Securities and Exchange Commission Chairman Jay Clayton issued a statement this week cautioning investors and market professionals about the use of initial coin offerings (ICOs) to raise capital. The statement, the latest communication from the SEC about the burgeoning ICO market, suggests there is no bright line test for determining whether a token sale runs afoul of federal securities laws and cases will continue to be evaluated on their specific circumstances.
“Main Street investors”
While acknowledging that ICOs can be an effective way for startups and others to raise money, Clayton warned “Main Street investors” of the dangers associated with cryptocurrency and ICO markets, which have less investor protections than traditional securities markets.
ICOs have seen a recent explosion in popularity, raising more than $3 billion. In fact, I receive a call about potential ICOs weekly. I’m currently working on a few. Clayton touched on some common questions from investors, including those surrounding the potential risk of loss associated with any particular offering and whether the offering is legal. “The answers to these and other important questions often require an in-depth analysis, and the answers will differ depending on many factors,” he wrote.
The SEC chairman highlighted some potential red flags for investors, including if a promoter guarantees returns or pressures them to act quickly. He also noted the global nature of the ICO markets, saying the SEC may not be able to pursue bad actors or recover funds that go overseas.
Clayton’s statement included a list of sample questions for investors considering investing in an ICO, which can be found here.
The SEC issued a report this summer concluding the currencies offered in an ICO by an organization called The DAO were subject to federal securities laws. Specifically, the commission, analyzing the offering using the age old “Howey Test,” concluded the token offering was a securities offering because it represented an investment of money in a common enterprise with a reasonable expectation of profit derived from the efforts of others.
Clayton in his statement said that in the wake of the report, some have attempted to highlight utility characteristics of their proposed ICO in an effort to claim the tokens are not securities. The chairman said many of these assertions elevate form over substance.
“Merely calling a token a ‘utility’ token or structuring it to provide some utility does not prevent the token from being a security,” he wrote. “Tokens and offerings that incorporate features and marketing efforts that emphasize the potential for profits based on the entrepreneurial or managerial efforts of others continue to contain the hallmarks of a security under U.S. law.”
Clayton also warned against promoting the offer and sale of coins without first determining whether those coins are securities (those who sell securities generally need a license). He further cautioned exchange operators that they may be overseeing unregistered exchanges or acting as broker-dealers that are in violation of the Securities Exchange Act (see my prior blog post on broker-dealers and finders).
Clayton’s statement came the same day as the SEC took action to stop an ICO by Munchee Inc. The California-based restaurant review site planned to raise $15 million by selling MUN tokens to further develop an iPhone app, according to the Commission, which intervened after concluding Munchee’s conduct constituted unregistered securities offers and sales. The focus there was on marketing materials emphasizing “the company would run its business in ways that would cause MUN tokens to rise in value.” The marketing materials stated “[a]s more users get on the platform, the more valuable your MUN tokens will become.” The 2 primary issues there were the plan to use the proceeds of token sales to fund operations and the overzealous marketing efforts focusing on the profits token purchasers could expect.
The SEC said the company refunded investor proceeds before any tokens were delivered.
The SEC has made it clear that all ICOs must be analyzed on their specific facts based on existing law. Pursuant to the “Howey Test,” a token is an investment contract and thus a security if it is a “contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”
ICOs are enticing in that they enable entrepreneurs to turn the typical financing life cycle on its head. Typically, companies build a real product/business before the founders exit/gain liquidity. Many ICOs have enabled founders to exit before they have created anything, though likely running afoul of US securities laws. Any “utility tokens” are likely securities before the network is launched, even if they will have functionality after launch, because before the launch the real risk/reward derives from the founders’ ability to execute and launch the network. If the network never launches, the tokens will never have functionality/value.
Before preparing a whitepaper and conducting an ICO, I highly encourage token promoters to contact a qualified attorney to discuss the risks involved and a strategy to reduce those risks.