Guidance from the Securities Exchange Commission (SEC) regarding Initial Coin Offerings (ICOs) has arrived a bit earlier than we initially predicted (we only missed it by a month or so), but nonetheless, represents a shakeup in the venture capital marketplace many, including BitAML, saw as a foregone conclusion.
In short, in light of the SEC’s guidance following investigation of the DAO, ICOs may not be the market disruptor that was initially envisioned.
Let’s take a closer look at the recent guidance and what it means going forward. First and foremost, we want to be honest about what this means — it’s not be taken lightly.
ICOs In Brief
Since their inception, ICOs have shown promise in generating a great deal of capital for startup companies through token-based equity shares. How it works is quite clever. The ICO is generated through blockchain software such as Ethereum and can be used to make “smart contracts” or investments. The amount of capital generated through this method of crowdfunding is astronomical; nearly $2.3 billion has been raised to date, with most of the earnings generated in the first half of 2017.
For this reason alone, it comes as no surprise that the SEC has investigated and cautioned against ICOs while treating the funding method more like an IPO (Initial Public Offering) than a novel method of crowdfunding.
SEC’s Guidance Is A Warning
However, an ICO is not the same as an IPO. An ICO sells investors royalties (membership coins) to a project through the cryptocurrency used in the ICO. The coins or tokens purchased allow investors to access, use, or vote on the service within which they’ve invested. Additionally, these cryptocurrency “coins” or tokens can often be traded or sold on secondary markets.
Through an IPO, investors gain shares in the ownership of a company which in return are sold to the public on a securities exchange. Although the technicalities differ, the SEC has now determined that these cryptocurrency financing events are to be treated and regulated as securities.
In light of this new announcement, many industry participants have sought to avoid the securities label by offering so-called “membership tokens” or attempting to restrict secondary sales on exchanges or other third-party platforms. However, this may not be enough. ICO participants are urged to contact a securities attorney prior to launch, for something as seemingly benign as paying your employees in tokens could give the appearance that the ICO is a security. There’s no telling if these ploys will work, therefore, industry participants are urged to take precautionary measures when proceeding with these endeavors.
The DAO Investigation
The SEC guidance regarding the ICO industry comes on the heels of their investigation of an initial coin offering facilitated by the DAO.
The DAO was a decentralized autonomous organization with open source code, thus, it was not tied to any particular jurisdiction or state. This posed many questions and concerns on how government regulators would deal with such an organization.
The DAO’s objective was to provide a decentralized pre-programmed business model for organizing and ruling both commercial and non-profit businesses. The dream was to eliminate the documents and people needed to run an organization by hard-coding certain rules that a company would follow from the get-go. For this to happen, the DAO was instantiated on the Ethereum blockchain and received funding through an initial coin offering. Through this offering, every investor who had access to the internet could hold DAO coins which meant they could vote on which projects to fund.
The offering was a massive success; the DAO generated the largest crowdfunding campaign in history, earning $150 million in just a few days in May 2016.
However, shortly thereafter, in June 2016, a hacker managed to drain $50 million worth of Ether from the DAO.
The problem with the DAO technology is that the code can not necessarily be changed once it’s initiated on the Ethereum blockchain. So, once this hacker had discovered a bug in the code, there was no stopping it.
After a controversial decision, developers decided to hard-fork the Ethereum blockchain, and all funds were restored to the original contract. Unfortunately, this decision went against the DAO’s rules and caused estrangement in the community.
The SEC’s Conclusion, In Brief
After investigation of the DAO case, the SEC determined that the DAO was offering securities as opposed to “membership tokens,” and is therefore subject to the federal securities laws.
The DAO will not be charged in this case; the SEC guidance offers the DAO as a cautionary tale to remind “investors of red flags of investment fraud, and that new technology may be used to perpetrate investment schemes that may not comply with the federal securities laws.” The SEC is continuing their efforts to learn more about the effects of distributed monetary transactions and other innovative technologies.
Additionally, after the investigation, Stephanie Avakian, Co-Director of the SEC’s Enforcement Division stated, “The innovative technology behind these virtual transactions does not exempt securities offerings and trading platforms from the regulatory framework designed to protect investors and the integrity of the markets.”
Going forward, the SEC’s Office of Investor Education and Advocacy will be educating investors about ICOs, and the possible dangers and investment fraud that may be associated with these new technologies.
BitAML’s Conclusion About The Market Impact Of The SEC Guidance On ICOs
We believe that the SEC will begin, if it has not already, an organized and comprehensive automated cease-and-desist letter-writing campaign, wherein it gives ICOs an opportunity to return the funds and cease operations in exchange for no or reduced regulatory actions or consequences. How the industry responds now will dictate subsequent and future interactions.
As for all of the cryptocurrencies concerned, the ICO guidance issued by the SEC may pose some serious setbacks. A number of startups looking to utilize this crowdfunding method may dwindle as investors become wary of the potential consequences. This could result in the drop of certain cryptocurrencies, but only time will tell.