In the following guest post, John Read Stark, President of John Reed Stark Consulting and former Chief of the SEC’s Office of Internet Enforcement, takes a look at the latest cryptocurrency phenomenon — the “initial exchange offering,” or IEO. A version of this article originally appeared on Securities Docket. I would like to thank John for allowing me to publish his article. I welcome guest post submissions from responsible authors on topics of interest to this blog’s readers. Please contact me directly if you would like to submit an article Here is John’s article.
Another SEC crypto-crackdown is in the works with a brand new target: the so-called initial exchange offering, or “IEO.” But what the heck is an IEO?
Not to be confused with initial coin offerings (or “ICOs”), an IEO is a crypto-financing model offered and administrated via a cryptocurrency trading platform on behalf of a company (typically some form of start-up) that seeks to raise funds with its newly issued cryptocurrency digital tokens. Each IEO negotiates its unique terms, deals, and conditions with the various cryptocurrency trading platforms.
In an IEO, cryptocurrency platforms essentially become the counter-parties in the entire token offering process, enabling crypto projects to launch their offering directly on the platform (as opposed to ICOs, where the counter-parties are the fundraising company’s development team that creates or “mints” the tokens). The tokens sold in an IEO are distributed to investors by the cryptocurrency platform itself (as opposed to ICOs, where the fundraising company’s development team distributes the tokens).
IEO buyers/participants/investors (whatever the preferred terminology for IEO token purchaser) typically create an account on the cryptocurrency trading platform where the IEO is conducted. They then fund their digital wallets with tokens typically issued by the cryptocurrency platform, and use those cryptocurrency platform tokens to buy the fundraising company’s tokens. After the cryptocurrency platform’s customers purchase the fundraising company tokens directly from the trading platform, their “coins” are then “listed” on the cryptocurrency trading platform after the IEO ends.
Token issuers typically pay a listing fee to the cryptocurrency platform along with a percentage of the tokens sold during the IEO. In connection with the IEO, the cryptocurrency trading platform might provide marketing, due diligence and other facilitation services relating to the newly issued coin.
The popularity of IEOs has increased significantly in the past few months, and the cryptocurrency marketplace is abuzz with the financial possibilities of the IEO phenomenon. While no official IEO data exists, Coinschedule claims to record cryptocurrency market movements, and reports significant IEO growth, with close to $175 million of IEOs orchestrated in March and April of 2019.
“Launchpad originally started in August 2017, and reopened with the BitTorrent offering that facilitated $7.2 million in sales with the exchange’s native BNB token in January 2019. Since then, Binance has launched four new projects and is marching ahead with at least one a month as it simultaneously develops a decentralized exchange (DEX) . . . Meanwhile, in contrast to Binance’s Launchpad, KuCoin’s comparable Spotlight division will launch its third IEO on May 28, featuring the CHROMA token issued by the software-as-service startup ChromaWay , which already garnered $11 million in a private token sale last year.”
But while it seems that IEOs have captivated a new cadre of cryptocurrency enthusiasts and other digital financiers, IEOs have also captured the attention of the U.S. Securities and Exchange Commission (SEC).
Speaking recently at CoinDesk’s Consensus 2019 conference, Valerie Szczepanik, SEC Associate Director of the Division of Corporation Finance and Senior Advisor for Digital Assets and Innovation (often referred to as the SEC’s “Crypto-Czar”) expressed significant concern about IEOs.
Szczepanik explained that if an IEO issuer or any of the IEO buyers are based in the U.S., cryptocurrency trading platforms that facilitate token sales for a fee likely meet the legal definition of broker-dealers and must follow the registration and licensing requirements for broker-dealers, alternative trading systems (ATS) or national securities exchanges. Szczepanik did not mince words, warning:
“Most obviously, cryptocurrency trading platforms seeking to list these tokens for a listing fee or bring buyers to the table for issuers are probably engaging in broker-dealer activity . . . If they are not registered, they will find themselves in trouble in the U.S., if they have a U.S. issuer or U.S. buyers, if they are operating on the U.S. market.”
Szczepanik is a seasoned and well-respected SEC veteran, with over 20 years of SEC enforcement experience, and is not known to make empty threats. Purveyors, promotors and others associated with IEOs conducted in U.S. markets and involving U.S. investors had best prepare themselves for an SEC IEO enforcement onslaught.
