Crypto companies working on a new coin or token project dream of making it big with an initial coin offering (ICO). As its name would suggest, an ICO is like an IPO, using crypto instead of stocks. Successful launches are able to rake in millions (to billions) of dollars from hopeful buyers and speculators who plan to resell them at a massive profit. ICOs are known as fundraising mechanisms utilized by cryptocurrency and blockchain projects to raise capital. When there is an ICO, a project gives out digital tokens to investors in exchange for established cryptocurrencies such as Ethereum or Bitcoin. These tokens often represent a stake in the project, access to its services, or some utility within its ecosystem. However, ICOs have raised some regulatory concerns because of their potential for fraud and lack of investor protection. This is where the Federal Securities Law comes in. Federal Securities Law refers to a set of regulations that are established by a country’s government to oversee the issuance and trading of securities. In the United States, the Securities Act of 1933 and the Securities Exchange Act of 1934 are key components.
These laws aim to ensure transparency, fairness, and investor safety in financial markets by mandating disclosure of relevant information and preventing fraudulent activities. Securities, which encompass stocks, bonds, and investment contracts, are subject to registration and regulation under these laws to maintain market integrity and safeguard investor interests.
In 2018, for example, EOS blockchain managed to raise more than $4 billion in an ICO that ran for almost a year. The EOS token ICO was the biggest the world has ever seen. But while its launch was a great success, it failed to live up to the hype post-ICO. Internal and structural issues as well as suspicions of fraud plagued the crypto project which resulted in a sharp decline in the market value of its token. In 2019, the SEC imposed a $24 million fine against the creators of EOS, block.one, for conducting the ICO without proper registration.
This cautionary tale is a perfect example of why government regulators are wary about ICOs. Most of the time, they expose retail investors to a high degree of risk arising from the inherent volatility of its market and the vulnerability of its participants to fraudulent schemes.
Knowing where the SEC stands as to ICOs is important in understanding the current regulatory landscape. Thus, in this blog post, we take a look at three important SEC reports and guidelines to give us an idea of their present legal view on ICOs.
1. The DAO Report: Securities are defined by the nature of a transaction rather than the form, name, or characterization given to the investment vehicle.
The EOS affair was far from the first time that the SEC found possible violations of federal securities laws from blockchain and crypto companies that conduct unregistered ICOs. It was also not the first time that a crypto project fell prey to bad actors who took advantage of its security vulnerabilities.
In 2017, the SEC investigated a German blockchain and IoT corporation called Slock.it UG. Slock.it UG led to the creation of an unincorporated entity called the DAO. The DAO was an example of a decentralized autonomous organization that was supposed to run as a “virtual organization embodied in computer code and executed on a distributed ledger or blockchain.”
From April to May 2016, the DAO conducted an ICO that offered and sold DAO tokens, the proceeds of which were supposed to fund projects that would be proposed by the token holders. Holders of the DAO token were likewise promised a return on their “investments” should these projects earn a profit.
In June 2016, however, an unknown group or individual was able to divert around 3.6 million ETH raised by the DAO to a blockchain address controlled by the attackers. This event caught the attention of the SEC which detailed the findings of its investigation in what is now known as the “DAO Report.”
In the said report, the SEC found potential violations committed by the DAO, Slock.it UG, and its founders. The SEC concluded that DAO Tokens were securities covered by existing regulations on securities.
What is particularly interesting about the SEC report is its finding that blockchain coins or tokens may still be deemed as securities notwithstanding their digital nature. The SEC stated that what should be determinative is the “economic realities underlying a transaction” rather than the form, name, or characterization given to an investment vehicle. Moreover, the SEC emphasized that federal securities laws apply even to unincorporated organizations or foreign corporate entities so long as they offer and sell securities in the United States.
Nevertheless, despite these findings of possible violations, the SEC in the DAO Report stated that it decided “not to pursue an enforcement action” for the time being.
2. The SEC’s Framework for “Investment Contract” Analysis of Digital Assets: Not all digital assets are securities using the Howey test.
In 2019, the SEC’s Strategic Hub for Innovation and Financial Technology released a document called the Framework for “Investment Contract” Analysis of Digital Assets which provided more guidelines and clarifications to the application of federal securities laws to ICOs.
The framework relied on the U.S. Supreme Court’s decision in SEC v. W.J. Howey Co. that gave rise to what is now known as the Howey test—a test often used by courts to determine whether a contract, transaction, offering, or scheme is a “security” under federal law.
In analyzing whether a particular transaction or scheme is an “investment contract” or security, the Howey test looks into whether there is (1) an investment of money (2) in a common enterprise with a (3) reasonable expectation of profits to be derived from the efforts of others. The existence of these three elements indicates the existence of a security.
The SEC’s framework, however, acknowledged that digital assets like blockchain coins or tokens are not necessarily securities just because they are offered and sold to the public with an expectation that their value would increase.
