On July 25, 2017, the United States Securities and Exchange Commission (the “SEC”) issued an Investor Bulletin1 on Initial Coin Offerings (“ICO”). The SEC’s Office of Investor Education and Advocacy stated while and ICO “may provide fair and lawful investment opportunities . . . new technologies and financial products, such as those associated with ICOs, can be used to improperly to entice investors with the promise of high returns in a new investment space.” The SEC is aware of the emerging and nascent cryptocurrency space and related ICOs built on the back of blockchain technology as a potential alternative to traditional securities offerings in order to raise capital and issued the Investor Bulletin to make investors aware of the potential risks of participating in an ICO.
As an initial step, investors should consider whether the ICO involves the offer and sale of a security required to be registered with the SEC under U.S. securities laws or whether it is being conducted pursuant to an exemption from such registration?2 If the ICO is required to be registered a registration statement will be available on SEC.gov through EDGAR. If an ICO is not registered, the investor should ensure it is an “accredited investor” meeting the net worth or income requirements under U.S. securities laws; and, should be wary of promoters that indicate no mandatory net worth or income limits are necessary for investment. Finally, if an ICO is promoted as a crowdfunding contract, investors should ensure compliance of the ICO with Regulation Crowdfunding and U.S. securities laws generally.
The Investor Bulletin warns investors that virtual currency exchanges and other entities holding virtual currencies may be susceptible to fraud, technical glitches, hacks or malware and the possibility that hackers could steal virtual currencies. The SEC notes that while U.S. securities laws may offer some degree of protection in such events, the ability of an investor to recover such loss may be significantly limited. Some of the challenges outlined by the SEC include:
- Many third-party wallet services, payment processors, and virtual currency exchanges may be located overseas or be operating unlawfully and typically such virtual currency wallets are encrypted making it difficult to freeze accounts or secure investor funds.
- Traditional financial institutions are not involved with ICOs or virtual currency transactions and since the business of many ICOs function as a “decentralized autonomous organization” tracing the flow of money is difficult.
- There is no central authority that collects virtual currency user information and the SEC and law enforcement officials must rely on non-traditional sources to obtain this information.
As part of the Investor Bulletin, the SEC provided a few questions investors should consider when determining whether to participate in an ICO:
- What will the money raised be used for?
- Was a White Paper provided? Was the business plan in the White Paper clearly laid out?
- What rights do the ICO coin or token provide? (e.g. voting rights? profits in the project?)
- Can you return the ICO coin or token for a refund?
- Can you resell the ICO coin or token?
- Did you receive an unsolicited sales pitch to invest in the ICO?
- If an investment professional advised you on the investment in the ICO, is such investment professional appropriately licensed or registered?
- Is the blockchain open to the public?
- Has the blockchain code been published?
- Has there been an independent cybersecurity audit?
- Are promoters of the ICO promising or guaranteeing high investment returns, low risk or using jargon laden sales pitches?
- Are promoters creating a sense of urgency and pressure to invest immediately?
The use of blockchain technology in the cryptocurrency space is evolving quickly and has the promise to be transformative and disruptive to traditional methods of doing business. However, given the rapidly evolving nature of this space it is important that investors take the necessary steps to protect any investment they may make.
If you are considering making an investment in or launching an ICO Nauth LPC would be happy to guide you through the current regulatory landscape. Please contact Daniel D. Nauth at 416-477-6031 or firstname.lastname@example.org.
1 The Investor Bulletin can be found here.
2 Concurrently with the Investor Bulletin the SEC also released its Report of Investigation on the ICO by the Slock.it DAO on the status of ICOs under U.S. Securities Laws which can be found here and the Nauth LPC release on the Report of Investigation can be found here.