A Little Background: IEOs, ICOs and The Howey Test
At its core, an IEO is basically an ICO that is run through a cryptocurrency trading platform which serves as the intermediary conducting the sale. Thus, in order to understand IEOs, it helps to first understand ICOs.
In a typical ICO, a company (generally the issuing entity) receives fiat currencies, such as U.S. dollars or Euro, or crypto-assets, such as bitcoin or ether, in exchange for certain rights embodied in crypto-asset digital tokens. These virtual coins or tokens come with particular rights, such as: a right to access to a future service once the ICO is launched; a right to redeem the token for a currency or service; or a right to receive future profits from the company (like a dividend).
To determine how traditional securities regulation applies to ICOs, the four-pronged Howey Test, derived from the 1946 Supreme Court decision in SEC vs. W.J. Howey Co., states that a security is an investment contract in which a person 1) invests their money; 2) in a common enterprise; 3) with an expectation of profits; 4) based on the efforts of the promoter or a third party. In order to be considered a security, an offering must meet all four prongs.
Most token purchasers expect that they will earn a profit by selling their tokens once they appreciate in value. Rather than prospectuses, token issuers put out so-called “white papers” describing the platform, software or product they are trying to build, and then investors buy those tokens typically using widely-accepted cryptocurrencies (like bitcoin and ethereum) or fiat currencies like the U.S. dollar. These issuers also often employ a litany of promoters and facilitators to generate interest, excitement and participation in the ICO.
Historically, the courts and the SEC have taken an extremely broad view of whether any kind of investment is a security. Indeed, the definition of “security” under Section 2(a)(1) of the Securities Act of 1933 (and the nearly identical definition under Section 3(a)(10) of the Exchange Act of 1934) includes not only a number of specific types of financial instruments, such as notes, bonds, debentures and stock, but also broad categories of financial instruments, such as evidences of indebtedness and investment contracts. The definition of security was plainly crafted to contemplate not only known securities arrangements at the time – but also to encompass any prospective instruments created by those who seek the use of the money of others on the promise of profits.
The DAO 21(a) Report
With respect to ICOs, the critical area of inquiry for the SEC is whether investors were relying on the managerial efforts of others. On July 25, 2017, the SEC provided important initial guidance on its views of whether ICOs are securities when it released a Section 21(a) Report of Investigation on its findings regarding the token sale by The DAO. The SEC’s Report of Investigation found that tokens offered and sold by a “virtual” organization known as “The DAO” were securities and therefore subject to the federal securities laws.
The bottom line from the DAO 21(a) Report is that the SEC views ICOs as selling securities. In making this determination, the SEC focused on whether the efforts of others were “the undeniably significant ones … that affect the failure or success of the enterprise.” The SEC found that the so-called curators of the DAO played the requisite role. The curators held themselves out as experts in, among other matters, the blockchain protocol, determined which projects would be voted on by DAO Token holders, addressed security issues and more generally held itself out in marketing materials as a group that investors could rely on for their managerial efforts.
The SEC also concluded that the voting rights of the DAO Token holders were limited, noting, “[e]ven if an investor’s efforts help to make an enterprise profitable, those efforts do not necessarily equate with a promoter’s significant managerial efforts or control over the enterprise.” The SEC concluded that the voting rights of DAO Token holders was largely “perfunctory.” Since they could only vote on projects approved by the curators, token holders did not receive sufficient information to vote in a meaningful way, and there were no means to obtain additional information.
Equally important, the SEC also noted: that the widely dispersed DAO Token holders could not identify and effectively communicate with each other; that there was a large number of them; and that they could not be deemed to be in a position to effectuate meaningful control.
The SEC message to the purveyors of ICOs was clear: ICOs are very likely selling plain-old shares of stock fancifully masquerading as tokens — and their offer and sale would need to be registered under the Securities Act of 1933 or qualify for an exemption from registration.
If the token offering is exempt from registration, the offering likely would need to be made to accredited investors, the tokens would be subject to limitations on resales or transfers, and any general solicitation would likely be prohibited. Regardless of whether the offering is registered or exempt, careful consideration would also have to be given to ensuring that prospective investors receive sufficient disclosure about the offering, including associated risks.
