Initial Coin Offerings in SEC Spotlight
This month, Telegram reported raising $850,000,000 in a cryptocurrency offering. As companies like Telegram are demonstrating, initial coin offerings (sometimes called ICOs) are a viable way to raise capital. As ICOs become increasingly common, the SEC is prioritizing its regulation of those offerings.
What is an ICO?
Before we get to the SEC’s recent statements on ICOs, let’s provide a brief answer to the question, “What is an ICO?”
Company offers tokens in exchange for capital
If you buy a coin in an ICO, what are you buying?
The benefit a purchaser of a coin is hoping to get may vary substantially from one ICO to the next.
Sometimes tokens enable users to access goods or services. For example, Telegram’s token is called a Gram, and is advertised as enabling owners of tokens to use Telegram’s messaging application once that application is launched.
Sometimes coins are not intended to be redeemed for anything in particular, but instead are supposed to be a medium of exchange. For example, Bitcoin is intended to be its own currency.
Some ICOs will be subject to regulation applicable to money services businesses. Some ICOs will be subject to securities regulations. Some ICOs might not be subject to either. Different regulations will apply to different ICOs, and which regulations apply to which ICOs depends in large part on what a company promises to individuals buying its tokens.
Companies issuing ICOs often utilize a distributed ledger
The coins or tokens are often tracked on a blockchain-style distributed ledger. Distributed ledgers create a peer-verified record for transactions. Basically, rather than having third parties like banks verify transactions, a group of people using agree to a protocol for verifying the transactions and recording the verified transactions on a shared ledger. This distributed ledger technology is often a core part of the business that’s doing the ICO.
The SEC’s recent statements on the regulation of initial coin offerings
In the last few months, the SEC chairman Jay Clayton has issued two public statements on initial coin offerings.
December’s public written statement
On December 11, 2017, Chairman Clayton issued a public statement focused on the regulation of cryptocurrencies and initial coin offerings.
He started with a warning to investors: “If you choose to invest in these products, please ask questions and demand clear answers.” His statement included a sample list of questions for investors to pose. The list includes questions like:
- Who am I contracting with?
- What specific rights come with my investment?
- If a digital wallet is involved, what happens if I lose the key?
Chairman Clayton acknowledged that initial coin offerings can be an effective tool for raising capital, but reminded folks that “any such activity that involves an offering of securities must be accompanied by the important disclosures, processes and other investor protections that our securities laws require.” He went on to say, “A change in the structure of a securities offering does not change the fundamental point that when a security is being offered, our securities laws must be followed.” In other words, Chairman Clayton is saying that the SEC is going to look at what is being promised to investors and what motivates investors to buy the tokens—if those promises and motivations are similar to what they would be in a traditional securities offering, then it doesn’t matter that the company’s promises are being packaged differently in an ICO—the company is still offering securities as far as the SEC is concerned.
January’s public remarks at a securities conference
On January 22nd, 2018, Chairman Clayton issued the opening remarks at the Securities Regulation Institute, a seminar for legal professionals. He began by saying, in essence, that lawyers need to do a better job of telling their clients that initial coin offerings are securities offerings.
In discussing some examples of what he’s seeing, he said: “First, and most disturbing to me, there are ICOs where the lawyers involved appear to be, on the one hand, assisting promoters in structuring offerings of products that have many of the key features of a securities offering, but call it an ‘ICO,’ which sounds pretty close to an ‘IPO.’ On the other hand, those lawyers claim the products are not securities, and the promoters proceed without compliance with the securities laws, which deprives investors of the substantive and procedural investor protection requirements of our securities laws.”
Chairman Clayton made it clear that the SEC will prioritize regulating ICOs: “I have instructed the SEC staff to be on high alert for approaches to ICOs that may be contrary to the spirit of our securities laws and the professional obligations of the U.S. securities bar.”
What do these statements mean for companies considering an ICO?
The takeaway here is that companies thinking about an ICO need to make sure that they act in compliance with state and federal regulations—that was always the case, but now the stakes are a bit higher as these types of offerings are getting increased scrutiny. If you have questions or concerns about an initial coin offering or an initial token offering, please contact us.