As anyone who is active in the blockchain space is very well aware, 2017 saw an enormous increase in the number of "Initial Coin Offerings" (ICOs) that have been arranged. Over US$5.68 billion was said to have been raised in 2017, with over 1.4 billion in December 2017 alone, for example.

The key advantages of ICOs for fund raisings have been:

  • speed;
  • lack of bureaucratic "red tape";
  • interest generated by offerings; and/or
  • low cost of the process.

In recent months, there has been an increased regulatory focus on ICOs. Just to recap in very basic terms – the regulations we are dealing with differ between the various jurisdictions, but all are directed at the same policy objectives, namely investor protection from abuses that were rampant around the world before regulation was introduced. So, for example, persons offering securities (e.g. an equity investment opportunity in a business) are required (subject to exemptions) to issue a prospectus that fully and fairly describes the business, the risks and the management, etc., so that investors can make properly informed decisions, with liability for misstatement. Post-investment share dealing by the pre-Initial Public Offering (IPO) shareholders may be restricted. This is, of course, a gross over-simplification of a significant area of law that keeps many thousands of lawyers very busy the world over.

Many in the blockchain space have exulted in the ability of the distributed technology to confound boring old world restrictions and set free the power of bold, forward thinking visionaries and their followers, and the ability of the little guy to get in on the ground floor, ahead even of venture capital.

Regulators have generally been slower than many expected to make their positions known. Possible contributing factors to the slowness to address these questions publically by regulators:

  • a number of jurisdictions have an eye on encouraging innovation, hoping to become or maintain early leadership as hubs for fintech business;
  • the difficulty in balancing questions of how to further such economic ambition with regulation to protect consumers;
  • although ICOs have raised large sums, there has been relatively little mainstream penetration; and/or
  • general uncertainty as to how to distinguish between ICOs with and without investment characteristics.

Lawyers have been watching carefully for indications from regulators around the world, recognising that, although ICOs may take an outwardly unusual form, many of them undoubtedly look, walk, and talk like securities.

Here we review developments in certain key jurisdictions since the United States (US) Securities and Exchange Commission (SEC) made an announcement on 25 July 2017.

United States

Perhaps not surprisingly, the US moved first. On 25 July 2017, the SEC's Enforcement Division announced its conclusions about whether The Decentralised Autonomous Organisation (The DAO) that had issued The DAO tokens in an ICO on the Ethereum blockchain in 2016, broke securities regulations. The SEC decided that The DAO tokens were securities and their offering and sale violated securities laws as it was not registered with the SEC and did not qualify for any of the permitted exemptions from registration (although it decided not to pursue enforcement action). The release is useful in that it lays out a brief history of The DAO and then analyses that against the US Securities Act and the case law.

One line is, we think, of interest to all proponents of a token sale:

"The touchstone of an investment contract [Note: an investment contract is a kind of security, and the SEC concluded that The DAO was an example of an investment contract] is the presence of an investment in a common venture premised upon a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others."

Lest we think that this is an invitation to devise an ICO that evades one or more of these descriptions so as to take it outside the definition, the SEC further goes on to quote the seminal case of SEC v. W.J. Howey Co. (328 U.S. 293 at 299) which calls the definition a "flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits".

Those words do convey perhaps a slightly darker view of the endless ways in which hopeful investors can be parted from their hard-earned money than many blockchain enthusiasts will feel is appropriate for this new world of technology-enabled early-stage participation, but let us see.

Emphatically, the SEC supports looking at substance rather than form and went on to consider whether what was invested was money, whether there was a reasonable expectation of profit and whether this was to be derived from the managerial efforts of others (in which analysis the role of the founders and the "curators" in The DAO were important).

The SEC also held that the platforms that traded The DAO tokens satisfied the definition of an "exchange" and were therefore required to have been either registered or to have been exempted from such registration – neither of which requirements were met.

The SEC went on to lay out who can have liability in an unregistered offer of securities that is not exempted: "Those who have a necessary role in the transaction are held liable as participants". So, for example, it will be illegal for a broker, dealer, or exchange to effect any transaction in a token which is a security unless the offering and sale of the security and the relevant exchange it is traded on are either registered or exempted from registration.

The SEC's final word:

"Those who offer and sell securities in the United States must comply with the federal securities laws, including the requirement to register with the Commission or to qualify for an exemption from the registration requirements of the federal securities laws. The registration requirements are designed to provide investors with procedural protections and material information necessary to make informed investment decisions. 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 [Note: blockchain is a particular type of distributed ledger technology (DLT)].

In addition, any entity or person engaging in the activities of an exchange, such as bringing together the orders for securities of multiple buyers and sellers using established nondiscretionary methods under which such orders interact with each other and buyers and sellers entering such orders agree upon the terms of the trade, must register as a national securities exchange or operate pursuant to an exemption from such registration."

