Anyone who reads the business pages these days has to be aware that there has been a surge of interest and activity involving cryptocurrencies, and in particular involving initial coin offerings (“ICOs”). In third quarter 2017 alone, 105 ICOs raised over $1.3 billion. This level of activity has in turn attracted regulatory scrutiny and even enforcement activity. In addition, there is now a securities class action lawsuit pending in connection with an ICO earlier this year, as discussed in detail below. As problems have emerged, investors, regulators, and others understandably have become wary of ICOs. However, because of the opportunities involved, ICOs are likely to continue, and for that reason it remains important to try to understand the promise they represent.
An ICO is an alternative method for raising capital. The process is intended to allow private startups to raise funding outside of traditional capital markets. In an ICO, the firm seeking funding creates a virtual coin or token and offers it for public sale. In an article last month in which it explained the ICO process (here), the Wall Street Journal called the ICO process “a cross between a traditional initial public stock offering and a crowdfunding.”
According to the Journal, in the first three quarters of 2017, 172 coin offerings raised a total of $2.27 billion (which represents more than 20 times the roughly $100 million raised in 2016). Part of the reason for this growth in activity is the significant rise in the price of bitcoin, the original digital currency. As its current price of $7,261, bitcoin is up over 930% in the 12 months. These kinds of investment returns inevitably attract investor interest. At the same time, platforms for trading digital currency have developed. For example, Ethereum, a digital-trading platform using blockchain technology, created standardized coding for creating a token, which it turn made it easier to create new coins.
The coin or token can represent value (as would be the case with a real currency or security) or it can represent an asset giving the holder the right to the product or services of the bitcoin creator. (As Forbes explained in an article earlier this year, these later kinds of cryptocurrencies, often called “utility tokens,” resemble store-specific loyalty points.) The key is that because the coins or token not only can be traded for the goods or services but are also tradeable on the public blockchain platform, there is an investment opportunity based on the current trading value of the coin or token on the platform.
This investment opportunity in turn creates incentives for investors to help publicize the sponsoring firm’s product or services. As Forbes puts it, “Combining a token with an initial offering through a crowdsale allows you to build an international network of early adopters and investors who will actively work to educate and spread awareness of your project.”
For an investor, the attractiveness of the investment is that the blockchain platform affords liquidity; unlike a traditional early stage investment where the investor may be unable to sell out of the investment until much later in the life cycle of the company, an ICO investor can trade out at any time, with full knowledge of the current trading price.
The largest single offering so far is the $262 million raised by a startup called Protocol Labs for a computer-memory marketplace called Filecoin. In addition, Dynamic Ledger Solutions raised $232 million for a ledger-technology service called Tezos (more about which below). It is important to note that although the transactions are referred to by reference to dollars, the investors usually are not investing U.S. currency; typically they are sending bitcoin or Ethereum’s native currency, called ether.
The Regulatory Environment
It will come as little surprise that these activities have attracted the attention of regulators. In July 2017, the SEC issued an Investor Alert concerning ICOs, noting that in some circumstances an ICO may involve the offer or sale of securities and therefore be subject to the U.S. securities laws, and in other circumstances offerings made in reliance on exemptions from the securities laws may not in every instance be compliant with the requirements for the exemption. The Alert including an express warning against fraudulent activity.
In a separate July 25, 2017 press release (here), the SEC released its findings that the tokens offered by a specific virtual organization (The DAO) were securities and therefore subject to the securities laws. In its report of its investigation of The DAO, the agency emphasized that “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.”
On August 29, 2017, the SEC announced several trading suspensions of the common stock of certain issuers who made claims regarding their investments in ICOs or touted coin/token related news.
In addition, on September 25, 2017, when the SEC announced the creation of an internal Cyber unit to focus on cyber-related misconduct, among the specific areas the agency identified that the task force will explore was “violations involving distributed ledger technology and initial coin offerings.” More recently, the SEC issued a warning about potential unlawful promotion of ICOs by celebrities and others.
The SEC’s oversight of this arena has not been merely passive; the agency recently launched an enforcement proceeding in connection with a purported ICO.
As discussed in its press release (here), on September 29, 2017, the agency filed an enforcement action against a businessman, Maksim Zaslavskiy, and two organizations, REcoin Group Foundation and DRC World, in connection with a pair of ICOs purportedly backed by investments in real estate and diamonds.
Among other things, the SEC alleged that the digital coins and tokens being peddled didn’t even exist. Investors were told they could expect substantial returns from the organizations’ operations, which also did not exist. Investors were also told that the company had a “team of lawyers, professionals, brokers, and accountants” that would invest REcoin’s ICO proceeds into real estate when in fact none had been hired or even consulted. Investors were also allegedly misled about the amount of funding the organizations had previously raised. The SEC’s enforcement complaint can be found here.
In addition to the SEC enforcement action, on November 1, 2017, the U.S. Attorney’s Office for the Eastern District of New York filed a criminal action against Zaslavskiy, charging him with securities fraud conspiracy in connection with engaging in illegal unregistered securities offerings and fraudulent conduct and misstatements designed to deceive investors as part of the two ICOs. The U.S. Attorney’s office’s November 1, 2017 press release can be found here. The criminal complaint filed against Zaslavskiy can be found here.
