ICOs Spark Ban and Regulatory Comment

September 14, 2017

Lisa LeFever

Digital currencies, such as bitcoin, have risen in popularity globally, gaining the attention of mainstream media, investors, and businesses. In 2017 alone, technology start-ups have raised over $1 billion in capital through what is known as initial coin offerings (ICOs). An ICO allows businesses to forgo the lengthy and time consuming process of conducting an initial public offering (IPO). Instead of issuing shares, investors in an ICO receive a token or virtual coin in exchange for their investment. This token can then be used to access the issuer’s platform or software, to otherwise participate in the project, or it can be traded on a virtual currency exchange. 

These ICOs have been conducted in a grey area of legal uncertainty and regulators have begun to take notice. On September 4, 2017, the People’s Bank of China (PBoC) issued a stern statement banning all ICOs effective immediately. The regulators called ICOs “illegal and disruptive to economic and financial stability.” Issuing the tokens and their subsequent trading, according to the Chinese regulators, poses the risk of “fraudulent assets” and “business operational failure.”[1] While the ban is considered temporary until regulators determine a means of regulating ICOs, many of the exchanges where tokens and digital currencies trade are faced with the threat of shutdown. 

Other regulators have taken a more lenient approach. On July 25, 2017, the Securities and Exchange Commission (SEC) released investor guidance on ICOs. The SEC warned that these token sales may “improperly [] entice investors with the promise of high returns in a new investment space.”[2] The SEC has stated that the coins offered or sold may be considered “securities” such that they are subject to federal securities laws provided they meet certain criteria. The definition of a “security” under Section 2(a)(1) of the Securities Act and Section 3(a)(1) of the Exchange Act includes those things typically known as a security and also “investment contracts.” 

The landmark case SEC v. Howey defined an “investment contract” in flexible terms to amount to an investment of money in a common enterprise with a reasonable expectation of profits derived primarily from the efforts of others.[3] If the coins offered in a particular ICO arguably meet this definition, a problem may arise if the offering is not registered with the SEC or performed pursuant to an exemption. Offerings that are exempt from registration are known as “private placements.”[4] Private placements require the issuer to adhere to specific guidelines such as limits to the size of the offering, investor net worth requirements, and the prohibition against advertising.[5] 

The ICO guidance came alongside the SEC’s Report of Investigation under Section 21(a) in which it purported that the tokens issued by a virtual organization, known as The DAO, were securities within the meaning of federal securities laws and the Howey test.[6] Thus, the offering conducted by The DAO, which raised over $150 million from April to May of 2016, should have been registered pursuant to Section 5 of the Securities Act or fall within one of the statutorily-prescribed exemptions. Registration under Section 5 requires detailed disclosures of the transaction and the issuer, including the filing and approval of a registration statement with the SEC. 

Violations of Section 5 not only subject the issuer of an unregistered, non-exempt security to liability under the Securities Act, but liability extends to “any person” who participates in the offer or sale.[7] ICOs may also result in liability imposed on participants under federal securities law’s broad antifraud provisions, Section 10(b) and Rule 10b-5 of the Exchange Act, which apply to both registered and unregistered offerings and prohibit any manipulative or deceptive conduct in connection with the purchase or sale any of any security.[8] Courts have found that a private right of action exists under the antifraud provisions.[9]

Regulators will continue to strictly surveil token sales and other activities conducted by virtual currency businesses. Established businesses that opt to integrate digital assets into their established practice will also contend with regulatory scrutiny. Time will tell how these new instruments fit into our financial infrastructure.

The information provided is for informational purposes only. It does not constitute legal or investment advice.

[1] http://www.circ.gov.cn/web/site0/tab6554/info4080736.htm (original report). https://www.coindesk.com/chinas-ico-ban-a-full-translation-of-regulator-remarks/ (English translation).

[2] Securities Exchange Commission, Investor Bulletin: Initial Coin Offerings (July 25, 2017), available athttps://www.investor.gov/additional-resources/news-alerts/alerts-bulletins/investor-bulletin-initial-coin-offerings.

[3] 328 U.S. 293, 301 (1946) (stating that the definition of a “security” under the Act should be a flexible one rather than a static principle).

[4] 15 U.S. Code § 77d(a)(2).

[5] See 17 CFR 230.500 (Regulation D); 15 U.S. Code § 77d(a)(6) (Regulation Crowdfunding); 15 U.S. Code § 77c(a)(11) (intrastate exception); and 17 CFR Part 230 §§ 230.251 - 230.300-230.346 (Regulation A).

[6] SEC, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Exchange Act Release No. 81207(July 25, 2017), available at https://www.sec.gov/litigation/investreport/34-81207.pdf.