Can ICOs be resuscitated from the dead?
HONG KONG, November 21 — Following last Friday’s SEC actions against Paragon Coin and Airfox, we file this quick report on the state of play for US and non-US ICOs and ask if all hope for a new funding model for blockchain networks is now lost.
Last Friday’s enforcement actions by the US Securities and Exchange Commission (“SEC”) against two ICOs conducted by US-based issuers during 2017 represents a significant gearshift in US regulatory enforcement.
In addition, the SEC’s Statement on Digital Asset Securities Issuance and Trading (the “Statement”), issued in parallel on the same day, serves as an extra reminder to ICO issuers, investment vehicles and exchanges in digital asset securities that market participants must still adhere to federal securities laws “regardless of whether the securities are issued in certificated form or using new technologies, such as blockchain.”
So far so predictable
Many practitioners rightly point out that last Friday’s SEC actions should not come as a surprise.
In many ways, the two enforcement actions and the Statement are entirely consistent with (and explicitly make mention of) past datapoints, including the SEC’s report on The DAO back in July and more recent actions against i.a. Crypto Asset Management, TokenLot, and EtherDelta’s founder.
As a result, the Statement in many ways consolidates the SEC’s approach in relation to 3 key market participants: ICO issuers, funds that invest in digital asset securities and exchanges that deal in them
(1) ICOs that offer and sell digital asset securities have to register with the SEC unless they fall within an exemption.
(2) Investment vehicles that hold digital asset securities must be registered as an investment fund. Those who advise others about investing in digital asset securities, including managers of investment vehicles, must be mindful about applicable registration, regulatory and fiduciary obligations.
(3) Secondary market trading of digital asset securities require registration as a national securities exchange or registration as a broker or dealer, as defined under the federal securities laws.
The significance of last Friday’s actions and the Statement is not so much that they summarise the SEC’s long-held views but rather that they seem to forebode a new zeal in regulatory enforcement.
This should have every team that ICOd from within the US but also from outside the US on tenderhooks:
1. Cease-and-desist, settle, repeat
The wording of both enforcement actions, whilst based on the individual characteristics of each token, is very similar both in its legal analysis and its remedies.
All indications are that last Friday’s actions may be the first in a series, part of a concerted campaign by the SEC to come after issuers who did an ICO to US investors without registration or without using one of the available safe harbours under US securities laws.
2. The SEC’s arm can reach beyond the US
An ICO done from outside the US that didn’t explicitly exclude US investors in their offering documents and marketing materials would still fall within the SEC’s enforcement ambit. They could be part of the next wave of regulatory enforcement action.
In addition, foreign issuers who explicitly excluded US investors are likely to face a high burden of proof to evidence that US investors did not participate in their ICO. Showing that IP blockers were in place at the time of the offering is unlikely to be sufficient.
3. Intent doesn’t count
In both actions of last Friday, the SEC did not seem to find fault in the issuer’s intent, only in their breach of US securities laws.
This indicates that enforcement actions are unlikely to discriminate between ICOs that were found manifestly fraudulent and issuers acting in good faith.
This should worry the entire community. Whilst some projects were obvious scams (and some less obviously so), enforcement action now hangs as a sword of Damocles above everybody who issued tokens in the belief — and probably upon the legal advice — they were mere utility tokens.
The road to redemption
However, not all is lost.
The SEC offers a “path to compliance” by letting issuers who have conducted an illegal unregistered offering of securities register and file periodic reports.
- The logic of the post-ICO registration is to ensure that investors receive the type of information they would have received had these issuers registered prior to the offer and sale of tokens in their respective ICOs.
- In addition, the ongoing reporting is meant to allow token buyers to make a more informed decision as to whether to seek reimbursement or continue to hold their tokens.
Such reimbursement may be the most painful part for any issuer forced to settlement with the SEC. Both actions of last Friday force the issuers to put a claim mechanism in place to compensate token buyers who wish to be reimbursed.