The SEC is not the only national securities regulator to have stepped in to the ICO arena. Other regulators have also taken stepped forward; as has been widely publicized, in September 2017, China banned ICOs and shortly thereafter banned all cryptocurrency trading platforms and ordered them to stop trading. South Korea followed suit and also banned ICOs.
ICO-Related Litigation Activity
As the Wall Street Journal discussed in an October 19, 2017 article (here), one of the year’s biggest ICOs, the July 2017 $232 million token sale by Tezos, quickly became controversial as a result of an internal management fight. An October 24, 2017 Wall Street Journal article (here) noted that in addition to the management dispute, questions had arisen whether the Tezos tokens were in fact securities subject to the U.S. securities laws.
The management fight at Tezos involved a dispute between the husband-and-wife team (Kathleen and Arthur Breitman) that organized the deal and the founder of the nonprofit (The Tezos Foundation) they selected to control the project. The Breitmans control Dynamic Ledger Solutions which claims to own “all of the Tezos-related intellectual property.” According to the Journal, the Breitmans used the Swiss foundation to “boost the company’s independence and add checks and balances in its early period.” The plan is that eventually the Breitmans will sell the company to the foundation for $20 million. However a dispute has arisen on the question of how much control the Swiss foundation has over the company’s direction, which has put the trading of the Tezos tokens on hold.
The disputes and delays have now led to litigation. As discussed in a November 2, 2017 Crowdfund Insider article (here), a Tezos investor has filed a purported class action lawsuit in California Superior Court in San Francisco against the Breitmans, Dynamic Ledger Solutions, the Tezos Foundation, and one of the Foundation’s principals, and the Tezos PR firm.
In his complaint (a copy of which can be found here), the plaintiff alleges that the Tezos tokens were not registered with the SEC and that many of the representations that the offering’s sponsors made in the run-up to the offering were “either exaggerations or outright lies.” In particular, the complaint alleges that it has become clear following the offering that the Tezos network will not be ready for trading until at least February 2018, contrary to the alleged representation at the time of the offering that the network would be up and running by September 2017. The funds raised in the offering allegedly are not being allocated as allegedly represented in the offering.
The complaint purports to be filed on behalf of all natural persons who purchased Tezos tokens in the July 2017 offering. The complaint asserts several causes of action, including the unauthorized sale of securities in violation of Section 5 of the Securities Act; fraud in the sale of securities under Section 17 of the Securities Act; false advertising; unfair competition; and alter ego liability. In the unauthorized sale of securities claim allegations, the complaint relies heavily on the SEC’s investigative report involving The DAO noted above. Among other things, the complaint seeks restitution and disgorgement of “ill-gotten gains,” as well as rescission of the offering transaction.
With the filing of the SEC enforcement action and the criminal action described above, and now with the arrival of the class action lawsuit in connection with the Tezos transaction, the phenomenon of ICOs and the development of cryptocurrencies seemingly have reached a critical stage.
Yet despite what can only be described as adverse recent publicity, current and projected ICO activity seems to be continuing, apparently unabated. The calendar for ICOs is busy; over 30 offerings are scheduled before the end of the year.
Perhaps even more importantly, on October 31, 2017, the CME Group (which includes the Chicago Mercantile Exchange) announced that it intends to launch bitcoin futures in the fourth quarter of 2017. As the Wall Street Journal put it, the CME Group’s move to establish bitcoin futures, “offers a stamp of approval from a financial giant at a time when the digital currency’s supporters say it is gaining respectability.” (The CME Group’s futures plan is subject to approval by the CFTC.) Along the same lines, earlier in October Goldman Sachs said that was weighing the establishment of a trading platform for bitcoin and other digital currencies.
There clearly have been excesses associated with ICO activity. However, notwithstanding the excesses, there is a good case to be made that the cryptocurrency activity continues to represent an economically significant and potentially important development that cannot be disregarded or written off as hazardous fringe activity. The continued interest in ICOs and the CME Group’s move to establish trading for bitcoin futures underscores the fact that despite the stumbles and miscues, cryptocurrencies may well be with us to stay.
A historical precedent may provide a useful perspective on these more recent developments. During the dot-com frenzy at the end of the 90s and in the early part of this century, there were undoubted excesses. In light of outside investment returns available at the time, dozens of companies were hurried through the IPO process, including some that were not ready for the rigors and requirements of public trading. There were a host of spectacular flops (cue the picture of the Pets.com puppet). However, some of today’s largest and most successful companies anywhere – Google, Amazon, Facebook — arose during period or in its immediate aftermath. My point here is that notwithstanding the problems that often are associated with ICOs and that all too often dominate the dialogue, there are legitimate ventures that will succeed among the ICO companies.
There is a good place to start in trying to think about the positive potential for ICOs. A recent action by the Ontario Securities Commission may point the way toward a more secure and reassuring pathway for ICOs themselves and for prospective ICO investors.
