What Lawyers Should Know About Initial Coin Offerings in 2018
Blockchain began 2017 as an obscure subject mentioned mostly to explain Bitcoin and ended the year as one of the most talked-about topics in finance and technology. Among its developments, one of the most problematic has been “initial coin offerings” (ICOs) – the financing of blockchain projects by sales of cryptographic tokens. ICOs boomed in number and valuations in 2017 and financed numerous blockchain projects, but in the second half of the year they came under increasing scrutiny from regulators in the United States and abroad.
Entering 2018, projects raising capital using ICOs must remain aware of and take into account the emerging responses of regulatory authorities in the United States and other countries to avoid subjecting themselves to increased regulatory scrutiny.
The 2017 ICO Explosion
ICOs began 2017 as an obscure activity and by mid-year had become a noteworthy aspect of finance. Also called a token sale or token generation event, an ICO funds a blockchain system development project by creating and selling a new cryptocurrency that will serve as a digital token in the system. In some respects, it resembles an initial public offering (IPO), differing fundamentally from an IPO in being conducted by the principal of the project itself, without an underwriter or other financial intermediary, and in issuing a digital asset different from existing types of securities covered by national securities laws.
As a result, ICOs initially proceeded without being subject to any regulation, and they were readily accessible by potential investors worldwide. ICOs attracted negligible investment and attention for several years after their first use in 2013, but they catapulted to attention as a result of raising over $3.7 billion in 2017.
Declarations of the significance of ICOs have followed their rise in 2017. ICOs substituted for capital from angel investors or venture capital firms for many startup companies, and capital raised in ICOs exceeded venture capital funding of blockchain projects in 2017. As a result, there was talk that an entirely new paradigm for funding technology projects had emerged.
ICOs in a Time of U.S. and Global Regulatory Scrutiny
The growth of ICOs also drew the attention of regulators, however, with the Securities and Exchange Commission (SEC) scrutinizing them for the first time in 2017. The SECaddressed ICOs during the second half of 2017 with a series of actions intended to maintain the intent of the U.S. securities laws. The July report by the SEC staff stated that U.S. securities laws apply to ICOs regardless of their use of new technology, and that tokens that meet the existing definition of a security are required to be registered in compliance with existing laws.
The SEC’s recently created Cyber Unit has been enforcing this policy, acting in December to stop a fraudulent ICO and sales of a token found to be an unregistered security. On the same day as the latter action, the SEC Chairman issued a warning that the risks of fraud and manipulation are high and that issuing securities without registering them was widespread in past ICOs.
With scrutiny from the SEC rising to a new high in December 2017, ICO issuers should be on notice regarding the need to examine the terms of their ICOs for compliance with U.S. securities laws. The SEC Chairman specifically warned that declaring an ICO offering to be a “utility token” is not sufficient to prevent it from being a security if it substantively meets the definition of a security, and that the structures of ICOs examined by the SEC by and large involved the offer and sale of securities.
There is now no excuse for an ICO issuer to be surprised by SEC scrutiny of its offering, even if it occurred under a “Simple Agreement for Future Tokens” (SAFT) or other terms intended to establish it as sale of utility tokens. SEC enforcement action for violations of the registration requirement is possible, as is action by state securities regulators, who are starting to become active toward ICOs and cryptocurrencies. Both current ICOs and those concluded earlier without any SEC action should be considered to be at risk.
Moreover, ICO issuers should be aware of the risks of action by regulatory authorities worldwide. The outright bans on ICOs by China and South Korea in September have been widely publicized, and even in jurisdictions considered the most favorable for blockchain and cryptocurrency projects, the SEC’s approach has become the mainstream response to ICOs.
Similar statements about the need for ICOs to avoid issuing securities or else comply with existing securities laws have come from the securities regulators of jurisdictions with regulatory sandboxes – Singapore, Canada, Hong Kong, and Australia – and from crypto-friendly Switzerland. As a result, ICO issuers may need to completely exclude buyers in China and South Korea, while also taking into account how to avoid having their tokens classified as securities under the laws of Singapore and other jurisdictions.
Token issuers and their legal counsels must structure current ICOs to comply with a range of foreign securities laws or else avoid selling in certain jurisdictions, and should not ignore the possibility of scrutiny of past ICOs by foreign securities regulators.
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