In summary, from the SEC’s perspective, every ICO falls into one of three categories: 1) registered; 2) exempt; or 3) unlawful — and every ICO the SEC has ever seen (whether it resides on a cryptocurrency platform or otherwise) falls squarely into the third “unlawful” category. Period. End of story.
Broker-Dealer Registration Requirements
Given that ICOs are deemed to be offering securities, IEO facilitators and intermediaries such as token platforms and promoters are trading securities for compensation, and would likely need to comply with broker-dealer registration requirements.
Specifically, Section 15(a)(1) of the Securities Exchange Act of 1934 makes it unlawful for a person to “effect a transaction in securities” or “attempt to induce the purchase or sale of, any security” unless they are registered as a broker or dealer under the rules and regulations of FINRA, the regulatory organization designated by the SEC to license and regulate broker-dealers.
The ramifications for failure to register as a broker-dealer are severe, even criminal. In addition, Section 20(e) of the Exchange Act, under which the SEC may impose aiding-and-abetting liability on any person that knowingly or recklessly provides substantial assistance in a violation of the Exchange Act, creating additional potential liability. Finally, merely retaining and permitting an unlicensed intermediary to help facilitate or effect a securities transaction (such as an IEO) may be a violation of federal and many state laws and may subject the IEO issuer (i.e. the fundraising entity) to possible civil and criminal penalties, including imprisonment.
In accordance with these fairly stringent requirements, those collecting IEO listing fees, marketing fees, facilitation fees or any other iteration of transaction-based compensation to help conduct an IEO, would likely trigger broker-dealer registration.
Even if the IEO arrangement conceals the true intent of the relationship between the funding company and the cryptocurrency trading platform, payment of transaction-based compensation i.e., a commission or some form of compensation that varies with the size or type of the resulting investment, is treated by the SEC as a nearly-conclusive indication that a person is engaged in the securities business and should be registered as a broker-dealer. Failure to register under such circumstances can render the IEO immediately and irrevocably tainted (more on that later in the Rescission Rights section below).
While the SEC has consistently viewed transaction-based compensation as the “hallmark” of broker dealer activity, there are a broad range of other kinds of transaction-related conduct that can trigger broker-dealer registration. The Venable law firm does a nice job of cataloging these other factors which the SEC would view as typical of broker activity (see also a similar discussion from Latham and Watkins, here and a less detailed list of indicators on the SEC website, here). Venable’s extensive list, based on prior SEC regulatory pronouncements, speeches, no-action letters, etc., demonstrates the extraordinarily wide breadth of Section 15(a) and includes:
- Participates in discussions and negotiations between the issuer and the potential investors;
- Assists in structuring transactions;
- Engages in “pre-screening” potential investors to determine their eligibility to purchase securities;
- Engages in “pre-selling” the issuance to gauge the level of interest;
- Conducts or assists with the sale of securities;
- Provides advice regarding the value of securities;
- Locates issuers on behalf of investors;
- Solicits new clients;
- Disseminates quotes for securities or other pricing information;
- Actively (rather than passively) finds investors;
- Sends private placement memoranda, subscription documents, and due diligence materials to potential investors;
- Advises on portfolio allocations to accommodate an investment;
- Provides analyses of potential investments; and
- Provides potential investors with confidential information identifying other investors and their capital commitments.
By skirting broker-dealer registration requirements, cryptocurrency trading platforms hawking IEOs are not adhering to a financial services regulatory framework meticulously harnessed to protect investors. For instance, broker-dealers are required to “observe high standards of commercial honor and just and equitable principles of trade” in the conduct of its business, including determining if an investment is “suitable” for its customer and maintaining meticulous records of communications, representations, transactions and other important information. Broker-dealers also are subject to SEC and FINRA examinations together with an exhaustive laundry list of regulations and rules of conduct as well as a rigorous training, testing and certification process.
IEO Services: Prima Facie Broker-Dealer Behavior
The vast array of broker-dealer activity by cryptocurrency trading firms peddling IEOs is astounding, which for the SEC, makes investigating and charging IEO broker-dealer registration cases like shooting fish in a barrel.
Transaction-based-compensation arrangements in IEO offerings are multifaceted, including listing fee arrangements and other transaction-related payments at the outset and throughout the IEO process. Also, the cryptocurrency trading platform’s own token is typically the instrument used to participate in the sale, providing an additional source of profiting opportunities.