On October 17, 2017, the Ontario Securities Commission granted an exemption from registration requirement in order to allow Token Funder, Inc. to launch an initial token offering under the offering memorandum prospectus exemption rules. As discussed in an October 26, 2017 memo from the Bennett Jones law firm (here), the agency granted the exemption subject to a number of requirements. Among other things, the exemption is contingent upon the offering of the tokens only to accredited investors, and to the trading of the tokens on any exchange or platform being subject to the agency’s oversight and approval. The exemption also requires initial and subsequent financial reporting to the agency.
The Ontario regulator’s action on the Token Funder application represents a more highly regulated model than ICO boosters may want, but the fact is that a more highly regulated approach may be inevitable. Among other things, the SEC likely will have to become much more involved and express in defining when a proposed cryptocurrency transaction does or does not represent the offer or sale of securities subject to the U.S. securities laws. In any event, the prospect of a more regulated environment points the way toward a more orderly landscape for cryptocurrencies to develop.
The Ontario regulator’s approach is also a much more constructive and forward-looking approach than the close-it-all-down mentality that the Chinese and South Korean regulators have adopted. Ontario is not the only regulator to try to find a more accommodating approach. Japan, for instance, and by contrast to China and South Korea, has embraced digital currencies. in April 2017 adopted a Virtual Currency Act providing definition and specificity and allowing cryptocurrency trading. In September 2017, Japan licensed its first digital currency trading exchange. As discussed here, the Japanese approach is conservative, but obviously much more helpful than an outright ban. An overview by the Freshfields law firm of the regulatory landscape in Asia for ICOs can be found here.
Even in absence of more active regulatory approach, or at least in the meantime while a more structured domestic regulatory approach develops here, there are indicia to sort among the various ICOs budding out there. The SEC releases to which I linked above are good places to start in thinking about sorting criteria.
For example, in its July 25 investor alert, the SEC identified a number of criteria for investors to use when scrutinizing ICOs. Among other things, the agency recommended that investors inform themselves about the organization’s operations and activities, as well as the intended uses of the offering proceeds and the relation of the offering to the organization’s business plan. The offering organization’s whitepaper should clearly lay out the rights the coin or token entails, including specifically investors’ rights to get their money back. In addition, investors will also want to ensure both that the blockchain is open and public and that there has been a cybersecurity audit. Danger signs include guaranteed investment returns and hard sales pitches. The agency’s investor alert also detailed the limitations on regulators ability to supervise cryptocurrency offerings and trading.
There are a host of other considerations that are relevant when sorting among ICOs. Among other things, it is important that the offering organization have identifiable ownership. It is also important for the organization to have a working product. (The Tezos offering shows the problems that can arise when the offering organization does not yet have a working product.) Also, the involvement of outside legal advisors and other professionals also supports the transaction’s legitimacy. More generally, the whitepaper offering organization’s publish will provide a host of information about the company’s operations, structure, ownership, and business plans, as well as the specifics of the offering, including its size, intended trading platform, and investor rights.
A full-scale exposition of the criteria that can be used to sort among offerings is beyond the scope of this post; the more important point here is that there is enough information available from public sources in order for sorting criteria to be established.
The very specific reason I am emphasizing the availability of information to allow ICOs to be segmented is to encourage the D&O underwriting community to engage on this topic. It would be far too easy for D&O underwriters to model China and South Korea and simply put a blanket prohibition on ICOs. However, the fact is that there is a business opportunity here, and I know from direct experience that there is interest among the principals involved in ICOs for the kind of risk management protection that D&O insurance provides.
Not only is there an opportunity for enterprising D&O insurers to develop business in an entirely new business sector based on appropriate risk segmentation criteria, but D&O insurers could even play a constructive role in helping to shape the ICO environment through their underwriting criteria. That is, if insurers make it clear that they are only willing to offer insurance protection under certain circumstances or for offerings with certain characteristics, the offering organization’s principals will have a substantial incentive to model their transaction to match the requirements and criteria. (Similarly, the unwillingness of offering organization’s to adopt reasonable controls provides a form of risk segmentation information all on its own.)
ICO activity is likely to continue for the foreseeable future. Obviously, if the bottom were to fall out of the market for bitcoin, that could curtail or eliminate some or all of the enthusiasm for ICOs. A more aggressive regulatory approach from the SEC could also curb ICO activity. For now, we are likely to continue to see more organizations seeking to launch initial coin offerings. ICOs represent an interesting and important opportunity – for offering organizations, for investors, and even for D&O insurers. It will be very interesting to see if there are enterprising D&O insurers who can see ICOs as something other than as a threat but rather as an opportunity.
For a more skeptical take on ICOs from a D&O perspective, please see Garrett Koehn’s post from August 2017 entitled D&O for ICO, here.
PLUS International Conference: Last week, I was fortunate to attend the 30th annual PLUS International Conference, in Atlanta. The sessions were great and it was great to see so many of my good friends from around the industry. I congratulate Debbie Schaffel of AON, the conference chair, the PLUS Board of Trustees, and the PLUS staff for a very well-organized and successful conference.