Cryptocurrencies, Initial Coin Offerings and the Securities Act of 1933
Businesses have begun to use initial coin offerings, or ICO’s, to raise capital in ways that appear similar to the traditional mode of “going public,” through an Initial Public Offering, or IPO. Although the IPO and ICO both function as vehicles for a company to obtain funding from the public, they vary in this important respect: in order to raise capital pursuant to an IPO, the company must adhere to the requirements of the Securities Act of 1933, including the filing of a registration statement. To date, no ICO has complied with the 1933 Act. Not a single registration statement has been filed.
Among other important investor safety features, Section 5 of the Securities Act requires that a company provide full and fair disclosure when offering shares to the public. This core requirement allows investors to make informed decisions because they will have complete and accurate information about the company’s finances, its management, and the risks attendant in making an investment. None of these protections are available to those investing in unregistered ICO’s.
A company seeking to raise capital through an IPO or ICO must address the fundamental issue whether the thing being offered to the public (a share of stock, a virtual coin or token) is a security. Simply stated, if it is a security, then the issuing company must comply with the Securities Act and register the shares. If it is not a security, then the Act is not implicated.
Is a cryptocurrency a security? It is if it is deemed to be an investment contract. An investment contract is i.) an investment of money, ii.) in a common enterprise, iii.) with the reasonable expectation of profits, iv.) to be derived from the efforts of others. This four part test is often referred to as the Howey test, after a landmark 1946 United States Supreme Court case, which stressed that it is the substance of the offering, not its mere form, that informs what constitutes a security. Howey provides a “flexible rather than static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”
Inspect all of the facts surrounding an ICO to get beyond the labels given by the promoters. Regardless of artful linguistics intended to disguise the true nature of the deal, if one is being asked to contribute value to an enterprise expecting to receive a profit from the efforts of management, the Howey test is met and the securities laws are implicated.
Recently, SEC Chairman Jay Clayton addressed this form/substance issue in a public statement he made on December 11, 2017. Chairman Clayton said, “A change in the structure of a securities offering does not change the fundamental point that when a security is being offered, our securities laws must be followed.” According to Clayton, most all of the ICO’s he has seen involve the sale of securities and thus implicate the Securities Act’s registration requirements.
Without the protections our securities laws afford, investors must be especially wary placing money into ICO’s. Besides taking on the risk of a cryptocurrency’ s high volatility, there are other considerations bearing mention. Cryptocurrency users may be targets for fraudulent schemes. The funds raised in an ICO may quickly be transferred overseas. This transfer may make recovering moneys from wrongdoers difficult, with funds being hard to trace and more difficult to seize. There are no regulated exchanges in the United States set up to handle cryptocurrencies, enabling greedy participants to manipulate the market by “pump and dump” schemes or to otherwise commit fraud.
Cryptocurrencies are here to stay. Thus, it is of paramount importance that our regulatory authorities and private litigants alike be vigilant in invoking the rights and remedies granted by virtue of our securities laws in order to achieve meaningful structural protections for participants in ICO’s, and to advance the proper use of cryptocurrencies in our modern, fast-changing financial marketplace.