For example, digital assets that are supposed to function as a “virtual currency” are not necessarily a security if its main purpose is to be a substitute for fiat or real money (and not as an investment vehicle). The SEC also recognized that tokens which “represents rights to a good or service” may not be securities if they are primarily utilized or consumed to redeem such goods or services.
3. The TurnKey Jet, Inc. No-Action Letter: Utility tokens must be usable the moment they are sold and marketed for their functionality rather than their ability to rise in market price.
For issuers of utility tokens, the SEC’s no-action letter to TurnKey Jet, Inc. in 2019 is a major positive development. A no-action letter is a letter from a government agency (e.g., the SEC) that states that it will not recommend legal action against the requesting party upon evaluating its planned course of action.
In a way, this no-action letter is historical in that it is the very first of its kind insofar as blockchain tokens are concerned. The SEC reached this decision by looking into the nature and character of the TKJ token and observed, among others that, the tokens were “immediately usable for their intended functionality (of purchasing air charter services) at the time they are sold.” The SEC also noted that the TKJ tokens were “marketed in a manner that emphasizes the functionality of the Token” and not the potential for the token’s market value to increase. These factors definitely helped emphasize the TKJ token’s “utility.”
The Howey Test and how it applies to ICOs
The Howey Test is a legal criterion established by the United States Supreme Court in 1946 to determine whether a particular transaction qualifies as an investment contract, thereby falling under the definition of a security and becoming subject to federal securities regulations. The test consists of three main elements: an investment of money in a common enterprise with an expectation of profits primarily from the efforts of others.
In the context of ICOs, the Howey Test is crucial in determining whether the tokens offered in an ICO are considered securities. If the tokens meet the criteria outlined in the Howey Test, they are subject to the regulatory framework of federal securities laws in the United States.
Applying the Howey Test to ICOs, it's essential to evaluate whether:
- Investment of Money: Participants invest cryptocurrencies (money) to obtain ICO tokens.
- Common Enterprise: The funds collected from ICO investors are pooled to develop and promote the underlying blockchain project, creating a common enterprise.
- Expectation of Profits: Investors anticipate that their token ownership will lead to potential profits as the project's value and adoption increase.
- Primarily from the Efforts of Others: The crucial aspect is whether investors rely predominantly on the efforts of the project's development team and promoters to generate profits, rather than their individual actions.
If all these elements are met, the ICO tokens are likely to be classified as securities, triggering the application of federal securities laws, including registration and disclosure requirements. However, if the tokens have genuine utility within the project's ecosystem and their value is driven by factors other than the efforts of the development team, they might not be deemed securities under the Howey Test and might fall outside the scope of strict securities regulation. It's worth noting that regulatory interpretations can vary, and the application of the Howey Test may differ in different jurisdictions.
Continuing regulatory uncertainty
Despite the SEC continuing to provide more clarifications and guidance, uncertainties remain as to the legal status of ICOs. The pro hac vice approach that the SEC appears to presently adopt does not completely erase the risk of potential violations and subsequent enforcement action.
While regulations are still in flux, it is important to deal with ICOs or any other token issuance with diligence and care. Legal solutions like Uptoken allow you to do this in the area of employee compensation by ensuring that token-based awards to workers and employees are compliant with existing laws and regulations on the matter. If you are planning to issue tokens to workers and employees but have some doubts as to its legal implications, we are here to talk and help.
FAQs about ICOs and Federal Securities Law
- Are all ICOs considered securities offerings?
No, not all Initial Coin Offerings (ICOs) are considered securities offerings. Whether an ICO token qualifies as a security depends on the specific characteristics of the token and the nature of the offering. While some ICOs do fall under the definition of securities offerings and are subject to regulatory oversight, others may not meet the criteria and could be classified as utility tokens or other forms of digital assets. The Howey Test or similar legal criteria is used to determine whether an ICO token is a security or not.
- What are the consequences if a company conducts an illegal ICO?
Conducting an illegal Initial Coin Offering (ICO) can have serious legal and financial consequences for a company and its founders. The severity of the consequences can vary based on the jurisdiction, the extent of the violation, and the impact on investors. Some potential consequences include legal penalties such as fines and even criminal charges for the company's executives, investor remedies, asset freezing, injunctions, reputation damage, and so on.
- Can employees legally participate in an ICO?
Whether employees can legally participate in an Initial Coin Offering (ICO) depends on several factors, including the nature of the ICO, the jurisdiction in which the employees reside, the company's policies, and applicable securities laws. Employees with roles directly related to the ICO or the company's financial matters might face more stringent restrictions due to their access to sensitive information.
- How does federal securities law apply to cryptocurrency?
Federal securities laws can apply to cryptocurrencies when the cryptocurrencies or related activities fall within the scope of securities regulation. The key determinant is whether a particular cryptocurrency or token qualifies as a security, as defined by these laws. Entities that facilitate the trading of securities, including cryptocurrencies deemed as securities, may need to register as securities exchanges or broker-dealers with the Security Exchange Commission. Federal securities laws also include anti-fraud provisions that prohibit misrepresentations or omissions of material information in connection with the offer, sale, or purchase of securities, including cryptocurrency securities.