ICO Primer: A Revolution in Startup Financing or a Regulatory Nightmare?


By Sammy Naji

A. What Are ICOs?

With the recent emergence of Initial Coin Offerings (“ICOs”), financing for startups has never been more accessible. The term ICO refers to the process of raising capital through the issuance of digital coins, known as tokens, on a blockchain ledger. These tokens, unlike cryptocurrency coins, not only serve as a medium of exchange or a store in value. Instead, ICO tokens also represent either equity in an issuer’s entity (“equity tokens”) or an entitlement to a good or service  (“utility tokens”). The presence of these tokens on a blockchain ledger allows the token issuer to bypass traditional venture capital firms and raise equity directly from the public through the sale of the tokens. These tokens can then be resold without the need for traditional markets such as Nasdaq and the Dow Jones. The opening of this previously untapped market for capital has been dramatic, with $6.5 billion raised through ICOs in 2017 alone.

B. ICO Fraud

The consequence of this massive democratization in access to early stage investment opportunities is the potential for investors to be subject to excessively risky investments and fraud. In fact, out of 760 token issuers that successfully raised their desired capital in 2017, 276 were not in operation by February of 2018. The large amount of risk and fraud that ICOs carry has caused the Securities and Exchange Commission (“SEC”) to take a much more assertive role in regulating the phenomenon. For example, the SEC recently issued around eighty subpoenas on individuals and entities involved with ICOs. These subpoenas follow numerous SEC enforcement actions against ICO issuers for fraud and/or failing to register their sales of securities with the SEC.

C. SEC Regulation

Unlike cryptocurrencies which are regulated mainly as commodities rather than securities by US regulators, ICOs almost always operate as securities and fall under the regulatory regime of the SEC under the Supreme Court’s Howey test. This test defines an investment contract security as an investment of money in a common enterprise with the investor expecting a profit solely from the efforts of the promoter or a third party.  ICO tokens that are securities must either be sold pursuant to registration with the SEC or through exemptions from registration. The consequence of these requirements is that an ICO issuer seeking to comply must either be willing to spend a large amount of money to register its security tokens with the SEC or severely decrease its access to investors by issuing pursuant to an exemption.

As of this past December, there have been zero ICOs registered as securities with the SEC. Instead, a large number of ICOs have been conducted with no regard to compliance with SEC regulations. Furthermore, despite the default requirement that exchanges hosting securities trading must register with the SEC, a majority of the ICO exchanges have not properly registered, which has caused the SEC to issue a statement warning investors from investing in these exchanges. The SEC will face difficulties in fully enjoining noncompliant ICOs and exchanges as they both often exist as decentralized entities with anonymous investors and development teams located across the globe. In the next installment of this two-part primer on ICOs, I will discuss the various ways that issuers are attempting to balance the need to comply with SEC regulations with their desire to utilize ICOs to raise large amounts of capital.