We are trying to obtain further clarity as to how such reimbursement would work and how such claims would be evaluated.
Larry Cermak crunched some numbers that suggest ICOs are not liquidating their ETH treasuries, yet. In our view, much will depend if the SEC expects issuers to offer reimbursement of principal in USD or in crypto.
Now we finally have the full realization of what to expect in the months ahead: an onslaught of enforcement actions and settlements against projects that raised money at the right time, but in the wrong way. The forced return of principal to ICO investors (plus penalties) will likely bankrupt many of the projects that went the token route in the first place. The little fish will settle. The big fish will use their 8–10 figure war chests to fight this out in court.
So I did an ICO, what should I do now?
Past issuers can either hope and pray that they won’t appear in the SEC’s enforcement vizor, or they can take a more proactive approach.
Checking whether KYC and AML was properly documented and where possible go back to token buyers to complete checks is probably good hygiene anyway.
If you did not register your offering and are based in the US, fleeing won’t really help at this stage. If it comes to it, choose the road to redemption.
If you did register, like most sane teams since mid-2017 typically under a Reg D safe harbour in the US combined with a Reg S non-US offering, you should be able to sleep sounder. However just in case that letter from the SEC drops, checking on how solid the accreditation was done and putting your lawyer’s number on speed dial may be a good precaution.
Funds that canvassed US investors to invest in digital asset securities should be conferencing with their legal team already, and exchanges including those based outside the US will want to take a good look who transacted through their platform.
If you’re still set to raise funds, choosing a jurisdiction where securities are less circumscribed by law and legal precedent does not really help: it is the locus of the offeree rather than the location of the issuer that brings ICOs within the gravitational field of local securities laws.
In addition, many countries have broadly adopted the Howey test hence utility tokens are likely to be considered securities. For instance, supposedly ICO-friendly Singapore applies a Howey-type test.
In the case of Singapore, whilst we believe that only a substantial and publicly reported ICO fraud that lead to losses by Singapore-based retail investors would prod Singapore’s MAS to show the same zeal as its US counterpart in going after issuers, such bet on regulatory laziness is probably not a good strategy.
The UK may hold some promise and who knows manages to do a repeat of its 1960s eurobond stunt when regs in the US drove all USD-denominated bond issuance to London. We’ll be posting on developments in the UK next.
Arguably, last Friday’s actions and the Statement by the SEC are the nail in the coffin of US ICOs and given the long arm of the SEC are likely to impact projects abroad as well.
Is there a chance ICOs can be resuscitated as a mechanism to fund blockchain projects?
Yes and no.
Under current laws, the regulatory window for doing a “consumer” token offering without it being considered a securities token offering in the US is very narrow, fraught with legal risks and arguably not worth the bother.
Whilst legal research such as Latham & Watkins’ report “The yellow brick road for consumer tokens: The path to SEC and CFTC compliance” by David L. Concannon, Yvette D. Valdez & Stephen P. Wink show there’s still room for experimentation, unless regulators make a U-turn, we would expect the bulk of innovation to come from securities token offerings (“STOs”).
The Consolations of STOs
Whilst perhaps not quite the flying cars we have been promised, securities tokens, especially if they can pave a path towards automated stock placement on blockchain via whitelisted registries, would still represent a major transformation in how investors’/users’ surplus money is channeled to projects in need of funds.
However, ultimately we cannot continue to shoehorn old rules into new technology.
The Fred Wilson school has urged new laws all along. Whilst this may be waiting for Godot, we can all contribute in our own way to help regulators be more imaginative in how genuine “consumer” tokens can become the new paradigm to power decentralised networks in a way that sets them apart from securities, and if they are deemed securities, how their issuance and sale on blockchains can be made compliant.
In the case of Otonomos, we hope our engagement with the SEC’s FinHub can help influence the debate about the shape of next-gen securities laws.
Disclaimer: None of the above is legal advice.