ICO Overview and Securities Law Analysis
After a number of recent, high-profile and wildly successful Initial Coin Offerings or “ICOs”, the blockchain-based asset industry has been abuzz about new ICOs as well as the regulatory issues that surround the space. This post provides a quick overview of the big securities laws issues surrounding these assets and discusses the regulatory structure currently applicable to the space.
An initial coin offering is the first distribution of a digital currency or digital token, normally offered exclusively through an online offering. These coins or tokens, like many existing cryptocurrencies such as Bitcoin or Ether, may represent some sort of fractional ownership in something (working similar to a security) or may represent a form of payment (like a currency). These tokens may be pre-launch (to raise money to develop the use case, similar to crowd-funding) or post-launch (use case already exists).
Are ICOs Securities?
The first and biggest question related to ICOs is whether they are securities offerings (essentially digitized IPOs). For any inquiry into whether something is a security or not, the starting point is the Howey Test. Howey is a basic four-part test that is used to determine whether a contract, a transaction, or a series of actions constitutes a security under the Securities Act of 1933. The very broad overview of the Howey prongs are:
- It is an investment of money
- There is an expectation of profits from the investment
- The investment of money is in a common enterprise
- Any profit comes from the efforts of a promoter or third party
For many ICOs the answers to all of the above are usually “yes”. We do, however, believe that some ICOs are not securities under the test and, although we start with Howey, that is not where the analysis stops. As mentioned before in our post dealing with Bitcoin Hedge Funds, we believe that Debevoise’s Securities Law Framework provides a thoughtful approach to think about and analyze this question. We also believe that the SEC will clarify its position regarding ICOs in the next several months.
Use Case – Blockchain Capital
One of the more interesting ICOs recently has been the ICO for the Blockchain Capital Token (BCAP Token, on TokenHub), which was placed by Argon Group, a blockchain asset investment bank. Here the value of the BCAP Token is linked to the value of a newly created venture capital fund (which initial assets were received through the BCAP Token ICO process). The subscription process of the ICO was conducted through a Regulation D 506(a) offering (see Blockchain Capital Token Form D), so there are a number of regulations that the group has already gone through, although none specifically dealing with the ICO itself. What is particularly amazing is that the offering of $10M was oversubscribed and closed in only 6 hours. The power of the ICO is apparent – what investment fund manager would not want to raise money in a very quick and efficient manner?
Blockchain Capital paved the way for ICOs linked to private investment funds – we would expect to see tokens linked to hedge funds and private equity funds in the near future. While the Blockchain Capital offering was limited to accredited investors, the offering still presents questions about regulations, including the potential for fraud. We liken the ICO process to something akin to the crowdfunding process and believe there are similar risks, in addition to the normal risks associated with the linked asset (in this case, a VC fund).
There is no doubt that the regulators will begin to figure out a regulatory regime for ICOs and cryptocurrencies, and this is likely to happen before any sort of Congressional action to change the laws of any of the securities or commodities acts. The CFTC has already been active in the space (see our previous notes in our Client Update here) and it is very likely that the SEC will be starting the process to issue regulations as well (see here where a group has petitioned the SEC to begin that process). We believe that during that comment and rulemaking process, the regulators will need to address a number of items, including the process with respect to ICOs. The SEC needs to move with a deft hand, however, because any onerous regulations will just push business offshore – there are already exchanges who discriminate against potential market participants based on domicile (either with respect to U.S. domicile, or in some cases, New York domicile for fear of issues around the New York BitLicense regulations).
The crowdfunding space became regulated fairly quickly and there are now specific crowdfunding broker-dealers and I believe the same will be the case with the ICO regime. We believe that any cryptocurrency regulatory regime will include requirements with respect to ICOs and ICO investment banks.
The ICO market is white hot and getting hotter. It will undoubtedly create both winners and losers (and the winners are likely to be massive winners) and in some cases will usher in new ideas and technologies that will help define the landscape of Web 3.0. The most important thing for regulators (and lawmakers) is to make sure all investors in these offerings are protected and provided with all necessary information and opportunities as provided through the current securities and commodities laws. We believe that such regulation will come sooner rather than later.
Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon has been instrumental in structuring the launches of some of the first digital currency-focused hedge funds. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.