In recent years, Initial Coin Offerings (ICOs) have emerged as a disruptive tool in entrepreneurial finance. ICOs involve the sale of a stake in a project with the aim of raising funds at an early stage of development. Although ICOs share some similarities with both IPOs and crowdfunding campaigns, they also differ, and in the last few months ICOs have significantly evolved in an effort to improve. Interactive Initial Coin Offerings (IICOs), Initial Supply Auction, the Simple Agreement for Tokens (SAFT), airdrops (free of charge distribution of tokens), Security Token Offerings (STOs), and the “reversible ICO” (RICO) are all examples of this transformation.
In a 2016 speech, U.S. Commodity Futures Trading Commission (CFTC) Chairman Christopher Giancarlo emphasized the similarities between the advent of blockchain technology and the internet, and referred to the “do no harm” approach as the best for regulating blockchain technology. That approach was successfully applied to the internet in the 1990s’ by the Clinton administration and can lead regulators to support innovations in blockchain technology without stifling them with burdensome rules.
In the context of ICOs, after a period of inactivity [1]), the SEC has shifted policy. In a recent paper I suggest that the SEC’s enforcement strategy is based on a “do no harm” approach and successfully pursues two fundamental goals: investor protection and facilitation of capital formation.
In doing so, the SEC has used the Howey test to conclude that ICO tokens are securities covered by the Securities Act of 1933 (Securities Act) and the Securities Exchange Act of 1934 (Securities Exchange Act). That action was instrumental to the adoption of more rigorous enforcement, leading to multiple sanctions against unlawful ICOs and the application of the securities laws to a broad range of exchanges, private funds, broker-dealers and others involved with ICOs. In this way, the SEC covered both primary and nascent secondary markets.
The shift from inactivity to enforcement was gradual, characterized by clearly identifiable steps. First, in July 2017, the SEC issued the “DAO report,” which addressed ICOs as securities and the application of the securities laws to them. Second, in October 2017 and December 2017, the SEC defined “security” with regard to ICOs, going beyond the semantics of phrases used in offering documents such as “initial membership offer” and “utility token,” as evidenced in the Recoin and Munchee cases. Third, in January 2018, the SEC advocated for more collaboration with “market professionals, and especially gatekeepers,” who have a duty to act responsibly and in accordance with the highest standards. Fourth, in March 2018, the SEC considered the infrastructure supporting ICOs, tokens, and cryptocurrencies: If coins and tokens are securities, the platforms for trading them may be subject to the securities laws applicable to exchanges.
A fundamental step in this phase was the enforcement action against EtherDelta in November 2018 for being an unregistered digital token exchange. Furthermore, the recent creation of FinHub and the commitment to a “path to compliance” expressed in two recent cases, In the Matter of Carriereq, Inc., d/b/a Airfox and In the Matter of Paragon Coin Inc., may have opened an era of enhanced collaboration between the agency and market participants. In this environment, market participants can benefit from prior guidance provided by FinHub and opportunities to comply with the securities laws after a breach. An essential precondition is a well-established and well-functioning federal securities law framework.
Data on ICOs demonstrates that rigorous enforcement of securities laws has not damaged the industry in the U.S., where the highest percentage—16.9 percent—of ICO projects occur[2] and has contributed to an ICO bull market there. In the first half of 2018, U.S. investments exceeded those in 2017[3], according to KPMG.[4] In addition, the growing number of Reg D and Reg S-1 filings related to ICOs (and more generally to blockchain) suggest that entrepreneurs have adapted to this enforcement approach.
By contrast, a lack of enforcement would probably have increased uncertainty to the detriment of investors and entrepreneurs and put the U.S. at a disadvantage in the international arena. However, in the short-to-medium term, it will be important to make securities regulation uniform and avoid differences at the state and federal levels. In addition, the SEC should encourage industry authorities such as SROs to develop high standards for self-regulation.
ENDNOTES
[1] Marco Dell’Erba, Initial Coin Offerings: The Response Of Regulatory Authorities, NYU Journal of Law & Business, Vol. 14, p. 1109, 2018, available at https://papers.ssrn.co/sol3/papers.cfm?abstract_id=3063536.
[2] ICO Watch List, ICO Statistics – By Country (May 8, 2018), available at https://icowatchlist.com/statistics/geo.
[3] See Jay Derenthal, 2018 Blockchain and Initial Coin Offering Investment Already Exceeds 2017 Total (Sep. 5, 2018), Nasdaq, available at https://www.nasdaq.com/article/2018-blockchain-and-initial-coin-offering-investment-already-exceeds-2017-total-cm1017687.
[4] KPMG, The Pulse of Fintech 2018, Biannual Global Analysis of investment in Fintech (Jul. 31, 2018), available at https://home.kpmg.com/content/dam/kpmg/us/pdf/2018/07/pof-1H-18-report.pdf.
This post comes to us from Marco Dell’Erba, a Hauser Post-Doctoral Global Fellow at New York University School of Law. It is based on his recent article, “Initial Coin Offerings (ICOs): From inactivity to full enforcement. The implementation of the ‘do no harm’ approach,” available here.