In 2017, Initial Coin Offerings (ICOs) raised approximately $4 billion of capital worldwide. ICOs are a digital asset fundraising mechanism where issuers sell to investors digital tokens or coins that are supported by the blockchain technology, and investors make the payment using Bitcoin or other cryptocurrencies or fiat currency. ICOs, by their nature, are exposed to high risks, including fraud and cyberattack, making investor protection an eminent concern. In 2018, the Securities and Exchange Commission (SEC) launched a series of investigations and enforcement actions aimed at illegal activities related to cryptocurrency and ICOs. On February 21, 2018, the SEC filed a complaint against BitFunder for issuing unregistered securities and on April 2, 2018, the SEC filed another similar case, charging two co-founders of Centra Tech., Inc. with engaging in offering unregistered securities, through which they raised at least $32 million from public investors. If the SEC determines that the digital tokens issued in ICOs are securities subject to registration, anti-fraud and other SEC regulations, this would pose significant economic and legal burdens on ICO issuers.
I. ICOs Process
Issuers raise funds through ICOs on the basis of funding projects, and provide a conditional return to investors based on the profitability of those projects. Procedurally speaking, ICOs are composed of three stages: (i) announcement and promotion through public online channels (ii) release of a whitepaper (analogous to a prospectus in an Initial Public Offerings (IPOs)) describing the project and the terms of the ICOs, including the number of tokens to be issued, the consideration and duration and (iii) sale of the tokens on blockchain platforms. Generally, the ICOs activities are posted on the Internet and distributed globally, and the digital tokens or coins offered and disseminated worldwide. There are no limits on the quantity or qualifications of the investors. After the digital tokens are issued, the token holders could trade with others in a secondary market on virtual currency exchanges platforms.
II. Are Cryptocurrencies in ICOs Securities?
The term “securities” is broadly defined in the Securities Act of 1933, including stocks, notes, and even investment contracts in a transaction or a series of transactions. To address whether digital coins or tokens offered in ICOs are securities, the SEC issued a Section 21(a) report on July 25, 2017, regarding its investigation into whether the Decentralized Autonomous Organization (DAO) violated federal securities laws.
1. The 4-Prong Howey Test
In SEC v. W.J. Howey Co., 328 U.S. 293 (1946), the Supreme Court set forth the foundational test (Howey Test) for whether a transaction qualifies as a form of security known as an “investment contract”. Therefore, the starting point for determining whether ICOs qualify as securities offering is applying the “Howey Test.” Under Howey, an investment contract is defined as (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived from the entrepreneurial or managerial efforts of others.
By applying the 4-prong Howey test, the SEC concluded the DAO is a form of security and should be registered with the SEC as a security unless exempted from it. This decision paved the way for the SEC’s subsequent enforcement actions both in the cases of BitFunder as well as Centra Tech., Inc. as they shared similar business models.
In the case of SEC v. Jon E. Montroll & Bitfunder, 18-cv-1582 (S.D.N.Y.), Montroll offered through BitFunder’s website Ukyo Notes and registered users purchased the Ukyo Notes with bitcoins. The raised funds were to be used, according to the white paper, for the purpose of private investment and Montroll promised to pay those purchasers a daily interest rate of 0.05%. These virtual shares were traded in secondary market transactions on the platform. Similarly, in the case of SEC v. Sohrab Sharma & Robert Farkas,18-cv-02909 (S.D.N.Y.), the two founders sold the Centra Token, which was issued on the Ethereum blockchain. In the complaints, the SEC reached the same conclusion that the Ukyo Notes and Centra Token were securities without filling of registration statements.
Are there any exemptions available to ICOs under the existing securities rules? Telegram was the first ICO issuer to file an exemption with the SEC. According to the Notice of Exempt Offering of Securities filed with the SEC on February 13, 2018, the Telegram ICO for the development of the Telegram Open Network (TON) raised $850 million under the SEC exemption Rule 506(c) from 81 investors. Prior to the issuance of laws and regulations governing ICOs specifically, it is a wise decision for cryptocurrency startups to take a proactive approach to file the exemption with the SEC.
III.Tailored Regulations regarding ICOs on the Way
Despite their similarity in appearance, ICOs differ significantly from traditional IPOs, particularly with respect to scale and social impact. Does it make sense to regulate ICOs under the existing securities laws relating to public offerings of shares? In February 2018, the heads of the SEC and Commodities and Futures Trading Commission testified before a joint Senate hearing, in which they discussed regulations tailored to cryptocurrencies and ICOs. Before Congress passes new laws and the SEC promulgates new regulations tailored to ICOs, the participants may comply with the current securities regulations.