“Men, it has been well said, think in herds. It will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.” – Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds, 1841
In this first part of our Boom or Bust series, we explore the digital gold rush era of cryptocurrencies and Initial Coin Offerings and the securities law-related repercussions emerging therefrom.
Cryptocurrencies have emerged from the depths of obscurity into the public eye, from the bowels of the Reddit underworld into mainstream headlines. Major news outlets are losing their proverbial [expletive] over crypto. World renown celebrities are promoting and endorsing cryptocurrencies as gospel. Hell, even your ordinary, prudent (i.e. “basic”) person is riding the crypto-hype train. Choo! Choo!
The total cryptocurrency market cap ascended above $600B in 2017. Prices of the most notable cryptocurrencies have soared well beyond astronomical heights from beginning to the end of 2017. Bitcoin? 15000%, give or take. Ethereum? About 8000%. Ripple? Upwards of 20000%. These baffling figures have left even the world’s most seasoned poets and quants utterly dumbfounded, yet wholly intrigued.
The sudden and exponential rise in cryptocurrency popularity sparked considerable interest in blockchain – the technology underlying cryptocurrencies. The surge in blockchain enthusiasm has opened the floodgates for a torrent of Initial Coin Offerings (ICOs).
An ICO is a crowdfunding method that allows a company (many of which are blockchain-based) to raise capital online by selling “tokens” in exchange for legal tender or cryptocurrency. Tokens function as digital assets that are transacted via smart contracts on a blockchain.
If you’re somewhat dazed and confused at this point, read this before proceeding.
In 2017, companies raised upwards of $6B via ICOs. Early-stage VC funding paled in comparison. ICOs allow fledgling startups to raise a ton of money with alarming rapidity. One ICO raised $35M in a mere 30 seconds. In the time that it takes Alexa to explain to us what an Initial Coin Offering is, you would have already missed out on that $35M ICO.
However… Not all that glitters is gold.
This mass influx of ICO cash has created a perfect breeding ground for fraud. Regulators are scrambling to catch up, while also competing amongst each other for administrative authority over ICOs. Information is highly asymmetrical in favor of the blockchain startup running the ICO. People base their token purchasing decisions on an ICO’s “white paper,” which is essentially a glorified pitch deck. Tokens impart no equity and no ownership rights in the issuing blockchain company to the token purchaser. Moreover, although an ICO may convey contractual rights to a token purchaser, such rights are likely limited in favor of the blockchain company conducting the ICO.
So if an ethically questionable blockchain company decides to pull a Billy Joe and Bobbie Sue and take the money and run, ICO participants have little recourse. Good luck trying to get your money back from Satoshi Nakamoto or any of the other anonymous purveyors of the crypto flavor of the week. Confido, a cryptocurrency startup, garnered close to $375,000 in funding through their ICO. Shortly thereafter, Confido’s team pulled a Harry Houdini, poof…
No more website. No more social media pages. No more team. No more money. Gone.
Yet despite all of the perils and uncertainty, it is undeniable that an ICO can be a tremendous asset, if managed properly and conducted in compliance with all regulatory authorities including but not necessarily limited to the U.S. Treasury Department, the IRS, SEC, CFTC and State governments.
Greed, ignorance and malfeasance have led to a cataclysmic downpour of securities class actions that has unsurprisingly followed the increase in dubious ICO activity. Tezos, a blockchain startup that raised a record-setting $232M this year, is currently defending four securities class actions at once. An ICO promoted by boxing legend Floyd Mayweather just got domed with a securities class action as well. Disgruntled token holders are expressing their discontent by making it rain 10b-5 class action securities fraud lawsuits. Securities class action litigation is a lengthy and laborious endeavor wrought with uncertainty, so class members are unlikely to recoup anything any time soon, if at all.
The Securities and Exchange Commission (SEC) has also set its crosshairs on ICOs’ laissez-faire approach to fundraising. The SEC recently made an example of blockchain-based restaurant review app, Munchee. The SEC issued a cease and desist order that stopped Munchee’s ICO dead in its tracks.
Munchee sought to raise $15M by selling their tokens to the mass consuming public. Munchee promoted its ICO through various online channels, including their website, social media, podcasts, and the like. Munchee openly touted that the value of their tokens would appreciate over time and provide an opportunity for future profit. In addition, Munchee lauded the tradability of their tokens on a secondary market. The SEC deemed Munchee’s tokens were “investment contracts,” and therefore, “securities” subject to federal securities regulations. In making such determination, the SEC applied the infamous Howey test – a creature of the Supreme Court born over half a century ago.
Under the Howey Test, a particular transaction or scheme constitutes an investment contract where a person invests his or her money in a common enterprise and is led to expect profits from the efforts of the promoter or a third party. In finding that Munchee’s tokens constituted securities, the SEC stressed that purchasers of Munchee’s tokens would expect profits from the significant entrepreneurial and managerial efforts of Munchee and its agents. Munchee and its agents publicized that they would revise the Munchee app and create an ecosystem that would increase the value of Munchee’s tokens, which was sufficient to support the crux of the SEC’s argument.
The SEC ultimately forced Munchee to discontinue their ICO and return all capital raised (~$60K). The SEC’s classification of Munchee’s token as a security mainly hinged on the positive correlation between the efforts of Munchee and its representatives and the value of the Munchee token.
Notwithstanding the SEC’s order, the determination of whether a token is a security requires a fact-intensive inquiry. The SEC’s order and other guidance are cryptic at best and should not be viewed as dogma. Startups looking to raise capital by ICO should tread carefully.
If you’re thinking of going down the ICO route, you have a handful of options to choose from (which we’ll explore in our next post) in order to stave off costly litigation and regulatory scrutiny.
If you opt to ignore the ICO regulations, the $35M that took you 30 seconds to raise might just cost you 5 years of litigation followed by 5 years of incarceration. Your best option for a worry-free ICO? Reaching out to JPF Securities Law at: firstname.lastname@example.org.
DISCLAIMER: This blog post is made available for educational and entertainment purposes only and does not purport to provide any investment, tax, or legal advice. You should consult your investment, tax, and legal advisor (which can be us) before acting upon any of the information contained in this blog post.