[Sorin is an office managing partner and cochair of the Venture Capital & Emerging Growth Companies practice at McCarter & English.]
With the advent of blockchain technologies and related service companies, many startups are employing or examining a new way to raise capital: initial coin offerings (ICOs).
Many of these ICOs are being conducted outside the scope of securities laws and regulations, relying on the presumption that the instruments being offered (referred to alternatively as coins or tokens) are not securities and, therefore, are not subject to the regulatory requirements applicable to securities offerings.
Issuer, beware! The SEC and other regulatory bodies are applying a facts and circumstances test to each ICO, and looking at underlying economic realities of the offering.
The U.S. Supreme Court long ago determined that an instrument was a security subject to U.S. securities laws if it (1) involved investment of money, (2) was in a common enterprise, (3) included a reasonable expectation of profits and (4) derived from the entrepreneurial or managerial efforts of persons other than the investor. These criteria are being applied to ICOs, and their first cousin, SAFTs (simple agreements for future tokens), to determine if the coin offered is a security.
While cryptocurrencies may result from technological innovation and increased reliance on and acceptance of a digital economy freed from the concepts of hard currency and related monetary instruments, securities laws are not the only issue to consider.
Some economists are concerned about the sovereign power of nation states to control and regulate their money supply, with the concomitant impact on the viability and effectiveness of monetary policy. Like the SEC, interested in maintaining confidence in securities markets, governments too are examining the risks and rewards of cryptocurrencies and their possible impact on the future viability of government power and economic policies.
What are ICOs? Basically, companies are able to raise capital by creating and selling their own cryptocurrency in exchange for either “real” currency or another form of virtual/digital currency. These tokens may be used to acquire future products or services of the issuer, but also may be held or traded for investment purposes.
Some issuers, perhaps in an effort to avoid SEC regulations, have narrowly defined their cryptocurrency as utility tokens, limiting their use only to acquire goods or services from the issuer, similar to a prepaid gift card whose value can change based on the laws of supply and demand. Utility tokens, properly defined, should not be classified as securities.
But SAFTs, dividend- or interest-bearing tokens, or those that involve revenue sharing or profit sharing, are securities, and issuers of these instruments should err on the side of conservatism and compliance. They may register their offerings of cryptocurrency in a traditional registered public offering, or otherwise comply with the securities laws and SEC rules and regulations, by relying on exemption therefrom, such as the private offering exemption, Regulation D, or Regulation A+ offering, the latter of which just may achieve the elusive twin goals of sales and issuances to non-accredited investors and free tradeability post-offering.
The SEC warned this summer that regardless of terminology, it is examining the “economic realities” of each ICO to determine if a coin or token is a security—and soon thereafter, intervened in the highly anticipated ICO by Protostarr, a blockchain-based startup. As a result, the company was forced to cease operations and refund the Ethereum collected in its crowdsale that it conducted outside the scope of securities regulatory requirements.
Because some professionals and investors caution that ICOs are speculative and ripe for abuse, it is undeniable that the SEC will, especially in light of the huge dollar amounts at issue and the high-risk nature of these transactions, seek to regulate most ICOs as securities, though some limited issuances of cryptocurrency may well be utility tokens, narrowly defined so that they do not fall within the purview of the securities laws.
ICOs face a rapidly evolving future. There are clear and compelling economic and monetary policies and implications associated with cryptocurrencies and their offerings and subsequent trading, yet cryptocurrencies offer incredible opportunities for capital raising, economic risk and reward, and peer-to-peer electronic cash exchange that can reduce risk and help companies avoid financial institution intermediation. The breadth of applications is stunningly large, with the possibility of disrupting virtually every industry.