“Regulators have never seen a new financial product explode with the speed and velocity [of ICOs].”[1] As we discussed last week, the SEC has started to regulate matters relating to Initial Coin Offerings (ICOs), such as setting out specific guidelines for celebrities who endorse ICOs and how investors should make informed decisions on the market. In the past year “$3.3bn has been raised in more than 200 ICOs” – but what are ICOs and why have they become so popular? The Financial Industry Regulatory Authority (FINRA) has published a comprehensive explanation for individuals looking to invest in trendy ICOs.[2]
In an Initial Public Offering (IPO), a company offers its shares of its stock to the public and investors receive ownership rights of that company. However, an ICO is substantially different as investors do not obtain ownership rights and instead of a prospectus they typically receive a white paper that sets out the details of the ICO. “In an ICO, a company creates a new virtual coin or token that they offer for sale and disseminate to purchasers using blockchain technology”.[3] Blockchain technology is a digital, decentralized ledger which can record any type of transaction on a peer-to-peer basis. These tokens are purchased using fiat or virtual currencies (such as bitcoin) and are subsequently recorded on the ledger.
FINRA explains that an ICO “involves the creation of a new virtual coin or token by a company looking to raise money.”[4] In a sense it is a type of high-tech crowdfunding. However, this is different than a bond since investors are not lending the money and there is no guarantee on the gains or losses. Can an ICO be a securities offering? Yes. As we noted last week, if the ICO is a securities offering, the company must adhere to U.S. federal securities laws and register with the Securities and Exchange Commission. As an investor, it is important to verify that the ICO offering securities meets SEC guidelines, unless it is exempt and therefore limited to accredited investors. There is a fine line between tokens on a blockchain platform and securities – the “SEC, for instance, argues that the technology is irrelevant: when tokens are used to raise funds, they are securities.”[5] However, advocates for ICOs argue that these tokens have a greater and more complex purpose. Many companies to avoid scrutiny from the SEC have offered options and futures for tokens, which “[dodges] the problem posed by projects that do not yet use the tokens.”[6]
Before purchasing tokens in an ICO, it is imperative to read the company’s business literature, terms and conditions, and white paper. These will set out the investors’ rights and benefits, how the tokens can be sold or exchanged, and whether reselling on a secondary market is permissible. Typically, ICO’s differ from IPOs as they do not grant ownership rights and therefore “token holders may not have any voting rights or influence on a company, its governance and how funds are used.”[7] It is key for investors to do their due diligence before making investment decisions so that they are aware of their rights.
The encryption methods used in blockchain technology make it secure, reliable and transparent. However, as the use of virtual exchanges are still new investors should ensure that companies take the necessary steps to “protect their platform and products” from cyber security threats. FINRA has published a list of scams and red flags to look for before investing in ICOs.
[1] The Economist. “regulators begin to tackle the craze for initial coin offerings.” The Economist. Available at: https://www.economist.com/news/finance-and-economics/21731157-they-raise-difficult-legal-questions-regulators-begin-tackle-craze. Accessed on Nov. 10, 2017.
[2] FINRA. (Aug. 31, 2017) “Investor Alerts. Initial Coin Offerings: Know Before You Invest.” FINRA. Available at: http://www.finra.org/investors/alerts/initial-coin-offerings-know-before-you-invest. Accessed on Nov. 10, 2017.
[3] Ib.
[5] Op. Cit. n1.
[6] Ib.
[7] Op. Cit. n2.