In addition, the manner in which cryptocurrency trading platforms manage, package and market IEOs make the SEC’s broker-dealer registration case even stronger (if that were possible). For example, in a typical IEO, cryptocurrency trading platforms boast of unique liquidity and marketing services such as: 1) easy access to a large potential purchaser base; 2) help with crypto-assets distribution; 3) an advertising boost from being promoted on the exchange’s social media; and 4) an immediate listing on the crypto-assets exchange post-IEO.
Cryptocurrency trading platforms also tout their internal due diligence vetting of IEO issuers and their highly professional “know your customer” services as a critical benefit to engaging their facilities. Cryptocurrency platforms go so far as to hawk the “security and safety” of their respective IEOs, committing themselves to rejecting certain ineligible projects that may pose risks to investor’s assets, thus creating “a safer crypto investment environment.”
The SEC’s Pending IEO Sweep
The stars seem perfectly aligned for the SEC to target IEO purveyors and expel them from U.S. markets, and IEO promoters and facilitators would be wise to prepare themselves for an SEC IEO sweep of epic proportions.
Broker-dealer registration is one of the more critical federal and state regulatory registration requirements, because broker-dealers serve as gatekeepers to protect investors in the marketplace. Thus, the SEC considers the principle of gatekeeper registration sacrosanct, broadly construing the broker-dealer laws while narrowly construing the few permitted exceptions.
IEO broker-dealer violations are also strict liability in nature, requiring little in the way of scienter, conspiracy or even motive. Section 15(a) does not require a finding of fault (such as negligence or tortious intent), so the SEC need only prove that the IEO broker-dealer activity occurred without the proper registration and that the defendant was responsible, regardless of what anyone in the process honestly believes or testifies.
The SEC has an entire division dedicated to broker-dealer registration; will not hesitate to enforce broker-dealer registration provisions; and enjoys an extremely low legal threshold to insure victory in any broker-dealer registration enforcement action, key indicators for a successful SEC IEO enforcement program.
IEO promoters, issuers and others involved in the IEO process could be compelled to return investor proceeds to any disgruntled IEO investors.
Purchasing an investment is not like buying a pair of shoes at Zappos. You can’t return the investment for a refund if you don’t like the fit. That is, unless you bought tokens in an IEO, and cryptocurrency trading platforms and IEO promoters should prepare themselves for IEO rescission demands. Thanks to a range of U.S. securities statutes, rules and regulations, IEO token subscribers may have so-called “rescission rights.”
Section 29(b) of the Exchange Act provides that every contract made in violation of any provision of the broker-dealer registration requirements “shall be void” as to rights of persons who made or engaged in the performance of such contract. It results in the underlying purchase of securities becoming a voidable transaction that gives the investor a right of rescission, so for purchasers losing money on the investment, there is an instantaneous and simple claim to get a refund of their investment, and perhaps even more.
Rescission rights essentially amount to a “put option for an IEO investment i.e. IEO token purchasers would have the right to sell their tokens back to IEO sponsors and obtain a full refund, plus interest from the company and sometimes its officers and directors. It all boils down to a fairly straightforward legal analysis:
- Even if an IEO is somehow SEC-registered or structured somehow to be SEC-exempt, the IEO is still likely offering what the law would deem “securities;”
- Anyone connected to an IEO who is marketing securities (who for example is receiving any form of transaction-based compensation) must be registered with the SEC as a broker-dealer;
- If there is any unregistered person or entity connected to the IEO and marketing the IEO, then the unregistered broker-dealer actions have permanently and irrevocably tainted the IEO; and
- Once an IEO becomes irrevocably and permanently tainted, per SEC rules and regulations, investors are entitled to rescission, that is, a refund of their initial investment.
At CoinDesk’s Consensus 2019 conference, Valerie Szczepanik referred to one specific SEC enforcement action involving a cryptocurrency trading platform violating the SEC’s broker-dealer activity requirements — TokenLot, a self-proclaimed “ICO superstore.” Szczepanik noted that:
“TokenLot was a platform that was assisting to bring buyers to ICOs . . . In that case, there was an enforcement action charging the platform with acting as an unregistered broker-dealer and participating in the distribution in violation of the registration provisions.”
