About a year ago, I wrote that the world of initial coin offerings resembled the Wild West. In November, the sheriff arrived.
The Securities and Exchange Commission announced last month that it had settled charges against two companies that sold digital tokens in ICOs. As a refresher, a digital or virtual token is what investors get in exchange for contributing funds to a business, usually a cryptocurrency or blockchain-based startup, engaged in an initial coin offering. The exact nature of virtual tokens has been the matter of significant public debate. Despite the characteristics they hold in common with stock or other securities, some companies have argued that they are more like an NPR tote bag – merely a souvenir of a decision to donate, not a true investment.
The SEC’s decision to bring charges against Carrier EQ Inc. (Airfox) and Paragon Coin Inc. makes clear that regulators have not been swayed by this argument. As a result of the settlements, the two companies must offer investors a refund and register their digital tokens as securities. Both also owe a $250,000 fine, though this is a small fraction of the money each raised in its respective ICO – $15 million for Airfox and $12 million for Paragon. The refunds, to the extent investors take them, will be the larger potential financial burden. The companies agreed to the terms without admitting or denying wrongdoing.
These two cases are the first ICO actions in which the SEC brought charges solely for registration violations, rather than fraud. I doubt they will be the last.
Both Airfox and Paragon made their ICOs after July 25, 2017, the date of an SEC report that warned it could view such events as securities offerings. Neither company registered their ICOs as such, nor did they apply for an exemption to the requirements, according to the SEC. The agency clearly hopes to use these charges to make a point to other companies that have made or are planning on ICOs: The Wild West days are over.
Yahoo Finance and Decrypt jointly reported in October that the SEC had approached several companies that conducted ICOs and privately threatened enforcement action, even without evidence that the offering was somehow fraudulent. Airfox and Paragon are evidently the first actions to get that far. And while many cryptocurrency enthusiasts celebrated when William Hinman, the SEC’s director of corporation finance, suggested that regulators did not view the cryptocurrency ether as a security, at the same summit Hinman strongly signaled that nearly all virtual token sales fell under existing securities law. His observation echoed remarks from SEC Chairman Jay Clayton in November 2017, in which Clayton stated that he had yet to see an ICO “that doesn’t have a sufficient number of hallmarks of a security.”
The recent actions against Airfox and Paragon signal that the SEC is ready to put its position on ICOs into practice. Companies that have already held ICOs should be prepared to pay a penalty and register in order to stay on the right side of the law. For the record, that group includes approximately 950 companies in 2018 alone. The relatively lenient penalties in these two settlements suggest that the SEC intends to offer companies a path to “get right” with regulators that won’t necessarily topple otherwise stable businesses, as long as none of their practices were fraudulent. Meanwhile, companies that are considering future ICOs have little reason to expect leniency from SEC regulators as the Commission’s stance on virtual tokens becomes increasingly clear.
As I wrote in my earlier post on ICOs, offerings previously represented something of a loophole to companies that wanted to bypass banks or venture capitalists in early fundraising stages. Offering virtual tokens was, in many ways, more like crowdfunding than a private equity sale. But many of the people who bought into ICOs, especially during the height of the cryptocurrency craze, saw their participation as an investment rather than a donation, regardless of companies’ claims to the contrary. From the outside, it seemed clear even then that it was only a matter of time before regulators caught up to the practice.
Current SEC guidelines do not forbid ICOs, and companies may continue to pursue them, at least in the short term. But based on the 2017 report and the SEC’s statements about the recent pair of settlements, regulators evidently take the position that nearly all token sales are securities offerings. Given the necessity of registering tokens as securities and making quarterly filings with regulators, many companies may find that ICOs no longer offer the advantages that made them attractive in the first place. In the future, initial coin offerings will probably look increasingly like any other private equity sale, in which companies will need to focus on wealthy and sophisticated investors or non-U.S. investors in order to avoid registering with the SEC. While this may be frustrating for companies, it is ultimately good for investors, or at least for American ones.
The state of the ICO market prior to the SEC stepping in illustrates why. Tezos, one company that tried to argue virtual tokens were more “souvenir” than “security,” still faces an investor lawsuit, slated to proceed in U.S. District Court in San Francisco. And in some ways, Tezos investors are the lucky ones; Tezos is still around to be sued. By February 2018, nearly half of companies that had held ICOs in 2017 had already failed. Some of these were scams, never meant to succeed, but many were simply bad bets. It is also worth noting that many ICOs require investors to pay in other forms of cryptocurrency, such as bitcoin or ether. The value of cryptocurrencies has fluctuated wildly, and most of them are significantly down compared to their value in 2017. This can create a variety of complications for companies that the SEC requires to offer refunds to investors, illustrating another reason why limiting unregulated investment to sophisticated investors in the first place is likely a good idea.
The Wild West couldn’t last forever, and neither could the unregulated ICO landscape. But for law-abiding investors, the sheriff’s arrival is a reason to sleep better at night.