SEC Begins Offering Guidance on Initial Coin Offerings

On July 25, 2017, the Securities and Exchange Commission (SEC) issued its first guidance on how it will interpret token issuances or “Initial Coin Offerings” (ICOs) under relevant securities laws. The headlines—“SEC Finds DAO Tokens are Securities”—come from Release No. 81207, “Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO” (July 25, 2017), in which the SEC determined that the tokens issued in association with the Distributed Autonomous Organization (DAO tokens) in April-May 2016 were securities and explored the various implications of that determination.  (See Steptoe’s analysis of this report here.) However, the real news may be the other document released on July 25, a notice to investors titled “Investor Bulletin: Initial Coin Offerings” (July 25, 2017).  In that document, the SEC sets out several areas of concern regarding ICOs—framed as advice to investors—from which the reader can discern the SEC’s initial expectations with respect to ICOs.  Much of the guidance is not surprising, but the SEC’s statement paves the way for more certainty for companies considering ICOs. In a question-and-answer section titled “Some Key Points to Consider When Determining Whether to Participate in an ICO,” the SEC gives recommendations in several pertinent areas, which if rephrased, form important considerations for companies looking to issue tokens through an ICO.

• The SEC will interpret certain ICOs as the offer and sale of securities. (See the DAO Report for an analysis of the DAO tokens.)
• If the tokens issued as part of the ICO can be considered securities, then the virtual coins or tokens must be registered with the SEC, or the sale must be made pursuant to an exemption from registration.
• Companies planning ICOs should carefully review the criteria for exemptions from registration, including the provisions relating to accredited investors and other restrictions involving net worth or income requirements, and should satisfy the criteria for those exemptions for US investors should the token be considered a security.
• The SEC will likely scrutinize representations that particular ICO offerings are exempt from registration.
• Sales of tokens as part of a crowdfunding should adhere to the requirements of the SEC’s crowdfunding regulations (called Regulation Crowdfunding) and other relevant securities laws.
• If the virtual token or coin is a security, “investment professionals and their firms who offer, transact in, or advise on investments” must be licensed or registered in accordance with federal and state securities laws.
• The SEC will scrutinize what it considers to be “jargon-laden pitches, hard sells, and promises of outsized returns.”

The SEC also made recommendations as to what investors should look for in a white paper or other offering document:

• Companies issuing tokens should have “a clear business plan that you can read and that you [can] understand”; the “rights that the token or coin entitles you to should be clearly laid out, often in a white paper or development roadmap”; it should include “how and when you can get your money back in the event you wish to do so,” including whether there is the right to receive a refund or to resell the token, and “any limitations on your ability to resell the coin or token.”
• The white paper, development roadmap, or other documentation should state “whether the blockchain is open and public, whether the code has been pubished, and whether there has been an independent cybersecurity audit.”

Additionally, the SEC noted a number of concerns regarding ICOs and virtual currencies more generally, including the following:

• The SEC is concerned that “virtual currency exchanges and other entities holding virtual currencies, virtual tokens or coins may be susceptible to fraud, technical glitches, hacks, or malware. Virtual tokens or virtual currency may be stolen by hackers.”
• The SEC is concerned that law enforcement faces significant challenges when investigating ICOs, including: tracing money, since “traditional financial institutions (such as banks) often are not involved with ICOs or virtual currency transactions, making it more difficult to follow the flow of money”; international scope, in that “ICOs and virtual currency transactions and users span the globe,” and that “the SEC may be unable to obtain information from persons or entities located overseas”; the lack of a central authority that would “collect virtual currency user information”; and the inability to freeze or secure virtual currency.

Finally, the SEC highlighted “potential warning signs of investment fraud,” including:

• Guaranteed high investment returns
• Unsolicited offers
• An offering that “sounds too good to be true”
• Unlicensed sellers
• Lack of net worth or income requirements for purchasers of tokens

The SEC will likely issue additional guidance in the months ahead, but these insights drawn from the Investor Bulletin on ICOs give companies a good sense of some of the SEC’s primary focus issues.