ICOs: Scams, Securities and the SEC
Table of Contents
- Introduction to ICOs
- What is an ICO?
- The dark history of ICOs
- The SEC vs ICOs
- Why the SEC classifies ICOs as securities
- The Howey Test vs ICOs
- The 2017 DAO report
- The SAFT framework
- Are ICOs still viable in 2020?
- STOs- the future of compliant ICOs?
It’s been a tough week for ICO fraudsters. In China, 27 individuals were arrested in relation to the infamous Plus Token scam, while in Mexico, two OneCoin promoters have been found dead in a suspected gang slaying. This comes hot on the heels of early July 2020’s court case against the celebrity-backed CentraTech ICO’s court case, where all 3 founders have since pleaded guilty.
For anyone familiar with the notorious crypto ICO scene, this comes as no surprise. Once considered to be Bitcoin’s second coming and a revolutionary new fundraising model for the blockchain economy, Initial Coin Offerings have crashed down to earth since 2018 much like the “pump and dump” trading and exit scams synonymous with the crypto industry.
It wasn’t always that way though.
What is an Initial Coin Offering (ICO)?
An Initial Coin Offering is a fundraising activity where a company or project (usually a startup with a good blockchain business idea) can raise capital from investors by issuing its own cryptocurrency in exchange for Bitcoin and Ethereum.
It takes its name from the traditional finance sector’s initial public offering (IPO) mechanism, however there are important differences between the two. The coins that an ICO provides an investor does not equal a stake in the company, but a token that is expected to go up in value if the project’s technical innovation it is touting is commercially adopted
The history of peak ICO
In late 2017, Bitcoin mania hit fever pitch as the world’s first cryptocurrency hit a 1000% growth to reach an all time high of just shy of $20,000. Crypto markets represented a digital Wild West in 2017, with Bitcoin climbing 1000% and heir apparent XRP skyrocketing a staggering 35,000%.
In the midst of this crypto gold rush, there seemed to be an insatiable need amongst crypto investors, the majority of them novices drawn in by Bitcoin’s meteoric rise, to buy into the Next Big Coin which would deliver gigantic returns.
As the market is prone to do when there’s a demand to be met, supply appeared soon enough. Pretenders showed up in their thousands, the vast majority of them armed with a hastily written (or copied) whitepaper extolling how they would disrupt the future of finance and make their investors rich in the process.
All they required was funding (preferably in Ethereum or Bitcoin that could be converted to fiat) and lots of it. Each ICO project issued its own name-carrying coin or ERC20 token, with total supply ranging from 1 million to 100 billion,which it sold in specific quantities and sales rounds that became increasingly expensive.
At first, buying into a popular ICO early virtually guaranteed that an investor would make anything from 10x to 100x on his investment once the cryptocurrency got listed on crypto exchanges. Project founders embellished their project and team’s merit and in many cases, outright lied. It didn’t matter, as investors in most cases still made money after a project got listed. In 2018, $20 billion was raised from nearly 800 ICO projects in 2018.
This all changed as 2018’s bear market hit. Faced with a tumbling Bitcoin which took the altcoin market crashing with it, investors became increasingly agitated as their ICO investments began to not only fail to deliver the riches it promised, but dropped to a fraction of their perceived value within weeks. In response, many projects simply took the money and ran. A report calculated that 80% of ICOs conducted in 2017 were scams. Billions were lost by investors, as ponzi schemes, exit scams driven by money laundering and terrorism funding proliferated.
In response, U.S. federal regulators the Securities and Exchanges Commission (SEC) and the Financial Crime Enforcement Network (FinCEN), who up to this point seemed largely disinterested in cryptocurrency, finally started to take action.
The SEC vs ICOs
The SEC was founded in 1934 with the signing of the Securities Exchange Act, five years after the stock market crash that triggered the Great Depression. The SEC’s purpose is to regulate securities and the companies that offer them in the United States in order to create market stability and protect investors.
The commission requires any company that sells securities to the American public to register with them. Registration necessitates disclosing a company’s financial information, something that the vast majority of crypto companies want to avoid at all cost. On the flip side, being a SEC-registered business can attract major capital investments from more diligent investors.
As digital assets like Bitcoin are not considered to be securities, but rather as virtual currency commodities, the SEC initially stayed clear from this new digital asset class, unless clear fraud, like a ponzi scheme (2013) was evident. This all changed with the rise of the ICO since 2017. The SEC made it clear in 2018 that they disapproved of this new unregulated fundraising tool, where 10% of funds were lost to hacks, and began to take action.
Does the SEC consider all ICOs to be securities?
No. According to the SEC, only some ICOs can be considered to be securities if they meet certain criteria. However, they can’t tell you exactly what those criteria are, as it’s up to the U.S. courts to decide that.
To understand the problem with ICOs and securities, we need to travel back over 70 years back in time. Under U.S. law, the basis for what constitutes a security was defined in the seminal SEC vs WJ Howey Co. ruling in 1946.
“For purposes of the Securities Act, an investment contract (undefined by the 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.”
The Howey Test and ICOs
Known as the Howey Test, this ruling classified securities as an “investment contract”, where an investor gives money to a business or person to invest on their behalf in a mutual business with the expectation that his investment yields a profitable return based on the work of the entity.
While the supply and price of Bitcoin can be manipulated by third parties who may “pump” the price or sell a large quantity to create an oversupply which will cause the price to drop, there is no central entity that controls it nor is there an expectation on any party to do work to drive Bitcoin’s price up.
