Initial coin offerings (“ICOs”) have served as an attractive method of start-up fundraising for a long time, but recent statistics show that investors are increasingly turning their backs on the ICO market. In 2018, ICO projects have raised $12.2 billion, but most funding was achieved during the first five months of the year. Since May of 2018, ICO funding is reported to have consistently declined, in large part due to ongoing regulatory uncertainty.
Where ICOs Fall in the context of Federal Securities Laws
All securities offered and sold in the United States must comply with the applicable registration requirements with the U.S. Securities and Exchange Commission (“SEC”), unless an exemption applies. Tokens offered in an ICO are not included in the list of financial instruments that are enumerated in the definition of a security, provided in section 2(a)(1) of the Securities Act and section 3(a)(10) of the Exchange Act, so the operative question is whether the tokens offered in an ICO could fall within the catch-all, “investment contract.”
In the seminal case of SEC v. W.J. Howey Co., the Supreme Court defined an “investment contract” as “a contract, transaction or scheme” where (i) a person invests his money; (ii) in a common enterprise; (iii) with an expectation of profits; and (iv) solely from the efforts of a third party. In developing what has come to be known as the Howey test, the Supreme Court considered the alleged “investment contract” as an entire package, including the ways in which the vehicle was marketed, thereby signaling that future determinations will also be dependent on a case-by-case, factual inquiry regarding the economic reality of the ICO transaction. Julianna Debler, Foreign Initial Coin Offering Issuers Beware: The Securities and Exchange Commission Is Watching, 51 Cornell Int’l L.J. 245, 255-56 (2018).
The factual nature of the analysis poses a problem for ICOs because there is a variety of ways in which tokens can be issued. For instance, an ICO issuer may offer tokens as either “utility tokens,” meaning that the token will grant to the tokenholders a right of some kind (e.g. access to a particular service or an application), or as “security tokens,” which will operate similarly to traditional securities. Generally, there are secondary markets for these tokens, where the tokens’ value fluctuates. Joseph D. Moran, The Impact of Regulatory Measures Imposed on Initial Coin Offerings in the United States Market Economy, 26 Cath. U. J. L. & Tech 213, 215 (2018).
Developers are incentivized to issue their tokens as “utility tokens” to avoid the costs of complying with the SEC’s registration requirements, but the SEC’s ruling in In re Munchee Inc. shows that how a token is labeled by its developer is not dispositive of whether the token will be brought under the purview of the federal securities laws. In In re Munchee Inc., Munchee sought to raise $15 million through an ICO with the goal of using the proceeds to develop its iPhone application. Munchee labeled its ICO tokens as “utility tokens” not subject to the registration requirements based on the idea that its tokens would be used primarily for consumption purposes, but the SEC disagreed. Even while accepting Munchee’s claim that their tokens will be used for consumption purposes, the SEC focused on how Munchee’s tokenholders were reasonably led to expect profits from the appreciation of the token’s value and that the tokenholders were able to resell at secondary markets.
This case is exemplary of the SEC’s position that a prospective ICO issuer cannot sidestep the existing regime of securities laws by simply labeling their tokens as utility tokens. Despite the lingering uncertainty, it appears as though ICO tokens will be, at least mostly, deemed securities. The SEC suggested as much in 2017 when it announced that tokens offered by the DAO (short for the Decentralized Autonomous Organization, a blockchain-based project that sold the DAO tokens for Ether, raising $150 million in 2016) were securities. In June of 2018, William Hinman, the SEC’s director of corporation finance, made comments which hinted that irrespective of the label attached, an ICO token will likely be considered a security.
Where ICO Regulation is Headed
The SEC has responded to calls for regulation in the ICO space with a policy known as “regulation through enforcement,” which refers to an approach where the SEC indirectly conveys its position primarily through enforcement actions pursued against individual defendants. Jay B. Sykes, Securities Regulation and Initial Coin Offerings: A Legal Primer, Congressional Research Service 39 (Aug. 31, 2018). The SEC’s annual enforcement report for the fiscal year of 2018 reported a substantial increase in investigations against potentially fraudulent ICOs. In 2018, the SEC pursued 20 stand-alone enforcement actions against ICOs, and in 70% of these cases, individuals were charged.
Recent enforcement actions against Paragon and Airfox, companies that conducted token sales in 2017, are noted to have provided some guidance for future ICO issuers, in part because the two sales were nearly identical in structure, and the legal analysis employed by the SEC to find the issued tokens as securities in both actions was consistent. However, some have called for more clarity in the virtual currency space by creating ICO-specific regulations (e.g., a new registration exemption for token issuers). The concern is that the lack of regulatory clarity is scaring off potential ICO issuers and destroying further growth of the virtual currency market in the United States.
Important Considerations for ICO Regulation
Any proposals to change the existing legal and institutional structures must be considered after a deep understanding of the incentives of a prospective token issuer and the nature of the investors on the buy-side have taken place. In addition to providing an additional avenue for capital-raising, ICOs are attractive to startups because of the potential for substantial network effects: unlike traditional sales of equity, ICOs can help the startup gauge the potential demand for its platform of product. Similarly, startups may conduct ICOs to accumulate as many purchasers as they can with the goal of creating a robust future market. Jay Preston, Initial Coin Offerings: Innovation, Democratization and the SEC, 16 Duke L. & Tech. Rev. 318, 321 (2017-2018).
Moreover, studies have shown that the investors in the ICO market can largely be divided into four categories: bubble speculators; criminals in the business of money laundering, tax evasion or holding of illicit cash; crypto gamblers seeking to become “Bitcoin millionaires,”; and “smart money” investors. David Hoffman, Regulating Initial Coin Offerings, Penn Wharton Public Policy Initiative (Oct. 22, 2018) at 5. In other words, contributors in the ICO market may not be the unwary public.
Regulators should also consider the existence of meaningful market correctives that are in the process of maturing, and self-correcting, the ICO space. The DAICO model is one such example. With the goal of reducing the risk of fraud by its design, the DAICO model allows the tokenholders to determine, by voting, the amount that the developers can withdraw from the accumulated funds, and to shut down the project in its entirety and walk away if appropriate. The DAICO model is not without its imperfections, but the important thing is that the ICO market is evolving to account for the risk of fraud, and in ways that provide more protections to investors. For example, there are secondary information sources that provide “ratings” information for ICOs, similarly to stocks. David Hoffman, Regulating Initial Coin Offerings, Penn Wharton Public Policy Initiative (Oct. 22, 2018) at 5.
Future efforts to regulate and monitor the ICO market should be done in a way that ‘matures’ the market, rather than creating substantial and unworkable obstacles for a prospective ICO issuer so as to destroy any future development in the virtual currency market.