The U.S. Securities and Exchange Commission (SEC) recently dampened the market for initial coin offerings (ICOs). This action may have been an opening salvo in what appears to be a growing consensus of securities regulators globally about the application of the securities laws to certain aspects of the ICO marketplace, driven in part by the potential for fraud, money laundering, and circumvention of securities laws in the ICO marketplace.
On July 25, 2017, the SEC issued an investigative report warning that digital tokens may be securities under the Securities Act of 1933 (the Securities Act) and the Securities Exchange Act of 1934 (the Exchange Act) and, therefore, subject to regulation under the federal securities laws. See Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, SEC Release No. 81207 (July 25, 2017) (the Report). The Report presents significant legal ramifications for certain issuers of ICOs and their intermediaries, which threatens to frustrate some of the motivating rationales for the use of ICOs, namely, the ease of fundraising and the flexible resale of tokens on a secondary basis. The subsequent resale of a digital token that is an unregistered security not subject to a valid exemption could itself be a violation of the securities laws. The SEC Report and the accompanying investor bulletin, which expresses concern about potential fraud and unregulated capital formation, are clearly designed to send a message that the SEC is scrutinizing the ICO marketplace. Coincident with the Report, the SEC issued an investor bulletin cautioning investors about the risk of fraud in the ICO market. Subsequent to the Report, the SEC issued an investor alert that highlighted enforcement concerns with ICOs and detailed several cases in which the SEC suspended trading in digital tokens issued in ICOs. Recent news accounts also indicate that at least one ICO issuer determined to cease operations and issue refunds after it was contacted by SEC staff.
The Report, which analyzes distributed ledger tokens issued by a virtual organization known as “The DAO,” makes clear that the SEC will scrutinize the facts and circumstances of a token offering under the traditional test for determining whether an instrument meets the definition of an “investment contract” and is therefore a security, as articulated by the Supreme Court in SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946). Under the Howey test, an investment contract exists when a transaction involves an investment of money or other valuable consideration in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. Where an ICO is done to raise start-up capital for an enterprise, a separate set of considerations may lead to a finding that the digital tokens issued in the ICO are securities even if they would not be considered as such under the Howey test . In applying the Howey test to The DAO tokens, the SEC focused on whether the tokens (i) created a commonality of interests between the purchaser and the enterprise, and (ii) vested voting or other ownership rights similar to the rights associated with traditional equity investments.
Issuers of tokens and their intermediaries should review with counsel the applicability of the Howey test to any outstanding or contemplated ICO. Deeming a token a security creates a cascading set of implications under the U.S. securities laws, including with respect to the Securities Act, the Exchange Act, the Investment Advisers Act of 1940, and the Investment Company Act of 1940. Issuers and intermediaries should take particular care to potential implications under the Exchange Act, including broker-dealer registration requirements, compliance with Regulation Crowdfunding, and registered exchange requirements. All participants making representations about an ICO or the associated smart contract must understand that they may be liable under the antifraud provisions of the Securities Act and the Exchange Act for material misstatements, omissions, or other forms of deceit.
Failure to comply with applicable securities laws may result in civil penalties, which may include investor rescission rights and monetary penalties as well as criminal penalties. Additionally, issuers and intermediaries must consider issues such as anti-money laundering obligations, Commodity Futures Trading Commission regulations, cybersecurity protections, tax structuring, and money transmitter laws.
Non-U.S. Regulator Actions
In addition to looking at U.S. regulatory issues, participants in ICOs and other token transactions must be mindful of non-U.S. regulatory issues. Many digital token offerings involve cross-border structures or participation. The consensus of regulators that ICOs may implicate non-U.S. securities laws is important because many ICOs have been structured, often ineffectively, to avoid offerings in the United States under the presumption that digital tokens issued in transactions outside the United States may not be regarded as securities.
After the SEC issued the Report, securities regulators in several countries issued warnings about the application of their securities laws to ICOs and the intermediaries and cryptocurrency exchanges that support them:
- The Monetary Authority of Singapore (MAS) issued clarification that it views certain tokens as securities under Singapore law. See MAS Clarifies Regulatory Position on the Offer of Digital Tokens in Singapore, Monetary Authority of Singapore (Aug. 1, 2017). The MAS’ guidance should disabuse the market of the perception that the MAS would not deem tokens to be securities.
- The Canadian Securities Administrators issued a notice that stated that many cryptocurrency offerings involve sales of securities under Canadian law. See Cryptocurrency Offerings, CSA Staff Notice 46-307 (Aug. 24, 2017).
- On September 3, 2017, South Korea’s Financial Supervision Commission, in conjunction with the Korea Fair Trade Commission and the National Tax Service, announced plans to introduce regulations on the trading of digital currencies in South Korea and indicated that “punishments” could be assessed against international ICOs involving the sale of “securities.”
- On September 4, 2017, the People’s Bank of China (PBOC) and other Chinese financial regulators went further than regulators in other countries, calling ICOs an illegal public financing activity and outright banning ICOs in China. (The Chinese language edict may be found here. An unofficial translation may be found here.) As a result of this pronouncement, sponsors should analyze whether they must unwind transactions with Chinese investors and return investor funds. Given the crucial role that Chinese investors have played in the growth of the ICO market and the recent rise in valuations, this sweeping ban may have a chilling impact on the ICO market.
- Also on September 4, 2017, the Central Bank of the Russian Federation warned about the risks of exchanging cryptocurrencies and participating in ICOs. (The Russian language version may be found here. A summary news article may be found here.) The bank stated that, at the present time, it would not allow tokens to be used on official exchanges in Russia.
- The day after the PBOC’s edict, the Hong Kong Securities and Futures Commission (SFC) cautioned that digital tokens in ICOs may involve the sale of securities and therefore would need to comply with the Hong Kong securities laws. See SFC, Statement on Initial Coin Offerings (Sept. 5, 2017).
It should be expected that regulators in other countries are examining the implications of ICOs under their respective securities and financial markets laws and may express similar views. Regulators in other jurisdictions, including Ukraine and the United Arab Emirates, have recently joined the list of those expressing concerns about the status of cryptocurrencies and ICOs, although regulators in Japan and in Taiwan have taken a more benign view. The securities regulators will probably look to apply their view of the law on ICOs where the issuer is in their country or if investors in their country receive marketing materials about an ICO or purchase a token issued in an ICO.
In conclusion, securities regulators globally appear to be coalescing on the securities implications for certain digital token issuers and the intermediaries for such offerings. Because of the market’s evolving nature and the distinct possibility of disruptive enforcement action, participants in this burgeoning market should carefully analyze existing and contemplated ICOs under applicable securities laws.