Bitcoin, Ethereum, Cryptocurrencies. With the advent of blockchain technologies and related blockchain-based service companies, many startups are now employing or examining a new way to raise capital: initial coin offerings (ICOs). In fact, in the first three quarters of 2017, startups have raised over $1.7 billion of capital via ICOs—with investments in ICOs surpassing venture capital investments in the U.S. To date, many of these ICOs are being conducted outside the scope of securities laws and regulations, relying on the presumption that the instruments being offered (coins or tokens) are not securities and, therefore, are not subject to the regulatory requirements applicable to securities offerings.
Issuer, beware! Change is coming, and quickly. The U.S. Securities and Exchange Commission (SEC) and other regulatory bodies are watching and examining ICOs very closely, applying a facts and circumstances test to each offering, and looking at the underlying economic realities of the offering. The U.S. Supreme Court long ago determined that an instrument was a security subject to the U.S. securities laws if it (1) involved investment of money, (2) was in a common enterprise, (3) included a reasonable expectation of profits and (4) derived from the entrepreneurial or managerial efforts of persons other than the investor. These criteria are being applied to ICOs, and their first cousin, SAFTs, or simple agreements for future tokens, to determine if the coin offered is a security.
While cryptocurrencies may well be the inevitable result of technological innovation and increased reliance on and acceptance of a digital economy freed from the concepts of hard currency and related monetary instruments, securities laws are not the only issue to consider. Some economists are concerned about the sovereign power of nation states to control and regulate their money supply, with the concomitant impact on the viability and effectiveness of monetary policy. Like the SEC, interested in maintaining confidence in securities markets, governments too are examining the risks and rewards of cryptocurrencies and their possible impact on the future viability of government power and economic policies.
What are ICOs? Basically, companies are able to raise capital by creating and selling their own cryptocurrency (referred to alternatively as coins or tokens) in exchange for either “real” currency (e.g., fiat currency, like the U.S. dollar) or another form of virtual/digital currency. These tokens may be used to acquire future products, services or solutions of the issuer, but also may be held or traded for investment purposes. Some issuers, perhaps in an effort to avoid SEC regulations, have narrowly defined their tokens or coins as utility tokens, limiting their use only to acquire goods or services from the issuer, almost akin to a prepaid gift card whose value can change based on the laws of supply and demand. Utility tokens, properly defined, should not be classified as securities. But SAFTs, dividend- or interest-bearing tokens, or those that involve revenue sharing or profit sharing undoubtedly are securities, and issuers of these instruments are well advised to err on the side of conservatism and compliance. They may register their offerings of coins or tokens in a traditional registered public offering, or otherwise comply with the securities laws and SEC rules and regulations by relying on exemption from registration, such as the private offering exemption, Regulation D, or a Regulation A+ offering, the latter of which just may achieve the elusive twin goals of sales and issuances to non-accredited investors and free tradeability post-offering.
Despite their controversy, ICOs continue at a rapid rate. The SEC warned early this summer that regardless of terminology, it is examining the “economic realities” of each ICO to determine if a coin or token is a security—and soon thereafter, on August 24, 2017, made good on its warning by intervening in the highly anticipated ICO by Protostarr, a blockchain-based startup. As a result, the company was forced to cease operations and refund the Ethereum collected in its crowdsale that it conducted outside the scope of securities regulatory requirements.
Outside the U.S., in September 2017, KIK, a messaging app/consumer internet company, rejected the more traditional venture financing route and raised nearly $100 million in a high-profile ICO, attracting over 10,000 “backers” and a handful of institutional investors. The lure of big capital raises without the shackles of securities regulations is very strong for many, creating an environment much like that of the Wild West, but the SEC is concerned about the potential for scams and illegitimate offerings.
Because some professionals and investors caution that ICOs are more speculative and ripe for abuse than similar offerings in the dot.com era bubble, it is undeniable that the SEC will, especially in light of the huge dollar amounts at issue and the high-risk nature of these transactions, seek to regulate most ICOs as securities, though some limited issuances of coins or tokens may well be utility tokens, narrowly defined so that they do not fall within the purview of the securities laws.
ICOs face a rapidly evolving future. On the one hand, there are clear and compelling economic and monetary policies and implications associated with cryptocurrencies and their offerings and subsequent trading. On the other hand, cryptocurrencies offer incredible opportunities for capital raising, economic risk and reward, and peer-to-peer electronic cash exchange that can reduce risk and help companies avoid financial institution intermediation. The breadth of applications is stunningly large, with the possibility of disrupting virtually every industry. Stay tuned and prepare for a bumpy ride.
For more information on best practices that McCarter attorneys have established for ICOs, please contact David Sorin, co-chair of the Venture Capital and Emerging Growth Companies Practice.