Originally published on March 11, 2018
The 2009 invention of Bitcoin has forever changed financial technology. Through the rise of economic innovation, Cryptocurrency makes it possible for any person or company to create a coin or token linked to their brand — and to give it a plethora of functionality. Some cryptocurrencies, like Monero and Pivx, offer its users enhanced privacy for their financial transactions. Others, like Rare Pepe trading cards, allow its users to create and trade art and music on the blockchain. Some of these cryptocurrencies function as tokens to play an online game, such as Bitcorns.com. Some countries, such as Moldova, have issued their own government-backed Coins. Venezuela has transferred its petro market onto the blockchain, while Factom has said it has begun migrating real estate and other data records onto the decentralized ledger. There are over 1,519 different cryptocurrencies listed on coinmarketcap.com today, and that number is growing rapidly. While the uses for these cryptocurrencies are extremely diverse, one thing they all have in common is that they their price is derived solely from the most pure of economic principles, the law of supply and demand.
As these innovative financial technologies have evolved, so too have their sources of funding. Rather than seek venture capitalists that may not understood the technology, or may insist on asserting control over the company’s vision, the Cryptocurrency community invented an alternative way to raise capital. By allowing community members to participate in the crowdfunding of interesting projects through the sale of tokens known as Initial Coin Offerings (“ICO’s”), the Cryptocurrency market was able to raise more money in 2017 than the entire venture capital sector combined. During an ICO, the company typically sells a certain number of tokens to willing Cryptocurrency market participants, and those individuals can then access the company’s goods and services. The purchaser can also often sell their ICO coins to a secondary buyer on a number of Cryptocurrency exchanges.
The market is still developing, and it currently only caters to those who are rather technologically advanced. As the Commodities Futures Trading Commission (“CFTC”) Chairman, Christopher Giancarlo (“Mr. Giancarlo”) has stated, “[p]erspective is critically important. As of the morning of February 5,  the total value of all outstanding Bitcoin was about $130 billion based on a Bitcoin price of $7,700. The Bitcoin ‘market capitalization’ is less than the stock market capitalization of a single ‘large cap’ business, such as McDonalds (around $130 billion).” See Introduction to Virtual Currencies, Written Testimony of Chairman J. Christopher Giancarlo before the Senate Banking Committee, Washington, D.C. (February 6, 2018).
While Cryptocurrency only comprises less than 1% of the global stock market’s asset capitalization, (Crypto is approximately $423 Billion and the overall stock market is over $80 Trillion), the United States Securities and Exchange Commission has begun to assert jurisdictional and prosecutorial power over any ICO projects that may be considered the sale of an unregistered “security” by using the — now infamous — Howey Test. In 2017, there were 210 global ICOs that raised a total of $4 Billion, and America was home to 18 of the top 50.
THE SEC’S JURISDICTION OVER INITIAL COIN OFFERINGS:
The SEC has made statements evidencing a concern for American “main-street” investors and has subsequently begun prosecuting Cryptocurrency start-ups that don’t follow the traditional Securities Laws in their capital-raising endeavors. In 1946, the Supreme Court developed a framework for assessing whether a business is selling an investment-contract (“security”) or not. SeeS.E.C. v. W.J. Howey Co., 328 U.S. 293, 299 (1946) (“An investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party . . .”). When the four elements of the Howey Test are satisfied, meaning (1) an investment of money, (2) into a common enterprise, (3) with an expectation of profits, and (4) derived solely from someone else’s work — an ICO’s token sale creates an investment contract between the ICO Company and the Cryptocurrency market participant and the SEC’s regulations must be observed.
The SEC has stated, “Whether a particular investment transaction involves the offer or sale of a security — regardless of the terminology or technology used — will depend on the facts and circumstances, including the economic realities of the transaction.” See Statement on Cryptocurrencies and Initial Coin Offerings, SEC Chairman Jay Clayton, December 11, 2017. In particular, the SEC has quantified a primary concern with the marketing efforts that emphasize potential returns to investors based on the managerial efforts put forth by the company issuing the tokens. Id.
Mr. Clayton elaborated as follows:
These offerings [ICOs] can take many different forms, and the rights and interests a coin is purported to provide the holder can vary widely. A key question for all ICO market participants: “Is the coin or token a security?” As securities law practitioners know well, the answer depends on the facts. For example, a token that represents a participation interest in a book-of-the-month club may not implicate our securities laws, and may well be an efficient way for the club’s operators to fund the future acquisition of books and facilitate the distribution of those books to token holders. In contrast, many token offerings appear to have gone beyond this construct and are more analogous to interests in a yet-to-be-built publishing house with the authors, books and distribution networks all to come. It is especially troubling when the promoters of these offerings emphasize the secondary market trading potential of these tokens. Prospective purchasers are being sold on the potential for tokens to increase in value — with the ability to lock in those increases by reselling the tokens on a secondary market — or to otherwise profit from the tokens based on the efforts of others. These are key hallmarks of a security and a securities offering.
Id. In a recent case, the SEC ordered the ICO to cease and desist its ICO mid-sale, and forced Munchee, Inc. (“Munchee”) to return the $60,000 it had raised from 40 community members. See In re Munchee, Inc. File №3–18304, 8 (Dec 11, 2017). Some of the primary concerns offered by the SEC included that the company had stated in its whitepaper that it was not a security offering because it did not meet the Howey Test, yet failed to offer any reason why. Munchee had been rather aggressive in the promotion of their ICO, creating posts that unequivocally stated the ICO purchasers could expect the MUN tokens to increase in value. Id. at 5. “Purchasers would reasonably believe they could profit by holding or trading MUN tokens, whether or not they ever used the Munchee App or otherwise participated in the MUN ‘ecosystem.’” Id. Some posts told users they could expect 199% gains. Id. at 6. Ultimately, the SEC decided to shut them down with a cease and desist letter, to which Munchee fully complied. Id. at 8.
Where do we go from here? Nobody knows… I’m advising all my clients to halt their ICO’s and go the Reg D Accredited Investor Route. This avoids the ambiguity, but also takes much of the excitement out of an ICO. Investors need to have over a Million in Net Worth (Assets-Liabilities — excluding mortgage) or have reported an income over $200,000 annually (or $350,000 for a joint filing) on the last two tax years. Once the ICO is complete, the shares need to be locked up for six months. Using 506(c) solicitation is still allowed, but the whole bounty program method doesn’t cater to the accredited investor crowd. There’s still other jurisdictions overseas that you don’t have to jump through all these hoops, but the legal costs of getting set up there are much higher, and you have to block Americans from participating in the ICO.