How the SEC is cutting off $15 billion by punishing ICOs
Currently, the ICO is the most widely used financial tool used by crypto companies for raising money. In total, crypto startups have generated around $15.1 billion worth of investments in the 2014–2018 period thanks to ICOs.
This number is almost equal to the market cap of Ripple, which is the third largest cryptocurrency in terms of market capitalization. The US Securities and Exchange Commission is now about to dry up this vital source of investment for startups.
The main problem with ICOs is that the process of crypto crowdfunding is still far from being secure. Even though the ICO was created as an analog of IPO (Initial Price Offering), the main difference is that ICOs rarely fall under the regulations of state authorities, which means that there is a greater opportunity for various crypto scams to take place.
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Everyone remembers the BitConnect Ponzi Scheme, which lured billions of dollars in investment. This was just one of the large fraud cases connected to ICOs.
In 2018, the first steps were taken to pull ICOs out of this regulatory gray area: since then the SEC has considered ICOs tokens as securities and thus regulated them in accordance with the current law. This year the regulator showed its teeth and opened a case against Kik Messenger, which was accused of securities law violations.
Issues with Kik and SEC
Just a few weeks ago, the SEC sued the crypto startup Kik and its $100 million ICO for violation of Section 5 of the Securities Act of 1933. According to the law, companies have to register securities offerings with the SEC, which Kik allegedly failed to do. It is also contended that they inadequately disclosed the required information about its ICO to investors.
Initially, Kik Messenger held an ICO in 2017 and raised more than $100 million, more than half of which was contributed to by US investors. However, the project has faced some problems; losing $30 million a year, according to the SEC. The startup’s plan to merge with a larger company in an effort to attract more capital wasn’t successful either. The situation for the company worsened still, as the price of the Kik token slumped two times after the ICO — an alarming sign for investors.
With all the information above about Kik, the SEC has accused the company of not only violating regulations, but also failing to provide investors with sufficient information to make well-grounded decisions. Kik pleads not guilty, as according to the CEO Ted Livingston, the company didn’t hold a securities offering.
Furthermore, he argues, the very concept of regulation is too obscure and vague to make for a successful accusation. Convinced of their innocence, the company behind Kik messenger has already spent about $5 million on the case with the Securities and Exchange Commission. No small change to a company in financial straits, it has organized a separate crowdfunding initiative in order to pay its bills.
Why the SEC considers some ICOs as security offerings
The law that the SEC used to sue the Kik company was approved back in 1933, and is still active in regulating the issuing and circulation of securities in the United States. More recently, the Securities Act introduced the Howey test, which provides companies with clear metrics if the assets they are issuing qualify as securities. According to the Howey test, if a company promises a future profit on investments, then their offering could be considered a security. The SEC emphasizes that Kik’s CEO’s promises of future profits to investors failed that test.
The crypto industry has often criticized the Howey test, since it was created long before blockchain and cryptocurrencies made their debut. The industry says it therefore cannot be a reliable tool in evaluating these types of assets. This argument motivated the Securities and Exchange Commission to develop detailed regulatory guidelines, that were published in April 2019.
According to the guidelines, tokens can be considered securities if:
- Investors can expect returns on investments. However, there are some exceptions: As stated in the guidelines, if the investor makes a profit from a rise in the price of the token, then the cryptocurrency is not necessarily a security. The rule applies only if value growth depends solely on external, market factors, such as the ratio of supply and demand
- One or a group of people is responsible for certain tasks within the network
- A group of project representatives create or maintain a market for a digital asset
- The investor relies on the efforts of others who have a significant impact on the development of the project. For example, if at the time of the token sale the project’s blockchain has not yet been finalized, the buyer relies on the company in the network’s development
The SEC also emphasizes that the guidelines are not legally binding — they are made to show how the law works. This fact means that crypto projects will still be assessed by the Howey test and fall under the 1933 Securities Act. Even as the SEC has made some efforts to clarify the law, the main question still remains; “When are tokens not considered securities?”.
The most prominent cases of the SEC punishing crypto projects
Last year, despite the “crypto winter,” there was a substantial growth of funds raised by ICOs: 1,253 projects raised $7.8 billion. This is a significant growth in comparison to the 29 projects that held ICOs in 2016 and raised a mere $90 million.
Data from ICOdata
Kik is not the only company that has issues with the SEC over the violation of regulations. In May, the founder of NextBlock investment company, Alex Tapscott, was fined for violating the rules related to issuing securities.
However, the company only used a debt tool called convertible debentures to raise $20 million without any help from ICOs. NextBlock received a $520,000 fine, and Tapscott was forced to pay an additional $25,000.
The SEC also reviewed the crypto company Gladius Network, which held an ICO in 2017 and raised $12.7 million. Allegedly, the company had failed to register a security offering with the commission. Later the company returned the funds to investors and agreed to register a securities issuance.
During 2018, the SEC fined many other projects including CoinAlpha (a $50,000 fine), Airfox (a $250, 000 fine), and Paragon Coin (a $250,000 fine).
Unregistered ICO
The regulation of the crypto industry is needed primarily to protect and make life easier for its participants. However, in regards to SEC rulings, more clarification is needed in order to make sure that companies don’t inadvertently fall foul of the law.
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