Registering ICOs as Public Offerings with the SEC
An initial coin offering (ICO) is a capital raising mechanism whereby companies sell bitcoins to investors or buyers in exchange for funds. (Usman Chohan, Initial Coin Offerings (ICOs): Risks, Regulation, and Accountability, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3080098). An ICO is different from traditional capital raises. Rather than selling shares of stock in a company, an ICO offers digital currencies or cryptocurrencies. In addition, most ICOs do not offer equity or a stake in the company’s projects. The concept of using ICOs to raise capital has grown exponentially in recent years as they pose a cost-efficient way of conducting transactions with little regulation. ICOs, however, also pose a greater risk of fraud due to their place in the unregulated market.
In response to these risks, the U.S. Securities and Exchange Commission (SEC) released a public statement proclaiming cryptocurrency exchanges as “potentially unlawful online platforms for trading digital assets”. (Tony Spilotro, Blockexplorer News). To regulate these online platforms, the SEC had to determine whether these digital assets were “securities” and therefore subject to regulation. The SEC reasoned that many of these digitals assets are in fact “securities” and must be registered with the SEC, essentially as an initial public offering (IPO); the method by which private companies issue corporate stock to the public. (Tony Spilotro, Blockexplorer News).
This public statement came about after the SEC investigated a Decentralized Autonomous Organization (hereinafter DAO), a virtual entity, which was selling tokens online. The SECexplained that an attacker used a defect in the DAO’s code to steal approximately one-third of the DAO’s assets, approximately $50 million dollars. The investigative report noted that the holders of DAO Tokens stood to share in the anticipated earnings from these projects as a return on their investment. In addition, DAO Token holders could monetize their investments by re-selling DAO Tokens on a number of web-based platforms (“Platforms”) that supported secondary trading in the DAO Tokens. Based on this information, the SEC determined that these exchanges met the definition of an investment contract, and therefore a security subject to regulation.
The Securities Act of 1933 created the registration requirements for securities. (Securities Act of 1933, Cornell Law). “The Securities Act serves the dual purpose of ensuring that issuers selling securities to the public disclose material information and that any securities transactions are not based on fraudulent information or practices.” (Securities Act of 1933, Cornell Law). To register securities, the company must provide a prospectus to prospective purchasers. A prospectus provides information such as “the issuer’s financial condition, the identity and background of management, and the price and amount of securities to be offered … .” and allows investors to make an informed decision. SEC v. Cavanagh, 1 F. Supp. 2d 337, 360 (S.D.N.Y. 1998). In essence, “the registration statement is designed to assure public access to material facts bearing on the value of publicly traded securities . . .”. SEC v. Aaron, 605 F.2d 612, 618 (2d Cir. 1979). In addition, Sections 5(a) and 5(c) of the Act prohibit the unregistered offer or sale of securities in interstate commerce, regardless of whether it is done with scienter or knowledge of the wrongdoing. SEC v. Universal Major Indus. Corp., 546 F.2d 1044, 1047 (2d Cir. 1976).
The SEC investigation into the DAO ultimately concluded that “these requirements apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology.”
Although the DAO investigation was released in July 2017, the first company to register an ICO with the SEC took place in March of 2018. The Praetorian Group referred to as a “Cryptocurrency Real Estate Investment Vehicle,” (CREIV), filed a $75 million dollar ICO as a security offering. (Molly Zuckerman, Cointelegraph). The purpose of the ICO was to raise money to buy and develop undervalued real state.
Before March of this year, the messenger app Telegram and camera giant Kodak filed an exemption to the registering requirements under SEC Rule 506(c), which provides that securities offered only to accredited investors do not need to be registered. (Molly Zuckerman, Cointelegraph). Under the SEC’s Code of Federal Regulation, an accredited investor refers to someone who, among other characteristics, has a net worth of at least $1,000,000, excluding its primary residence, or has an income of at least $200,000 each year for the last two years.
In May, Monster Products, Inc., filed the largest filing to date, registering a $300 million-dollar ICO to create the “Monster Money Network,” a platform for purchasing products online with Ethereum tokens. (Brady Dale, Coindesk).
The practice of registering ICOs with the SEC is still very new within the cryptocurrency industry. The use of Bitcoin and other cryptocurrencies as a way of raising funds will continue to develop as the SEC continues to regulate these “securities.” As J. Christopher Giancarlo, chairman of the US Commodities and Futures Trading Commission stated, “[w]e owe it to this generation to respect their enthusiasm about virtual currencies with a thoughtful and balanced response, not a dismissive one.” (Andrew Nelson, Nasdaq).