Reference:

Developments since:

  • The SEC announced the formation of a new cyber unit within its enforcement division that will also investigate "violations involving distributed ledger technology and initial coin offerings".
    https://www.sec.gov/news/press-release/2017-176
  • The SEC warned investors that some companies may have been publicly announcing ICOs (or related events) to affect the price of the company's shares. Specific warnings include companies claiming that their ICOs are "SEC compliant" without specifying how they are compliant, or companies describing their ICOs in "vague or nonsensical terms" or using unexplained technical jargon.
    https://www.sec.gov/oiea/investor-alerts-and-bulletins/ia_icorelatedclaims
  • The SEC charged a businessman and two companies with fraud in connection with two ICOs purportedly backed by diamonds and real estate. The pitch claimed that the offerors had a "team of lawyers... and accountants" when in fact, says the SEC, none had been retained.
    https://www.sec.gov/news/press-release/2017-185-0
  • The SEC's newly created cyber unit filed its first charges against an ICO alleging that a company called PlexCorps and its top officials had defrauded investors. The SEC has also obtained an emergency asset freeze in relation to this ICO.
    https://www.sec.gov/news/press-release/2017-219
  • The SEC issued a cease-and-desist order against Munchee from its ICO, stating that the tokens to be issued were "investment contracts" with the token purchaser having "a reasonable expectation of obtaining a future profit based on Munchee's efforts". The tokens were therefore securities, and Munchee violated the law by offering and selling the tokens without having obtained relevant approvals or exemptions.
    https://www.sec.gov/litigation/admin/2017/33-10445.pdf
  • The SEC filed a complaint against AriseBank (a cryptocurrency banking firm that claims to offer several banking products related to cryptocurrency) and its founders, alleging amongst others, that its ICO was an illegal offering of securities as there was no relevant registration or exemption from registration. The SEC stated that the ICO was "a general solicitation that uses statements posted on the Internet and distributed throughout the world – including the United States", and "was not limited by size, geography, number of investors, or investor accreditation status". The SEC also noted that AriseBank ICO's website "does not prohibit investments from U.S. citizens or make any assessment of an investor's accreditation".

    The SEC's complaint: https://cdn.ethnews.com/documents/318-cv-00186-M-02-06-2018.pdf
  • The Chairman of the SEC issued a statement on cryptocurrencies and ICOs.
    https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11:

    • the SEC recognises that ICOs may be "effective ways for entrepreneurs and others to raise funding", and "[t]he technology on which cryptocurrencies and ICOs are based may prove to be disruptive, transformative and efficiency enhancing";
    • however, any activity that involves an offering of securities must be accompanied by disclosures, processes and other investor protections required by law;
    • the statement made clear that not all digital tokens are securities:

"A key question for all ICO market participants: "Is the coin or token a security?" As securities law practitioners know well, the answer depends on the facts. For example, a token that represents a participation interest in a book-of-the-month club may not implicate our securities laws, and may well be an efficient way for the club's operators to fund the future acquisition of books and facilitate the distribution of those books to token holders";

  • however, the SEC will look at substance over form:

"... a blockchain entry on a distributed ledger may change the form of the transaction, but it does not change the substance... [m]erely calling a token a "utility" token or structuring it to provide some utility does not prevent the token from being a security. 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 ... simply calling something a "currency" or a currency-based product does not mean that it is not a security";

  • "market participants should treat payments and other transactions made in cryptocurrency as if cash were being handed from one party to the other", and shall ensure that their cryptocurrency activities are not undermining anti-money laundering (AML) and know-your-customer (KYC) obligations; and
  • market participants and their advisers should thoughtfully consider legal implications, including the principles-based U.S. securities law framework and to engage with the SEC staff to aid in their analysis.
  • The Chairmen of the SEC and the Commodity Futures Trading Commission (CFTC) testified before members of the Senate Banking, Housing and Urban Affairs Committee on 6 February 2018. In relation to ICOs, the key messages from the written testimony and the hearing were:
    • various regulators need to "come together" in crafting a coordinated plan, and put in place sound regulatory frameworks;
    • additional legislations and/or powers may be needed for effective regulation;
    • to date no ICOs have been registered with the SEC, with the SEC Chairman declaring that "I believe every ICO I have seen is a security"; and
    • the SEC will continue to "police these markets vigorously and recommend enforcement actions against those who conduct ICOs or engage in other actions relating to cryptocurrencies in of the federal securities laws".

Written testimonies of the Chairmen of the SEC and the CFTC:
https://www.banking.senate.gov/public/_cache/files/a5e72ac6-4f8a-473f-9c9c-e2894573d57d/BF62433A09A9B95A269A29E1FF13D2BA.clayton-testimony-2-6-18.pdf

; and
https://www.banking.senate.gov/public/_cache/files/d6c0f0b6-757d-4916-80fd-a43315228060/A2A6C1D8DDBB7AD33EBE63254D80E9E3.giancarlo-testimony-2-6-18b.pdf

Recording of the hearing:
https://www.banking.senate.gov/public/index.cfm/hearings?ID=D8EC44B1-F141-4778-A042-584E0F3B9D39

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