediately find experienced counsel before you start talking to SEC staff.
4. But it’s not necessarily all gloom and doom. The recent SEC reports do not make it impossible to have a true utility token and not a security when you look at all the facts and circumstances. However, there is a lot of risk, and there will be a lot of scrutiny. You should, in a perfect world, be able to create a token that’s linked to the use of a particular product or service not marketed as an investment, use it as a medium of exchange and have a closed system that would work. But realistically, in this climate, it’s going to be a pretty high bar to say that what you have developed is definitely not a security.
5. Just remember to use caution while we’re in this hot moment for enforcement. If you’re thinking of an ICO, you want to think seriously about whether you can do it as a compliant securities offering. There will be some drawbacks to do it as a securities offering compared to the freewheeling ICOs of the good old days last year, but it may keep you out of trouble. There are a few different exemptions that could be available. Regulation D is one that many are thinking about and is available if you’re willing to limit the purchasers of the tokens to accredited investors and meet the other requirements of the safe harbor, which includes taking reasonable steps to verify that the ultimate purchasers of the tokens are accredited investors.