ICOs: Emerging Regulatory Framework

Abir Varma

Introduction

Last year, entrepreneurs raised some $6 billion¹ through “initial coin offerings”, or ICOs—a crowdfunding mechanism by which firms issue cryptocurrency, or digital coins, in exchange for legal tender or, usually, other cryptocurrency. Coin holders can stand to share in the projected returns of ICO-funded projects but do not necessarily receive a claim on the issuer’s earnings à la equity-holders who purchase stock in IPOs. Despite their name, digital coins serve as ‘currency’ only for the projects they are meant to finance—and serve a kind of dual function as a security as well as a utility. For instance, those who received digital coins in the ICO for Filecoin, a decentralized storage network project, will only be able to trade storage space in the Filecoin network using that particular cryptocurrency.² Unfortunately, as The Economist puts it, many ICOs sound “like the kind of bargain that would appeal only to people who reply to e-mails from Nigerian princes offering millions.”³

SEC: The New Sheriff in Town

Left unregulated, the ICO mania has the propensity to attract scammers—some estimate that 10% of all funds raised through ICOs between 2015 and 2017 were appropriated for fraudulent purposes.⁴ The SEC recently decided, however, to fill in the regulatory void in the name of investor protection. In July last year the SEC issued an investigative report (“DAO Report”) announcing that some digital coins may be considered “securities” under the 1933 Act and the 1934 Act and thus fall under the purview of the U.S. Securities Laws.⁵

The DAO Report–Applying the Howey Test to the Offer and Sale of Digital Coins

Sections 5(a) and 5(c) of the 1933 Act prohibit the unregistered offer or sale of securities in interstate commerce. In particular, ICO purveyors violate Section 5 of the 1933 Act if they offer, on the basis of an unregistered prospectus, digital coins that could be subsumed under the catchall term “investment contract” in the statutory definition of the instruments considered “securities.”[6]To be deemed an investment contract, a scheme must be one in which a person (1) invests his money in (2) a common enterprise and is led (3) to expect profits from the managerial efforts of others (“Howey test”).[7] To determine whether an instrument meets all the requirements of the Howey test, courts pay attention to substance—the “economic realities underlying a transaction”— and not to form—or, the “name appended thereto.”[8] However, at least prior to the DAO Report, many digital coins were marketed to prospective purchasers on the basis of an unregistered ‘White Paper’ prospectus (and seemingly still today, given the multiple SEC enforcement actions that have followed the July Report⁹).

The SEC has put the blockchain universe on notice: the SEC Chairman issued a public statement in December in which he asserted that the “structures of initial coin offerings […] involve the offer and sale of securities and directly implicate the securities registration requirements and other investor protection provisions of our federal securities laws.”¹⁰ Would-be digital coin issuers should be wary of offering their products to prospective investors without complying with the SEC’s registration requirements.

To provide guidance to ICO issuers, the SEC applied the Howey test in the DAO Report to determine whether the digital coins issued by The DAO, a self-professed “decentralized autonomous organization” would be considered investment contracts, and therefore, securities.

The factual web comprising The DAO and the rights attached to DAO Tokens included many features that are likely to recur in the context of commercial ventures grounded in blockchain technology. The DAO issued DAO Tokens that gave token holders the right to receive a return on projects executed by The DAO, to vote on projects proposed in the form of smart contracts (self-executing contracts written in code), and to propose projects themselves. The SEC determined that in exchanging another type of cryptocurrency for DAO Tokens, investors made an investment of money into a common enterprise with a reasonable expectation of profits to be derived from the managerial efforts of others—the legal analysis largely centered on whether The DAO’s ICO met this third Howey requirement.

The potential universe of rights represented by digital coins—such as the right to propose self-executing contracts even without intermediary ‘insiders’ like directors or executive officers performing an oversight role and the right to use cryptocurrency for functional purposes—make analyses concerning whether investors reasonably expect profits from someone else’s efforts particularly interesting.

A theoretical concern over the link between an investor’s lack of control over business operations and her risk of overpayment for cash flows related to those operations lies at the core of an application of the third Howey requirement.11 Courts have been more likely to consider non-vanilla commercial transactions as falling under the definition of “investment contracts,” and thus the ambit of the 1933 Act’s registration requirements, in schemes involving infusion of capital by passive investors.12

In a crypto world where an enterprise’s operations could largely center around smart contracts, widely-held digital coins might eventually subvert the traditional conception of principal-agent relationships underpinning publicly listed corporations—and retail investor passivity. The organizational structure of The DAO itself was composed of three levels of actors: the co-founders who pre-determined The DAO’s master protocols, DAO Token holders, and “Curators,” individuals selected by the co-founders who would sift through the smart contracts proposed by DAO Token holders and select the ones that would be put forward for DAO Token holders’ voting consideration. It is conceivable however that an organization existing on a distributed ledger does away with intermediaries analogous to a directors or executive officers all together and functions solely as a peer-to-peer network. Ethereum—the decentralized blockchain platform known for speculation in Ether, its associated cryptocurrency—allows developers to do just this. Courts might find it devilishly difficult to identify actors who either ‘control’ or ‘do not control’ anonymous peer-to-peer enterprises running on smart contracts. If so, perhaps the digital coins associated with these enterprises could be considered more ‘currency’ than security—as indeed Ether is viewed itself­.

Courts have also been more likely to find that a particular instrument meets the third Howey requirement, and thus should be regulated as a security, where investors purchase a particular instrument primarily for investment (rather than functional) purposes.13 Where issuers of digital coins emphasize the speculative rewards possible from secondary market trading, and investors part with capital primarily in order to benefit from resales of a particular digital coin, courts would likely consider returns on ‘investment’ to be the investors’ driving motivation. However, digital coins that serve substantive functional purposes may not necessarily be considered securities. For instance, if Groupon were to be executed on a blockchain today, it is conceivable that its digital coin would function as some type of generic Groupon discount coupon as well as a kind of equivalent to Groupon common stock. Courts then would have to determine whether the digital coin should be considered more utility than security.

Conclusion

Perhaps more empirical research is needed to determine whether investments in digital coins constitute the type of systemic macroeconomic risk that should legitimately draw the SEC’s ire: it is unclear who the average investors in digital coin offerings are, what their average contributions amount to, and what the rest of their portfolios consist of. Nevertheless, the SEC has decided to wade into the arena. ICOs raise fascinating questions about whether various digital coins should be considered securities—perhaps lawyers should consider moonlighting as economists to delineate the boundaries between currency, security, and utility in the crypto world.

[6] Securities Act of 1933, 15 U.S.C. § 77b(a)(1).

[7] See DAO Report (quoting SEC v. Edwards, 540 U.S. 389, 393 (2004); SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946)).

[8] See id. (quoting United Housing Found., Inc. v. Forman, 421 U.S. 837, 852-3 (1975)).

11 See SEC v. Aqua-Sonic Products, 687 F.2d 577 (2nd Cir. 1982).

12 See id, SEC v. Koscot Interplanetary, Inc., 49 F.2d 473 (5th Cir.1974).

13 See United Housing Found., Inc. v. Forman, 421 U.S. 837 (1975).