Initial coin offerings, or ICOs, have emerged as a trendy way to raise capital for emerging companies. Year-to-date, approximately $3.2 billion worldwide has been raised through ICOs.
ICOs can take the form of selling a new cryptocurrency, like Bitcoin or Ether, or a tradable electronic-like token that could be used to purchase a designated product or service on a platform created by the ICO. Often the tokens are sold in exchange for cryptocurrencies. The tokens that are sold, and the platforms that are supposed to be created with the proceeds, often use a blockchain, or distributed ledger technology, to track ownership and other matters without the need to have a centralized ownership ledger.
Current and upcoming ICOs are expected to address many and varied applications, including payment systems, online learning platforms, video sharing, digital insurance, gaming platforms and car towing.
However, considerable risk accompanies the hype surrounding ICOs. A recent study indicates only one in 10 tokens sold in ICOs is currently in use, implying the promised benefits only rarely materialize. Others have indicated that, prior to sale, tokens are placed in the hands of technology gurus who tout the technology and then quickly dump the tokens following the offering. Celebrity endorsements are common as well, further contributing to the fervor for ICOs.
In a high-profile example highlighting the risks and rewards of ICOs, Tezos last July raised $232 million in one of the largest ICOs ever, yet recent news reports indicate its future may be in doubt. The creators of Tezos have become embroiled in a governance dispute with an independent Swiss foundation established to conduct the ICO and to develop a transaction system that the ICO proceeds would fund. Tezos' creators remain optimistic the situation can be resolved.
The risk investors face in ICOs has not gone unnoticed by the Securities and Exchange Commission (SEC). In July, the SEC issued an investigative report analyzing an ICO by a virtual decentralized autonomous organization referred to as DAO. The SEC's report noted that initial coin offerings can be subject to securities laws. That means, among other things, that the offerings must be registered or subject to an applicable exemption. The SEC also stated that aftermarket trading in ICO tokens that are securities would be illegal unless the trading is conducted on a registered national securities exchange or pursuant to exemptions available for alternative trading systems. The report also discussed a cybersecurity attack on DAO where Ether proceeds from the ICO were temporarily diverted to another organization while holders of DAO tokens were powerless to take action.
The SEC used the DAO report to educate the industry regarding its views and did not bring charges against those involved in an effort not to stifle innovative capital raising techniques. Subsequently, the SEC brought charges against those involved in a pair of fraudulent ICOs.
The SEC alleged those involved were selling unregistered securities and the digital tokens or coins being peddled did not exist.
The Commodity Futures Trading Commission (CFTC) has also expressed its views on ICOs. In a recent publication the CFTC noted ICOs and tokens can be subject to commodities laws as commodities or derivatives contracts depending on the particular facts and circumstances.
Other regulators around the world are jumping on the bandwagon. China and South Korea have banned ICOs while Canada and Singapore have issued warnings like the SEC's noting that ICOs may be subject to regulation as securities offerings.
Notwithstanding the posture of regulators worldwide, there are signs that ICOs may be emerging from the darker corners of the internet. For example, Nasdaq-listed Social Reality Inc. recently announced preliminary plans for an ICO to help consumers keep control of personal information that may reflect the start of a trend toward mainstream offerings by established companies.
T Zero, a portfolio company of Overstock.com, has also recently announced plans to conduct an ICO. News reports indicate the ICO may raise as much as $500 million. The T Zero tokens will trade on a U.S. regulated alternative trading system and platform capable of trading both security tokens and app tokens issued via ICOs and related mechanisms. The ICO will comply with existing U.S. securities laws by structuring as a private placement offering solely to accredited investors pursuant to SEC Rule 506(c), which will allow T Zero to make public offers and sales of the tokens based upon compliance with requirements under the Securities Act.
The future of ICOs will depend upon responsible offering practices that comply with existing laws and regulations. While we hope that occurs, it is clear that securities regulators are poised to ensure that ICOs are conducted within these parameters. We expect to see continued enforcement actions against those ICOs that do not.
Steve Quinlivan, a partner in the Minneapolis office of Stinson Leonard Street, focuses on securities offerings and mergers and acquisitions. Bryan Pitko, Of Counsel, focuses on advising Stinson Leonard Street's public company clients on securities law compliance.