The SEC enforcement action against TokenLot, filed on September 11, 2018, was the SEC’s first administrative enforcement proceeding charging unregistered broker-dealers for selling digital tokens. According to the SEC’s order, TokenLot, Lenny Kugel, and Eli L. Lewitt promoted TokenLot’s website as a way to purchase digital tokens during ICOs and also to engage in secondary trading. Michigan-based TokenLot received orders from more than 6,100 retail investors and handled more than 200 different digital tokens, which the SEC found included securities.
TokenLot’s profits included trading profits and a percentage of the money that TokenLot raised for ICOs. TokenLot advertised digital tokens available on its website through social media postings and forums, email newsletters, websites dedicated to digital assets, and paid internet advertising. The SEC noted that TokenLot received marketing fees from issuers in return for promoting the issuers’ digital tokens on TokenLot’s website. The SEC charged that their activities required TokenLot, Kugel, and Lewitt to be registered with the SEC as broker-dealers, but they were not.
Stephanie Avakian, Co-Director of the SEC’s Enforcement Division, noted at the time, “U.S. securities laws protect investors by subjecting broker-dealers and other gatekeepers to SEC oversight, including those offering ICOs and secondary trading in digital tokens.”
Without admitting or denying the SEC’s findings, TokenLot, Kugel, and Lewitt consented to the SEC’s order and agreed to pay $471,000 in disgorgement plus $7,929 in interest, and they will retain an independent third party to destroy TokenLot’s remaining inventory of digital assets. Kugel and Lewitt also agreed to pay penalties of $45,000 each and agreed to industry and penny stock bars and an investment company prohibition with the right to reapply after three years.
If Szczepanik had more time when discussing TokenLot, she probably would have added four additional TokenLot takeaways for cryptocurrency platforms offering IEOs, including:
- The TokenLot order does not specifically address whether the underlying digital tokens were securities. Rather, as the SEC did in the Khaled and Mayweather enforcement actions, the SEC order simply stated that “the digital tokens issued in the ICOs and traded by TokenLot included securities.” This is clearly a trend for the future concerning ICOs i.e. whether ICOs are securities is no longer a question, their legal classification as securities is now axiomatic;
- The TokenLot order includes no allegations of fraud, and evidences the SEC’s willingness to charge securities violations in the cryptocurrency market, despite their being no apparent nefarious scheme involved;
- In addition to the typical SEC administrative remedies (a cease-and-desist order, disgorgement, civil penalties and industry bars), the SEC TokenLot order included an unprecedented undertaking where its owners agreed to retain an “independent intermediary,” apparently akin to a receiver, with a specific mandate: to take control of TokenLot’s remaining token inventory and “destroy” it within 30 days. This is a dramatic remedy and evidences the SEC’s doggedness with respect to cryptocurrency-related violations; and
- The SEC emphasized the central role that TokenLot and its website played in effecting sales, including that investor funds were transmitted to digital asset wallets controlled or maintained by TokenLot. The SEC was clearly making good on its promise of a year or so ago to crackdown on digital wallet services, set forth in the SEC’s Statement on Potentially Unlawful Online Platforms for Trading Digital Assets. Back then, the SEC stated ominously:
“Some online trading platforms . . . directly or indirectly offer trading or other services related to digital assets that are securities. For example, some platforms offer digital wallet services (to hold or store digital assets) or transact in digital assets that are securities. These and other services offered by platforms may trigger other registration requirements under the federal securities laws, including broker-dealer, transfer agent, or clearing agency registration, among other things.”
Cryptocurrency Trading Platforms as Unregistered Exchanges
Engaging in unregistered broker-dealer activity is not the only worry for cryptocurrency trading platforms offering IEOs. They may have also failed to register with the SEC as a securities exchanges.
Put simply, a securities exchange is a company that creates the opportunity for potential buyers and sellers of a security to come together for trading – and per the SEC, cryptocurrency tokens are securities. Hence, the need to register under Section 6 of the Exchange Act, or operate pursuant to an appropriate exemption (such as an alternative trading system that complies with Regulation ATS, which requires, among other things, registration as a broker-dealer and filing of a Form ATS with the SEC).