The “expectation of profits from the promoter’s efforts” is an important indicator for the SEC. ICO investors bought into the ICO project’s team, whitepaper of technology, and the understanding that the team will continue to work and apply their work to reach success and grow both the value of the business and the tokens they’ve issued.
The 2017 DAO report’s impact on ETH, XRP and EOS
In 2016, the DAO (decentralized autonomous organization) raised millions of dollars for its venture capital fund that was built on the Ethereum network. A security vulnerability caused the DAO to lose $50 million in ETH. This had a dual impact: the DAO had to close shop, and the Ethereum community controversially decided to hard fork Ethereum to undo the hack and restore the funds to investors. This ultimately caused Ethereum to split in two blockchain, the network still going by that name and the other being the lesser known Ethereum Classic.
As U.S. investors initially lost their funds, the SEC had to get involved. The SEC found the DAO to be an unlicensed securities offering, but ultimately decided not to prosecute the company behind the DAO. However, the SEC drew a firm line in the sand. On 25 July 2017 it issued the DAO Report that partially grandfathered in ICO projects (like Ethereum) if these token offerings managed to decentralize their network soon after and were not seen to be controlled by a mainly centralized entity.
This is where the creators of other prominent cryptocurrencies like XRP and EOS struggled to stay clear of regulators. Ripple Labs, the company behind XRP, was penalized by FinCEN in 2015 for contravening the Bank Secrecy Act’s money transmitter laws and is still currently in the SEC’s crosshairs for largely running XRP as a centralized currency and unregistered security. This has also given rise to a class action suit against Ripple Labs in 2020, which is strongly contested by the company.
Probably the biggest ICO success story has had to be Block.One’s EOS, led by prominent cryptocurrency figures Dan Larimer and Brock Pierce and invested in by Silicon Valley legend Peter Thiel. Touted as the next Ethereum, the project raised a staggering $4 billion over a 12-month period. While EOS has had its moments since, it has largely underperformed and is currently nowhere near its 2018 highs.
The SEC investigated EOS’ ICO, but based on a number of mitigating reasons that could scupper its chances of success, such as that the ICO expressly forbade investments from U.S. investors, the regulator ultimately settled for a “paltry” $24 million fine.
What is the SAFT Framework?
As ICO investments soared, cryptocurrency firms’ lawyers worked feverishly to appease the SEC and stave off any future prosecutions. A consortium of blockchain developers created the Simple Agreement for Future Tokens (SAFT) framework, which aimed to differentiate between the selling of ICO tokens and their subsequent distribution to investors only when they’ve evolved to a more fully fledged version. The SAFT project respected the need for regulatory compliance and considered their framework as an “extensive effort to formalize a framework for compliant token sales, across many jurisdictions.”
With SAFT, project founders tried to sell the idea that ICO tokens based on its framework at the time of their delivery to investors were not securities,but utility tokens.
As the SAFT website explains:
The SAFT is the commercial instrument used to convey rights in tokens prior to the development of the tokens’ functionality. In the U.S., the SAFT itself is a security, so it could be offered in a private placement to accredited investors. The tokens that are ultimately delivered to the investors, though, should be fully-functional, and therefore not securities under U.S. law. Outside of the U.S., the need to limit SAFTs or tokens to accredited investors will depend upon the laws of the local jurisdiction.
This industry initiative was cautiously welcomed by the SEC chairman Jay Clayton.
What were the biggest ICO Scams?
Research showed that while over 70% of the $11.9 billion raised in ICOs in 2017 went to legitimate projects, over 80% of the total ICOs in 2017 were later found to be scams.
(If you’ve been the victim of an ICO scam, you may qualify for a free legal consultation with Kelman PLLC. Get in touch with our legal team here.)
According to researchers, the top 10 biggest ICO scams swindled nearly $700m from investors by 2018. They were:
|ICO Scam||Money scammed ($)|
|Pincoin and iFan||660,000,000|
|Opair and Ebitz||2,900,000|
|REcoin and DRC||300,000|
Are ICOs still viable in 2020?
In 2017 China banned ICOs, and others soon followed suit, which in hindsight was understandable.
In 2020, the ICO’s heyday is in all likelihood behind it, as the recent SEC actions against Telegram’s failed TON ICO, the app KiK and even actor Steven Seagal have underscored. Increasing regulations not just in the U.S., but globally, have curtailed its viability and made project founders hesitant to raise funds by way of initial coin offerings.
Many countries now take a hardline stance against ICOs in order to stay on the right side of regulators like the AML/CFT watchdog FATF and its Standards.
Yet, some progressive and politically stable nations have chosen to embrace ICOs as an important vehicle to foster technical and financial innovation in their jurisdictions.
Sophisticated financial hubs Singapore and Switzerland have blockchain-friendly regulatory frameworks that encourage the development of compliant ICOs, while the Cayman Islands announced a regulatory sandbox recently for startups to test their crypto products before being allowed to enter the market. Meanwhile, Anguilla’s Utility Token Exchange Act was announced in May 2020 to complement its groundbreaking Anguilla Utility Token Offering (AUTO) Act of 2018.
STOs- The future of compliant ICOs?
Since 2018, there have been high hopes for secure token offerings (STO), a compliant form of crypto fundraising where the investor gets an actual share of the company much like with traditional stocks, to replace ICOs. While STOs struggled since 2018, some projects like Blockstack have recently made progress and are starting to live up to expectations.
Evolving and improving are features intrinsic to the nature of crypto and blockchain technology. While ICOs in their 2017 form have died a deserved death, the future of fundraising through crypto is alive and well, thanks to the increased gains made by the STOs, and of course, the zeitgeist technology of 2020, Ethereum’s Decentralized Finance (DeFi) applications.