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ICO Issuers Must Self-Regulate While Regulators Get Up To Speed




An Initial Coin Offering has become a popular way for virtual currency entrepreneurs to raise funds for a new project or concept. This type of venture capital model, a hybrid between initial public offerings and crowdfunding, has been used to finance many virtual currency projects. However, as state and federal regulators have not enacted disclosure regulations that are specific to ICOs, there is little protection for investors. In order to maintain investor confidence, ICO issuers must proactively self-regulate and engage in responsible disclosure practices until a regulatory framework is in place.

Initial Coin Offerings (“ICO”) are the new trend for virtual currency businesses seeking funding to support their projects. In just a few steps, anyone with internet access can create an ICO and collect significant amounts of money in an alarmingly short period of time, even though investors have no ability to hold the issuer accountable for how the invested funds are spent. This unique venture capital model should be the subject of specific government regulation to ensure that ICO issuers make necessary disclosures and that investors have avenues to hold ICO issuers accountable should they act unethically or illegally. Until such regulations exist, ICO issuers must proactively self-regulate to maintain the reputation of blockchain and virtual currency technology.  

An Initial Coin Offering (“ICO”) has become a popular way for virtual currency entrepreneurs to raise funds for a new project or concept. For example, Golem raised more than $8.6 million in just 29 minutes for its Golem Network Token (GNT) ICO and Lisk raised $5.8 million in its four weeks long ICO. Despite its rapidly-growing prevalence in the ever-expanding virtual currency community, a lag in a regulatory structure for this type of fundraising has left investors with little protection from unethical issuers.

Anyone with internet access can create and/or invest in an ICO in just a few steps. A company proposes its project idea during its pre-development or initial development phase to interested backers, who are then given a short window to purchase a percentage of the company’s proprietary cryptocurrency in exchange for fiat money or another cryptocurrency, such as Ether or Bitcoin. After the initial offering period ends, the company is supposed to utilize the funds from the ICO to further develop its project. Ideally, the investor receives some sort of ownership or return on investment in the ICO when the project is completed and becomes profitable, which is represented by the increased value of the issuer’s cryptocurrency. This type of venture capital model, a hybrid between initial public offerings (“IPOs”) and crowdfunding, has financed projects for many virtual currency startups, but there is currently no governmental oversight or investor/consumer protection in place.

Without being subject to a regulatory scheme, companies can issue individualized tokens for ICOs regardless of where they are in the development phase of their projects, sometimes by providing potential investors, who are typically individuals, with only a short description of the project. Without certain basic information and disclosures, it is virtually impossible for ICO investors, who are generally not experienced and have a limited understanding of venture capital practices, to make decisions as informed investors. Those wishing to invest in ICOs have no systematic way to gather information about ICO issuers, how the issuers plan to allocate the funds from the ICO or the development status of the projects in which they are considering investing. As a result, many ICO tokens are issued without any substantive perspective or due diligence disclosures. Given the exponential growth of ICO investments, the government will undoubtedly step in to regulate ICOs as it does other financial instruments.

Typically, companies seeking to raise money are subject to U.S. securities laws. The Securities Act of 1933 requires all offers and sales of security financial instruments to be registered unless an exemption from registration is available. If no such exemption exists, private companies planning to offer stock to the public must first comply with the Initial Public Offering (IPO) requirements set forth by the U.S. Securities and Exchange Commission (“SEC”). In 2015, the SEC adopted Regulation Crowdfunding, an exemption from registration for certain crowdfunding transactions. Crowdfunding focuses on the size and number of investors who back a project, allowing for “the use of small amounts of capital from a large number of individuals to finance a new business venture.” In order to fall under this exemption, a company issuing securities must have a maximum offering amount of $1 million and cap individual contributions based on his/her net worth or annual income. This regulatory structure allows for small businesses and start-ups to raise funds for their new innovations, while still protecting investors from unethical or illegal practices.

In order for the SEC to have jurisdiction over an ICO, the issuer’s tokens themselves would need to be classified as a security. Industry experts have started to examine whether ICO tokens are securities under existing securities laws, but, as the SEC has yet to offer any guidance, this is just speculation. Whether or not ICO tokens may be eventually categorized as securities, or subject to other regulation, in the future, at this point in time, ICO issuers must proactively self-regulate and implement responsible business practices in order to allow blockchain and virtual currency technology to continue to flourish. 

ICOs are akin to IPOs to the extent that private entities offer an investment opportunity to the public. They also have elements of crowdfunding.  In order to ensure that potential investors are fairly informed, ICO issuers should make basic disclosures about the company, projects, and tokens such as some of those required by the SEC for IPOs and crowdfunding.

For most private companies looking to register an IPO, the SEC requires extensive disclosures in a basic form:

  1. A description of your company’s business, properties, and competition;
  2. A description of the risks of investing in your company; 
  3. A discussion and analysis of the company’s financial results and financial condition as seen through the eyes of management; 
  4. The identity of the company’s officers and directors and their compensation; 
  5. A description of material transactions between the company and its officers, directors, and significant shareholders; 
  6. A description of material legal proceedings involving the company and its officers and directors; 
  7. A description of the company’s material contracts;
  8. A description of the securities being offered;
  9. The plan for distributing the securities; 
  10. The intended use of the proceeds of the offering;
  11. Important facts about its business operations, financial condition, results of operations, risk factors, and management;
  12. Audited financial statements; and
  13. Copies of material contracts

The SEC has enumerated the following disclosure requirements for crowdfunding companies that fall under the Securities Act exemption:

  1. Information about officers, directors, and owners of 20 percent or more of the issuer;
  2. A description of the issuer’s business and the use of proceeds from the offering;
  3. The price to the public of the securities or the method for determining the price;
  4. The target offering amount and the deadline to reach the target offering amount;
  5. Whether the issuer will accept investments in excess of the target offering amount;
  6. Certain related-party transactions; and
  7. A discussion of the issuer’s financial condition and financial statements.

Providing the entire list of IPO disclosures would likely be too stifling for most ICO issuers; however, combining some of these categories with the disclosure requirements for crowdfunding transactions strikes a reasonable balance that provides investors with necessary disclosure while not placing too large of a burden on smaller companies seeking to innovate in the developing, but still very young, blockchain and virtual currency ecosystem. To accomplish that goal, at the absolute minimum, ICO issuers should disclose to potential investors:

  1. A description of the company’s business and properties;
  2. A description of the token being offered;
  3. Information about the company's management;
  4. The target offering amount and the deadline to reach the target offering amount;
  5. A description of the investor’s return on investment;
  6. The intended use of the proceeds of the offering;
  7. The plan for distributing the tokens;
  8. The material risks of investing in the company; and
  9. Any material legal proceedings involving the company, any of its officers, or any of its directors.

The virtual currency and blockchain community has collectively embraced ICOs as the current standard investment model for businesses seeking to raise funds for their projects.  This procedure has allowed for large sums of money to be raised in a matter of hours or even minutes. In the absence of specific regulation that applies to ICOs, or any guidance from securities regulators that their regulations cover ICOs, it is imperative that ICO issuers provide potential investors with sufficient disclosures. Although potential ICO investors can always decide not to invest if they are unable to obtain sufficient information concerning an ICO, issuers must maintain the integrity of the virtual currency and blockchain ecosystem by self-regulating.

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