Actual SEC exchanges are heavily regulated and provide an array of investor protections inherent with their registration. For instance, registered exchanges: 1) mandate that investors funds and securities be handled appropriately; 2) ensure that investors understand the risks involved in purchasing the often illiquid and speculative securities that or traded on a cryptocurrency exchange; 3) make buyers aware of the last prices on securities traded over a cryptocurrency exchange; and 4) provide adequate disclosures regarding their trading policies, practices and procedures.
Entities providing exchange-like services must also: carefully handle access to, and control of, investor funds; maintain meticulous records of certain communications; insure robust cybersecurity; install a vigorous culture of compliance under a formalized and detailed compliance program; and provide all users with a broad range of adequate protection and fortification.
SEC Exchanges are also subject to routine and for cause examinations. The federal regulatory framework governing registered national securities exchanges and exempt markets is designed to protect investors and prevent against fraudulent and manipulative trading practices.
Hence, SEC exchange registration is an extraordinarily robust regulatory requirement, which is why there are only a small handful of actual SEC-registered exchanges, and makes the group an exclusive fraternity of responsible and rock-solid financial institutions.
While cryptocurrency trading platforms often refer to themselves as “exchanges,” they bear little resemblance to the traditional securities exchanges currently operating within U.S. markets, such as the New York Stock Exchange or the NASDAQ. This inappropriate (and perhaps even unlawful) nomenclature is disturbing to say the least.
Along these lines, the SEC staff has previously published an explicit warning that many online cryptocurrency trading platforms appear to investors as SEC-registered and regulated marketplaces when they are not. The SEC became so concerned about this problem that they conjured up an unusual official statement, stating on March 18th, 2018:
“Many platforms refer to themselves as “exchanges,” which can give the misimpression to investors that they are regulated or meet the regulatory standards of a national securities exchange. Although some of these platforms claim to use strict standards to pick only high-quality digital assets to trade, the SEC does not review these standards or the digital assets that the platforms select, and the so-called standards should not be equated to the listing standards of national securities exchanges. Likewise, the SEC does not review the trading protocols used by these platforms, which determine how orders interact and execute, and access to a platform’s trading services may not be the same for all users. Again, investors should not assume the trading protocols meet the standards of an SEC-registered national securities exchange. Lastly, many of these platforms give the impression that they perform exchange-like functions by offering order books with updated bid and ask pricing and data about executions on the system, but there is no reason to believe that such information has the same integrity as that provided by national securities exchanges.”
The SEC has already begun its efforts at policing unregistered exchanges in the cryptocurrency marketplace, and IEO purveyors should take heed. Specifically, on November 8th, 2018, the SEC settled charges against Zachary Coburn, the founder of EtherDelta, a digital token trading platform, initiating its first SEC enforcement action based on findings that such a platform operated as an unregistered national securities exchange.
According to the SEC’s order, EtherDelta is an online platform for secondary market trading of ERC20 tokens, a type of blockchain-based token commonly issued in ICOs. The order found that Coburn caused EtherDelta to operate as an unregistered national securities exchange.
EtherDelta provided a marketplace for bringing together buyers and sellers for digital asset securities through the combined use of an order book, a website that displayed orders, and a “smart contract” run on the Ethereum blockchain. EtherDelta’s smart contract was coded to validate the order messages, confirm the terms and conditions of orders, execute paired orders, and direct the distributed ledger to be updated to reflect a trade. Over an 18-month period, EtherDelta’s users executed more than 3.6 million orders for ERC20 tokens, including tokens deemed securities under the federal securities laws.
The SEC charged that EtherDelta offered trading of various digital asset securities and failed to register as an exchange or operate pursuant to an exemption. SEC Enforcement co-director Stephanie Avakian noted sternly at the time, “EtherDelta had both the user interface and underlying functionality of an online national securities exchange and was required to register with the SEC or qualify for an exemption.”
Without admitting or denying the findings, Coburn consented to the order and agreed to pay $300,000 in disgorgement plus $13,000 in prejudgment interest and a $75,000 penalty. The Commission’s order recognized Coburn’s cooperation, which the Commission considered in determining not to impose a greater penalty.
Just when it seemed there might be a slowdown to the audacity, distortion, spin and deception of the crooked world of ICOs, up crops one more wholly unregulated crypto-casino fund-raising mutation – the IEO.
