Attorney: Michele S. Carino
Pomerantz Monitor May/June 2018
The ability to raise capital through an Initial Coin Offering, or “ICO,” has been hailed as a boon to innovation and economic growth, allowing small businesses and start-ups to bypass traditional (and more expensive) financing sources, such as venture capitalists and investment banks. In fact, in the first four months of 2018, ICOs have raised over $4 billion in funding, already exceeding the $3.3 billion raised in ICOs in 2017, and well ahead of the amounts raised through traditional venture capital.
But what exactly is an ICO, and what are investors buying? And what happens if they don’t get what they expected? Until recently, this emerging, decentralized capital market has been largely unregulated, exposing investors to price volatility, pump-and-dump schemes, and outright theft by fraudsters and hackers – oftentimes, with no legal recourse. Regulators have now started to take action, making it clear that while cryptocurrencies may be novel, they are not outside the bounds of existing laws.
Cryptocurrency, also known as virtual currency, coins, or “tokens,” is a representation of value that can be digitally traded and exchanged, and that may entitle the owner to certain other rights, such as access to a technology or platform. But it is more than just digital money. According to the Securities and Exchange Commission (“SEC”), coins and tokens may also qualify as “securities” under U.S. laws, and thus be subject to regulation, including registration and disclosure requirements. The seminal Supreme Court case SEC v. Howey Co., decided in 1946, sets forth the test for determining if a financial instrument – actual or virtual – is an “investment contract” that meets the definition of a security. Specifically, a transaction is an investment contract if: (1) money is invested in a common enterprise, (2) the investor expects profits from the investment, and (3) the profit comes from the efforts of someone other than the investor. An instrument must meet all three criteria to be considered a security. Coins and tokens, like any other financial instrument, can take many forms, but to the extent a company utilizes coins or tokens to raise capital with the promise of increased value based on the company’s plans or growth prospects (e.g., launch of a new technology or product), coins and tokens seem to satisfy the “common enterprise” and “efforts of others” elements of the Howey test, in the same way as shares of stock. Indeed, just as with stock, the value of a coin or token on an exchange will fluctuate depending on the perceived performance of the issuing company.
Seeking to avoid the complications and costs of compliance with U.S. securities laws, many entities have re-packaged and re-labeled coins as “utility tokens” and have downplayed the expectation of profit and/or promised some future use, such as participation in a digital community. But the SEC recently clarified that labels do not matter: “Whether a particular investment transaction involves the offer or sale of a security – regardless of the terminology or technology used – will depend on the facts and circumstances, including the economic realities of the transaction.” SEC Chairman Jay Clayton further stated: “By and large, the [ICOs] that I have seen … directly implicate the securities registration requirements and other investor protection provisions of our federal securities laws.”
While some have decried the regulatory intrusion into this new digital frontier, and others simply have gone the route of blocking U.S. investors from participating in offerings, the benefits of increased investigation and enforcement more than outweigh the potential downside. Industry insiders, including Joseph Lubin, the co-founder of the cryptocurrency Ethereum, and Brad Garlinghouse, CEO of Ripple, agree that curbing fraud will strengthen and legitimize cryptocurrencies and the distributed ledger platforms (“blockchains”) on which they trade. Moreover, to the extent ICOs mirror initial public offerings or other smaller offerings or private placements, there is already a well-established legal framework to ensure both access to capital and protection for investors, including that the coins or tokens be registered and that the issuer make adequate disclosures. These requirements would provide investors with recourse under the Securities Act for initial sales, as well as potential recovery in the instance of market manipulation and insider trading, which have been rampant in secondary markets for coins and tokens.
The SEC’s involvement in this area is likely to increase, as evidenced by the creation of a new cyber task force charged with policing ICOs. That task force already has been busy – the SEC filed a fraud suit against the organizers of the PlexCoin ICO in December, with the founder sentenced to jail by Canadian authorities. In recent weeks, the SEC has launched an investigation into Overstock.com’s token sale through its subsidiary tZero, which was supposed to be the first fully-compliant ICO by a publicly-traded company, but which has now been postponed. The SEC also halted trading in Longfin Corp., a cryptocurrency business, alleging that executives committed securities fraud by running up the stock price and then illegally selling large blocks of restricted stock to the public while the price was elevated. The SEC obtained a court order freezing more than $27 million in trading proceeds before the illicit gains could be transferred to offshore entities.
Cryptocurrencies may still disrupt the financial industry and change the way we do business in the future. However, in terms of regulation, the old adage that “the more things change, the more they stay the same,” may still hold true, especially in terms of investor protection.