The emergence of initial coin offerings revolutionized public companies and fundraising. With very few SEC regulations, companies were allowed to raise millions of dollars that weren’t scrutinized by red tape. Companies who were able to sell their vision and coin to the public earned big. However, ICOs are now governed by regulatory bodies that provide oversight to deter scams and fraud. The ICO space is still relatively new with substantial growth potential. Therefore, companies must now ensure that they also adhere to SEC regulations or risk paying taxing fines.

What are ICOs?

Initial coin offerings are the IPOs or initial public offerings of the cryptocurrency industry. Companies wanting to raise money to support a new coin, app, service, or produce, launch an ICO to fundraise. Investors buy into the company and receive a token in exchange for their support. This token often represents a share in the company.

ICO Rules and Regulations 

In 2017, the SEC broke its long silence regarding the regulation of means of raising capital using blockchain technology. This includes initial coin offerings (“ICOs”), token generation events, among others. They issued a press release, investigative report, and investor bulletin exploring these concepts in the context of The DAO (a “Decentralized Autonomous Organization”). This innovative but ultimately failed organization made use of the Ethereum blockchain. While substantive regulations likely are distant, the pronouncements lend much-needed color to the SEC’s posture regarding cryptocurrency.

Decentralized Autonomous Organization

The DAO represents the first large-scale attempt to create a “virtual,” code-based organization through the distributed ledger and “smart contract” technology. The DAO, created by Slock.it, raised funds and hold a body of assets through the sale of DAO Tokens. Proceeds from token sales were supposed to fund various “projects”. Such projects were to be selected by Slock.it and presented to token-holders for voting. Each token-holder was to vote on which projects to adopt and share in the earnings generated by such projects. Besides, token holders could liquidate their DAO Token holdings through many platforms that supported secondary trading.

From April 30, 2016, through May 28, 2016, ~12 million Ether were exchanged for over 1.15 billion DAO Tokens. Ether is the primary virtual currency used on the Ethereum blockchain. This equated to a value of approximately $150 million. Following the DAO Tokens’ sale, but before funding any projects with the proceeds, a major event happened. A code-based attacker stole nearly one-third of The DAO’s assets and put a halt to its operations.

SEC Analysis

The SEC’s analysis of The DAO centers on two things. Whether DAO Tokens constitute securities under the Securities Act of 1933 (the “Securities Act”) and the Securities Exchange Act of 1934 (the “Exchange Act”).

Under the Securities Act Section 2(a)(1) and the Exchange Act Section 3(a)(10), an “investment contract” is considered a security. Applying a test based on the “facts and circumstances” of each case, courts generally treat four items as an investment contract, and therefore a security. These include (i) an investment of money, (ii) in a common enterprise, (iii) with a reasonable expectation of profits, and (iv) to be derived from the entrepreneurial or managerial efforts of others.

The majority of the SEC’s analysis centered on whether profits from the DAO were derived from others’ managerial efforts. The central inquiry was “whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.”

The SEC first drew attention to the investors’ reliance on the efforts of Slock.it to maintain the DAO and to propose projects to generate profits for token-holders. Next, the SEC noted that token-holders’ expectations were “primed by the marketing of The DAO and active engagement” between Slock.it and token-holders.

The SEC also drew attention to the pseudonymity and significant dispersion of token holders. They concluded that token holders resembled corporate stockholders, not limited partners. These attributes of token holders, compounded by their sheer numbers, contributed to a system in which investors generally exerted minimal control. The investors had little ability to “consolidate their votes into blocs powerful enough to assert actual control”. As a result, the SEC concluded that DAO Tokens were functionally equivalent to traditional securities. They should be subject to similar regulations.

Should My Company Start an ICO?

The SEC report does not mince words. Blockchain token sellers are not exempt from federal securities laws. Moreover, the argument that smart contracts operate autonomously and remove managerial control from token issuers just became less attractive. However, the upshot for any company contemplating an ICO is that not all tokens will be considered securities. An ICOs determination is based on the “facts and circumstances” of each case. Moreover, the SEC broadly endorsed the use of blockchain technology. They stated, “We welcome and encourage the appropriate use of technology to facilitate capital formation and provide investors with new investment opportunities.”

Tips For SEC Regulations

To remain on the friendly side of the SEC, however, issuers who seek to avoid regulation should consider the following:

“Utility Tokens” Remain a Valid Alternative to “Securities Tokens”.

Utility tokens provide holders with specified utility or functionality. This is unlike tokens on which purchasers expect a return on investment. Utility coins could be used, for instance, to fund the development of software. Additionally, they can be used to purchase software or to access additional functionality within the software. Utility tokens’ value may fluctuate with demand for any related products or services. However, utility tokens do not entitle the holder to ownership rights. They thus are more likely to avoid onerous regulation. In its report on The DAO, the SEC makes a clear statement. The SEC stated that its investors were “motivated, at least in part, by the prospect of profits on their investment.” The report did not explicitly delineate the boundary between utility tokens and “securities tokens”. But, the report certainly implies that non-investment-based expectations should be the only expectations of utility token holders.

Avoid “Investment-Like” Communications.

Be careful about communications with token holders and potential token holders. You should avoid language which mistakenly creates the expectation of profit through the issuer’s efforts. The SEC meticulously analyzed communications by Slock.it in its white paper and elsewhere. They aimed to determine the extent of the issuer’s actions and the expectations of coin holders. Issuers of utility tokens should avoid language concerning return on investments altogether.

Voting Rights are not Enough.

While it may not come as a surprise, voting rights do not constitute significant efforts on the part of token holders, such that they should be considered akin to limited partners. In other words, voting rights alone are not “essential managerial efforts that affect the enterprise’s failure or success.” After all, voting rights are often granted for shares of stock and other traditional securities. To shift significant “managerial efforts” from an issuer of tokens to token purchasers, such purchasers must play a much more essential role in making the enterprise profitable.

Launching an ICO in 2020

In 2020, the SEC collected $1.26 billion from unregistered ICOs. As it stands, most coin issuers must make a choice-attempt to create a “pure utility” coin. This coin is one that does not meet the SEC regulations definition of a security. It also does not meet that definition and concede the liquidity and scale of investment offered by public trading. Some have found a third path, excluding contributions from citizens or residents of the US altogether. But the dilemma remains for most issuers.

One fact compounds the trepidation of potential issuers. Per the Exchange Act, unregistered security buyers can, on their own, sue sellers for a return of his investment. In such a case, a judge, rather than the SEC, can determine whether an ICO constitutes a securities offering. With such looming uncertainties, coin issuers require more clarity than ever before. Until clear regulations are set forth, “securities” tokens are increasingly likely to be treated like securities of any other kind. It’s anyone’s guess what effect that will have on the market.

Let us know if you need more information about ICO opportunities and how SEC regulations can impact your company. Schedule a consultation with Bagchi Law.