It’s almost insulting. First off, IEOs represent yet another blatant attempt to hijack a similarly sounding acronym — “IPO” — in an effort to lure investors seeking to get rich quick. However, just like ICOs, the IEO has not a single element in common with the IPO (other than the first and last letters of its acronym).
IPOs are thoroughly and fastidiously regulated by the SEC, enforcing a strict and elaborate set of legal requirements and mandating a rigorous formal process for how they are carried out. In contrast, ICOs and IEOs are investments offered in a virtually unregulated space, where there exists tremendous opportunity for investor loss due to fraud, manipulation, insider trading, hacking and a broad range of chicanery, with little recourse after-the-fact. For example, researchers from the University of Texas found that manipulation in the cryptocurrency market is rampant and much of the run-up in Bitcoin’s price during 2017 was due to manipulation orchestrated by the Hong Kong exchange Bitfinex.
Given its complete and utter lack of oversight and meaningful licensure, the cryptocurrency marketplace is not just the Wild West — its anarchy.
Don’t get me wrong, the blockchain technology on which cryptocurrencies are based may turn out to be the most exciting, disruptive, transformative and efficiency enhancing breakthrough since sliced bread. But aside from complex issues of privacy, security, ethics and simple practicality, blockchain technology remains embryonic; has still yet to be proven; and happens to reside amid an economic ecosystem rife with fraud, deceit, dishonesty and thievery. Consider blockchain’s most celebrated accomplishment — bitcoin. Much of bitcoin’s value, outside of mere speculation, is derived solely from its ability to facilitate criminal activity.
Need a fake I.D., bottle of opiates, a cache of credit card numbers or a thousand social security numbers? Need a way to collect a ransomware payment? Need to fund terrorist-related activities? Need to hire a hitman? Need to finance an election tampering scheme? Cryptocurrencies like bitcoin have become the payment of choice for these, and a slew of other, criminal enterprises.
Moreover, just because some mythical engineer has discovered a potentially revolutionary manner to engage in and verify commercial transactions (e.g. replacing a traditional corporate entry recorded in an intermediary institution’s centralized ledger with a virtual entry recorded on a blockchain’s decentralized distributed ledger), it does not mean U.S. regulators like the SEC should abandon their critical regulatory mandate of investor protection.
In the history of financial innovation, modernization and invention, there has always existed one constant: whatever the product, fraudsters and con artists will attempt to exploit its excitement and enthusiasm in an effort to steal from investors. Hence, the June 6th, 1934, creation of the SEC with its exhaustive compendium of onerous and sticky regulations, policing U.S. securities markets while simultaneously fostering economic growth and capital prosperity.
Cryptocurrency fanatics argue that the SEC, with its antiquated regulatory framework is stifling technologically driven transformation. But policing ICOs, IEOs and the like does nothing of the sort. In stark contrast, the SEC’s cryptocurrency enforcement efforts ensure that U.S. securities markets remain the most efficient; most admired; most respected and most sought after in the world.
So-called “fintech” developments might very well provide promising investment opportunities for institutional and Main Street investors alike and might even make the world a better place, but only when kept in check by the SEC, whose mission is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.
Suppress SEC oversight and enforcement of new-fangled, hi-tech concoctions like IEOs, and prepare for a return to the investor carnage of the Dutch Golden Age of February 1637, and the devastation of Tulip-mania and the Semper Augustus bulb. Not a beneficial outcome for anyone to say the least.
John Reed Stark is president of John Reed Stark Consulting LLC, a data breach response and digital compliance firm. He currently also works as a Senior Lecturing Fellow at Duke University Law School teaching a course entitled, “The Law of Cybersecurity and Data Breach Response.” Formerly, Mr. Stark served for almost 20 years in the Enforcement Division of the U.S. Securities and Exchange Commission, the last 11 of which as Chief of its Office of Internet Enforcement. Mr. Stark also worked for 15 years as an Adjunct Professor of Law at the Georgetown University Law Center, where he taught several courses on the juxtaposition of law, technology and crime, and for five years as managing director of global data breach response firm, Stroz Friedberg, including three years heading its Washington, D.C. office. Mr. Stark is the author of, “The Cybersecurity Due Diligence Handbook.”