The US's Securities and Exchange Commission (SEC), which conducts oversight of the country's stock and options exchanges as well as the securities industry as a whole, has increasingly been cracking down with severity on fraudulent initial coin offerings (ICOs), for violating securities laws. Ever since Bitcoin and other cryptocurrencies have entered the mainstream, willing but naive investors interested in this new asset class have also become targets.
Which means, if you're considering investing in an ICO, it's a good time to become more familiar with what the SEC calls the 3-Rs, the Risks, Rewards and Responsibilities surrounding these offerings.
Buyer Beware
For those unfamiliar with ICOs—which have become a popular way for start-ups to raise funds without having to rely on middlemen such as venture capitalists or investment banks—an initial coin offering is the cryptocurrency world's version of an initial public offering (IPO) for stocks. ICOs are also sometimes called ITOs or initial token offerings. And much like investing in shares of a stock, some coins provide investors with a stake in a healthy, growing enterprise, while some only provide issuers with a way to defraud investors.
Earlier this week the SEC alleged that Sohrab Sharma and Robert Farkas, co-founders of Centra Tech, a company billing itself as a financial services start up, masterminded a fraudulent ICO via its CTR token. The SEC accused the pair of "orchestrating a fraudulent...offering."
This latest example is just one of a number of recent cases across a broad array of industries. Last October the SEC charged Maksim Zaslavskiy and two of his companies with selling unregistered securities. According to the SEC, Zaslaviskiy was selling digital tokens that he claimed were backed by diamond and real estate investments.
Unfortunately for investors, the assets being peddled via Zaslavskiy's REcoin Foundation and Diamond Reserve Club didn't really exist. The charge includes Zaslavskiy falsely claiming to investors that between $2 million and $4 million had already been raised when in fact the actual amount was approximately $300,000.
Another recent case involves Overstock.com (NASDAQ:OSTK), the online retailer of such things as homegoods and jewelry that has been trying to transform itself into a cryptocurrency powerhouse via its tZero subsidiary. The company's stock, which started the year at $86.90 has tanked. It's down 58% so far this year, currently selling at $36.65 as of yesterday's close. These heavy losses have been fueled by the company frantically selling off shares in order to pay off debt and finance tZero's activities. It doesn't help matters that its efforts to raise capital for tZero via an ICO are currently under investigation by the SEC.
A document published by Kevin M. LaCroix, the executive vice president at RT ProExec in Ohio, a division of R-T Specialty, LLC, underscores that Overstock is more than just a 21st century technological morality tale. He writes that the SEC’s slow but serious enforcement approach will culminate in a crackdown that knocks out the excesses.
But in the meantime, and at least for now, there are going to be more companies, even established firms such as Overstock, getting involved with, and possibly into trouble from, these digital assets. According to LaCroix:
“For starters, there is the context within which Overstock was making its blockchain and cryptocurrency play. According to CoinSchedule (here), in 2017, issuers raised $3.88 billion through 210 ICOs. Pretty impressive, for sure. But in just the first three months of 2018, issuers have already raised $4.9 billion in 158 ICOs. Of the total of nearly $8.8 billion raised in ICOs in 2017 and so far in 2018, $6 billion was raised just in the fourth month period from December 2017 to the end of March. Regardless of how you feel about all of this, you have to acknowledge that this is a serious amount of economic activity.”
Trace Schmeltz, a partner who works in both the Chicago and Washington, D.C. offices of Barnes & Thornburg LLP, explains that in the US it's become abundantly clear that the SEC intends to treat any ICO that seeks to raise money for an enterprise as the sale of a security that either must be registered or has to meet an exception of registration.
“Any debate about whether a coin is a utility token or not—during the fundraising phase—is entirely academic. The SEC will pursue enforcement action against anyone seeking the benefits of the United States capital markets without following the requirements of the Securities Act. Of course, this is even more true if the token offered as part of the fundraise is entirely illusory, as recent enforcement actions demonstrate.”
Schmeltz cautions that the rules are getting tougher. Indeed, the wild west atmosphere that was once a hallmark of the cryptocurrency eco-system is beginning to fade. Schmeltz offers some advice for anyone looking to launch an ICO:
“As a result, anyone looking to sell a utility token without registering or meeting an exception to registration ought to seriously consider doing three things: (1) ensure that the coin launch is entirely unrelated to fund raising; (2) have a proven, demonstrable, concept for the utility token; and (3) be prepared to provide users with near-immediate access to the blockchain network on which the tokens can be used. If you are in development or concept phase, your token is not appropriate for an initial coin offering.”
Though the SEC might be cracking down, crypto investors need to become more wary as well. Elad Shabi, COO of Firmo Network stresses that before making any investment decision, it's critical to be aware of who the founders and team members are and to have done a deep drilldown on their track records and experience and reputation in their relevant fields.
“It's also important to understand whether they are fully committed and devote their time to the ICO company. The lead investor is also an indicator. Is it a long term player that believes in the product and tech or simply a flipper that has invested for a quick buck. The token model has to be valid i.e meaning that if the company will be successful one day, it will be reflected by the token demand and token price. Investors and founders incentives should be alligned and linked to the token price for the very long term. And most importantly, ask all the questions you'd ask a regular start-up looking to raise money for its first round…”
Only Fools Rush In
Dr. Jeppe Stokholm, a Danish attorney based in Zurich who specializes in crypto law says:
“Only fools rush in where angels fear to tread. The remedies for violation of securities laws include rescission of the offering, cease-and-desist orders, fines and penalties, bans from participating in the securities industry, bans on serving as an officer or director of a public company, and, potential referral to the local authorities for possible criminal prosecution.”
Stokholm notes that since blockchain projects can be handled peer-to-peer without any physical borders, there's one key risk to watch out for: a token, as well as its offering, could trigger different legal hazards in different countries based on sovereign securities laws. It's therefore highly recommended to investigate, which tokens may – and may not – be qualified as crypto securities when preparing or launching or investing in a blockchain project.
There are some basic points to keep in focus. According to Stokholm, crypto securities are legal in most developed countries, but the regulation is dependent on the jurisdiction in which the crypto security will be used. Legal status will also depend on the purpose of the activity that's driving the crypto issuance.
As a rule of thumb notes Stokholm, to determine whether a token is a crypto security or not, a “substance over form” test should be applied. It's not the form (i.e. the label or mask of a token), but the actual underlying facts and circumstances—including the economic realities of a transaction—that define whether a token must be categorized as a crypto security.