Initial Coin Offerings (ICOs): SEC Regulation and Available Exemptions From Registration

Initial Coin Offerings

Initial Coin Offerings or Token Offerings (commonly known as “ICOs”) became an increasingly popular means of raising capital in 2017 and 2018, with showing over $7.8 billion raised from ICOs in 2018 alone. The ICO market, however, has cooled considerably in 2019, with showing only 98 ICO’s raising an aggregate of $0.36 billion as of the end of October 2019, and this decrease is likely a result of increased scrutiny from regulators, including, in particular, the U.S. Securities and Exchange Commission (“SEC”). While the regulatory pendulum has swung in the direction of the SEC demanding more registered offerings of ICOs, there are still two methods in which ICO offerings may be conducted without the need to go through a lengthy full registration with the SEC: namely SEC’s Regulation A+ under the JOBS Act (“Reg A+”) and SEC’s Regulation D (“Reg D”).

In July 2017, the SEC released the “Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934:  The DAO” (known as the DAO Report).  In this report, the SEC stated that most tokens sold in ICOs constitute securities and warned issuers and other market participants to comply with federal securities laws in connection with offers and sales of such tokens.

Prior to the DAO Report, there were a number of ICOs that were offered in the marketplace in reliance on several “Whitepapers” that were published at the time, making the case that the relevant ICO (often employing a method called a Simple Agreement for Future Tokens or “SAFT”) was a “utility” token which provide the holder with future access to a company’s product or service. The defining characteristic of utility tokens was that since they were not designed as investments if properly structured, they would be exempt from federal laws governing securities.  In its simplest form, these could be analogous to airline frequent flyer miles or loyalty rewards programs, and several utility tokens had launched without SEC sanction (including KodakCoin, Filecoin).  Ultimately, the analysis of whether a token is a security follows the “Howey Test” established in the US Supreme Court case of SEC v Howey,  and as SEC Chairman Jay Clayton has stated, tokens and offerings that feature and market the potential for profits based on the entrepreneurial or managerial efforts of others contain the hallmarks of a security under U.S. law.

Following on the DAO Repot, in December 2017, the SEC brought a non-fraud-related ICO enforcement action, halting an ongoing ICO by Munchee Inc. that was neither registered nor exempt from registration and causing Munchee Inc. to refund proceeds before any tokens were delivered to investors.  Within the SECs findings, they noted that Munchee touted itself as a “utility” token, however, the SEC found the Munchee was actually releasing a security masquerading as a utility. Through the Munchee Inc. precedent and the DAO Report, the SEC made it clear that a token may be a security even if it has some purported utility, and emphasized that digital assets offered and sold as investment contracts (regardless of the terminology or technology used in the transaction) are securities.

Following the steps of the DAO Report, the SEC has increased its enforcement activity in connection with ICOs, and (i) in August 2019 announced it has settled the charges against SimplyVital Inc., a New England-based blockchain company for offering and selling approximately $6.3 million of securities to the public in unregistered transactions; and (ii) in September 2019, commenced legal action in the Central District of California against ICOBox and its founder for $14M on a non-registered ICO and $650M for FINRA broker-dealer violations.

Therefore, under current SEC guidelines, it is clear that the SEC views most ICOs to involve offerings of securities, and accordingly, such offerings must either be registered with the SEC or exempt from registration under the Securities Act of 1933.

Given the time, effort and expense involved in registering ICO offerings with the SEC, some issuers are avoiding the US altogether, offering their ICOs in other jurisdictions and taking steps to avoid permitting US investors to participate.  On the other hand, we have recently represented other ICO issuers who are offering ICOs in the United States to accredited investors and any other qualified purchasers under Reg D or Reg A+.


ICOs through Reg D

Rule 504 under Reg D allows a company to offer and sell virtual tokens through an ICO to an unlimited number of investors, when the offering is limited to only $5M during any 12-month period.

Alternatively, Rule 506 under Reg D enables a company to offer and sell an unlimited amount of virtual tokens through an ICO under some restrictions as of the nature of the investors.  Rule 506(b) permits sales to up to 35 purchasers who do not qualify as “accredited investors” but prohibits general solicitation. Rule 506(c) requires that all purchasers qualify as “accredited investors” but permits general solicitation.  It is important to note that even though a general solicitation is permitted under Rule 506(c), the company must conduct “reasonable steps” to verify each accredited investor (which makes a “self-certification questionnaire” insufficient).

Regardless of which rule is used to exempt an ICO offer of virtual tokens under Reg D, the tokens will be subject to transfer restrictions.  In general, those restrictions require a holding period of six-months or twelve-months.   In addition, the offering is still subject to the anti-fraud rules under the U.S. Securities Exchange Act of 1934, and issuers need to make sure their offering materials are free from material misstatements and contain such information as a reasonable investor would want to know about the ICO.


ICOs through Regulation A+

Introduced in 2012 under the JOBS Act, the Regulation A+ exemption enables equity crowdfunding campaigns to offer and sell securities to U.S. investors via two tiers, either for $20 million or $50 million, each over a 12-month period. A company can initiate a Regulation A+ offering by filing an offering statement with the SEC which requires far fewer disclosure obligations than in a traditional IPO.  Some benefits of using Regulation A+ as opposed to a traditional S-1 include scaled-down disclosure requirements, simpler qualifying process, simpler audit requirements and no resale restrictions for the purchasers since securities are not defined as restricted securities.

On July 10, 2019, Blockstack was the first company to get approval of its ICO through Regulation A+ in a $20 million completed offering, and at least one more startup, YouNow Inc., has also filed for a Reg A+ offering for proceeds of up to $59 million.

In conclusion, companies who would like to conduct an ICO should operate under the assumption that the SEC will treat the ICO like a security offering. Companies who wish to raise capital in the US but would like to avoid the lengthy process of a full registration with the SEC can either use the Reg A+ exception for a shorter process or conduct the offering in the framework of the various Reg D exceptions to avoid the need of a registration altogether.

For more information on Initial Coin Offerings, contact Alon Harnoy.

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