In this month’s Feder Law Firm Newsletter we discuss the new frontier in securities law—“cryptocurrencies” and “initial coin offerings” (“ICOs”).
Social media platforms and financial markets are abuzz about cryptocurrencies and ICOs. Cryptocurrencies are a new form of digital currency that is self-regulated via an algorithm that protects the currency from being digitally forged. All transfers of cryptocurrency from one individual to another are recorded on a digital “blockchain” that ensures (allegedly) that no transfers can be replicated or forged. Cryptocurrencies can be purchased on various online exchanges, such as “Coinbase” and “GDAX” and stored in a “digital wallet.” There are tales of incredible fortunes being made. The rapper 50 Cent reportedly was paid ~$463,000 for an album in 2014 and he agreed to accept payment in Bitcoin (one of the most well-known forms of cryptocurrency). 50 Cent says he forgot he had accepted Bitcoin payment for the album, and just recently discovered that his Bitcoin holdings are worth over $8 million.
In this newsletter we will primarily discuss ICOs, which are similar to traditional offerings of new securities, and thus potentially subject to all of the state and federal securities laws governing the offering of new securities. While the U.S. Securities & Exchange Commission (“SEC”) may eventually step in to regulate the sale of cryptocurrencies traded on exchanges such as Coinbase and GDAX, the more interesting regulatory question concerns how the SEC will approach the continued release of new cryptocurrencies though ICOs.
Initial Coin Offerings
As new cryptocurrencies continue to come onto the market, they are released in ICOs, which are similar to initial public offerings of securities, but unregulated. ICOs are used by new cryptocurrency ventures to bypass the rigorous regulatory framework that governs capital-raising by venture capitalists and banks.
An example of a successful ICO that was profitable to early investors is the “smart contracts” platform called Ethereum which uses “Ethers” as its cryptocurrency coins. In 2014, the Ethereum project was announced and its ICO raised $18 million for a value of $0.40 per newly issued Ether. The project launched in 2015. As of February 1, 2018, Ethereum was trading at over $1,000 per Ether with a total market capitalization of over $100 Billion.
Despite the incredible gains seen by early investors in cryptocurrencies and ICOs, as this new form of investment has come into the spotlight it has begun to garner the attention of federal securities regulators due to the potential for investor fraud.
On January 25, 2018, the SEC filed suit in the Northern District of Texas against defendant AriseBank, a cryptocurrency banking firm. The complaint alleges, inter alia, that AriseBank raised over $1 billion in public and private sales of its own ICO offering of “AriseCoin” in what the SEC alleges were unregistered securities offerings. A link to the SEC’s complaint can be found below:
Due to the increasing and rapidly evolving regulatory climate surrounding cryptocurrencies and ICOs, it would behoove potential investors in cryptocurrencies to familiarize themselves with some regulatory basics before deciding if, and how, to add cryptocurrencies to their investment portfolio.
Are ICOs legal to purchase? The answer depends on whether the purchaser is a “main street investor” subject to significant regulatory restrictions, or whether the purchaser is an “accredited investor.”
Main Street Investors
A number of concerns have been raised regarding the cryptocurrency and ICO markets. For example, as currently operating, there is substantially less investor protection than in traditional securities markets, with correspondingly greater opportunities for fraud and manipulation.
Investors must understand that, to date, no initial coin offerings have been registered with the SEC. The SEC also has not, to date, approved for listing and trading any exchange-traded products holding cryptocurrencies or other assets related to cryptocurrencies. An exchange-traded fund (“ETF”) is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. There are currently no ETFs registered with the SEC that track cryptocurrencies and are purchasable by the public. If someone tells you otherwise, be especially wary of investing in their cryptocurrency-based product.
The SEC has issued investor alerts, bulletins and statements on initial coin offerings and cryptocurrency-related investments, including with respect to the marketing of certain offerings and investments by celebrities and other actors, who may not possess a nuanced understanding of U.S. securities laws. If you choose to invest in cryptocurrencies, it is important to ask questions and demand clear answers. Although 50 Cent has evidently made a significant profit through his investments in Bitcoin, other cryptocurrencies may eventually become worthless.
As with any type of potential investment, if a promoter guarantees returns, if an opportunity seems too good to be true, or if you are pressured to act quickly, you are well-advised to exercise extreme caution and be aware of the risk that your entire investment may be lost.
Any activity that involves an offering of securities must be accompanied by the important disclosures, processes and other investor protections that U.S. securities laws require. A change in the structure of a securities offering, such as by styling the offering as the purchase of a “digital coin” rather than an investment contract, does not change the fundamental concept that U.S. securities laws must be followed when a security is being offered. In other words, replacing a traditional corporate share recorded in a physical ledger with a digital interest recorded through a “blockchain” entry on a digital ledger may change the form of the transaction, but it does not change the substance.
Market professionals, including securities lawyers, accountants and consultants, should read closely the investigative 21(a) Report released by the SEC below:
In that report the SEC applied longstanding securities laws principles to demonstrate that a particular cryptocurrency constituted an investment contract and, therefore, constituted a security under U.S. securities laws. Specifically, the SEC concluded that the offering represented an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.
Following the issuance of the 21(a) Report, market professionals have attempted to highlight utility characteristics of their proposed ICOs in an effort to convince the SEC that their proposed tokens or coins are not securities. Many of these assertions appear to elevate form over substance. Merely calling a cryptocurrency a “utility token” or structuring it to provide some utility does not prevent the token from being deemed a security. Cryptocurrencies and offerings that incorporate features and marketing efforts that emphasize the potential for profits based on the entrepreneurial or managerial efforts of others continue to contain the hallmarks of a security under U.S. law. Investors should continue to be guided by the principal legal considerations of registration, offering process, and disclosure requirements before advising clients to invest in cryptocurrencies or ICOs.
Finally, brokers, dealers, and other market participants that allow for payments in cryptocurrencies, allow customers to purchase cryptocurrencies on margin, or otherwise use cryptocurrencies to facilitate securities transactions, should exercise particular caution, including ensuring that their cryptocurrency activities are not undermining federal anti-money laundering and “know-your-customer” obligations. These market participants should treat payments and other transactions made in cryptocurrency as if cash were being handed from one party to the other—including all accompanying regulatory and legal considerations associated with cash transactions.