Staff Reporter (2021 – 2022)
The U.S. Securities and Exchange Commission (“SEC”), which was created to protect investors from fraudulent schemes and maintain fair and orderly markets, is focusing its attention on the sudden spike in initial coin offerings (“ICOs”). ICOs are a new, popular capital-raising method where companies offer tokens for investments that will fund future projects.1 ICOs have raised billions of dollars.2 However, without the protections afforded by the SEC, many investors were scammed into fraudulent sales,3 leaving regulators concerned about the risks associated with ICOs. Due to these concerns, in 2017, the SEC announced that ICOs would be covered by the Securities Act of 1933 (“Securities Act”), and the agency was tasked with the duty to protect investors in digital assets.4
What is an ICO?
Established companies and entrepreneurs alike can seek funding through an ICO.5 In an ICO, a company will sell “tokens,” or “coins,” in exchange for investors’ money.6 To attract investors, a company will publish a whitepaper that details their cryptocurrency, their company’s team biographies, the intended division of proceeds, and an expected timeline for the token’s sale.7 Investors in an ICO will not take an ownership stake of the company; rather, they will be given cryptocurrency.8 This cryptocurrency is issued with the expectation that its value will increase, yielding a return on investment for the investor.9
Is an ICO a security?
Absent an exemption, the SEC views ICOs as securities, leveraging the Howey test to make this determination. The Howey test is used to understand whether a financial instrument qualifies as an investment contract and is therefore considered a security subject to the Securities Act and Exchange Act.10
Under the Howey test, a digital asset is an investment contract if (1) it is an investment of money; (2) there is an expectation of profits from the investment; (3) the investment of money is in a common enterprise; and; (4) any profit comes from the efforts of a promoter or third party.11 The court has clarified that investments do not have to be monetary; they can be any contribution of value such as goods or services. Altogether, the Howey test embodies a flexible standard that applies to an array of situations.12
In July 2017, the SEC issued its Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO. The DAO Report described the agency’s investigation into a sale of tokens to American investors by a German corporation and, using the Howey test, determined that the tokens were securities and, thus, subject to federal security laws absent a valid exemption.13 Therefore, the SEC views most ICOs as securities, and accordingly, those offerings must be registered with the SEC or exempt from registration under the Securities Act of 1933.
What federal regulations or rules must an ICO follow?
If an ICO is considered a security, the issuer is required to follow registration procedures, or otherwise be liable for violations of Sections 5(a) and (c) of the Securities Act.14 Furthermore, all securities transactions, including those that are exempt from registration, are subject to the antifraud provisions of the federal securities laws.15 This means that any company will be liable for false or misleading statements regarding the company, the securities offered, or the offering itself.16
With the exponentially increasing activity around ICOs, this financial instrument has instantiated a multi-billion dollar crowdsale market. However, with this popularity also come opportunists seeking capital via fraudulent means, creating degrees of anxiety for investors in this space. Thus, in attempts to quell these fears, the SEC leverages the Securities Act, along with the Howey test, to determine whether an ICO’s offering is subject to the Securities Act and Exchange Act. Retrospectively, such registration requirements may have protected investors of billions of dollars (for example, the $2 billion BitConnect fraud in 2017).17 Cases such as this only highlight the extreme importance of regulation around the booming ICO markets, and the ongoing importance of investors to thoroughly understand the inherent risk of their ICO interests.
1 Zachary Missan, VI. the SEC and Initial Coin Offerings: How Securities Laws Affect ICOs, 37 Rev. Banking & Fin. L. 85 (2017).
2 Dirk A. Zetzsche, The ICO Gold Rush: It’s a Scam, It’s a Bubble, It’s a Super Challenge for Regulators, 60 Harv. Int’l L. J. 267 (2019).
3 Nareg Essaghoolian, Initial Coin Offerings: Emerging Technology’s Fundraising Innovation, 16 UCLA L. Rev. 294 (2019).
4 Rep. Of Investigation Pursuant to Section 21(a) of the Sec. Exch. Act 0f 1934: The DAO, Release No. 81207 (July 25, 2017).
5 Nareg Essaghoolian, Initial Coin Offerings: Emerging Technology’s Fundraising Innovation, 16 UCLA L. Rev. 294 (2019).
10 SEC, Framework for “Investment Contract” Analysis of Digital Assets (2019). 132 Harv. L. Rev. 2418 (2019).
11 SEC v. W.J. Howey Co., 328 U.S. 293, 298-99 (1946).
12 Michael Mendelson, From Initial Coin Offerings to Security Tokens: A U.S. Federal Securities Law Analysis, 22 Stan. Tech. L. Rev. 52 (2019).
13 Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, SEC Release No. 81207, 2017 WL 7184670, at *8 (July 25, 2017).
14 15 U.S.C § 77e
15 Thomas Lee Hazen, Tulips, Oranges, Worms, and Coins- Virtual, Digital, or Crypto Currency and the Securities Laws, 20 N.C. J. L. & Tech. 493 (2019).
17 7 Bromberg & Lowenfels on Securities Fraud § 23:4 (2d ed.)