The Regulatory Squeeze on Token Offerings as a Funding Mechanism for Blockchain-Related Ventures
KENNEDY K. LUVAI
According to Coindesk.com’s ico-tracker, “initial coin offerings” or “token sales” (collectively, ICOs) have been used to raise approximately $7.3 billion through January 2018 as a means of funding early stage blockchain-related ventures, with about $7 billion of that cumulative funding having closed in the thirteen-month span between early January 2017 and late January 2018. See https://www.coindesk.com/ico-tracker/. ICOs thus came of age in 2017 as the funding mechanism of choice for blockchain-related ventures, far surpassing traditional venture capital.
What is an ICO?
An ICO is a relatively new fundraising method through which virtual tokens or coins are created and distributed using distributed ledger or blockchain technology. These tokens may be denominated in fiat currencies or, more commonly, in cryptocurrencies like bitcoin or ether. After issuance, tokens may be resold in secondary markets and have their own market value independent of the cryptocurrency used on the associated platform.
Capital raised from the ICOs may be used to fund development of associated digital platforms, networks, or applications, while granting the token holder some interest in the project. In other cases, purchased tokens may be used to access the digital platform or application, or otherwise participate in the project, once it is functional. Thus, generally, tokens can be viewed as falling into two categories: “investment tokens” and “utility tokens.” An investment token is analogous to a traditional security like corporate stock, LLC membership interests, or partnership interests. A utility token is intended to facilitate access to a product or service on the digital platform or network thus deriving value primarily from consumptive use, meaning that it may be analogized to a gift card or software license.
Uncertainties Surrounding ICOs
In view of an uncertain regulatory environment, the accelerated rise in 2017 of ICOs as a fundraising paradigm for blockchain-related startups has elicited some notes of caution. ICOs have drawn criticism from some who contend that ICOs make it possible for issuers to bypass the highly regulated capital-raising process that venture capitalists, banks, and underwriters are obligated to follow in IPOs. Regulators in the United States and elsewhere appear to be concerned that ICOs, which usually involve innovative and highly technical projects disclosed in white papers, risk creating informational asymmetries between issuers and investors to the extent that disclosures are not fully and fairly made. Some markets for tokens may also be susceptible to manipulation by unscrupulous actors. Further, because blockchain technology, broadly speaking, is still in its relative infancy, there have been instances where possibilities disclosed have not ultimately materialized as advertised – a phenomenon that, though hardly unique to blockchain technology, has implications for investors.
For issuers, whether a token is deemed to be a “security” has practical implications. If a token is deemed to be a security, then its offer and sale is regulated under federal securities laws, and registration with the Securities and Exchange Commission (SEC) is required unless an exemption is available. Registration of a traditional underwritten public offering is time consuming and expensive, and, once an issuer becomes public, carries with it extensive reporting requirements. The most commonly used exemption is the “private placement” to accredited investors. In contrast to a public offering, in which anyone is eligible to invest, a private placement limited to “accredited investors” – wealthy individuals and institutions – does not require any specified disclosures or audited financial statements.
Neither SEC registration nor an exempt offering provides the same freedom of action, lower expense, and shorter time to completion as compared to an ICO not subject to SEC regulation. Consequently, whether a particular token is deemed to be a security is a threshold question. That said, regardless of the nature of the token, i.e. whether the offering may be subject to SEC regulation, the issuer may not make any material misstatements or omit material facts in the course of the offering.
The DAO Investigative Report
While the SEC has yet to issue formal guidance that puts to rest much of the uncertainty surrounding the treatment of tokens as securities and under what circumstances that may be, it has offered some useful insight when it affirmed that whether a particular token is indeed a security depends on the specific facts and circumstances in play. The SEC began to do so in July 2017, when it issued an investigative report titled “Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO” (the DAO Investigative Report). The focus of the report was on the...