I’m not mad I’m terrified. These are blue chip deals with top law firms who checked every box they could think of. And the SEC is going after not just the companies but the investors.
– Arrington XRP Capital’s Michael Arrington in a since-deleted Tweet
The U.S. Securities and Exchange Commission’s (SEC) probe of the cryptocurrency sector has very much been the story of the month, dominating headlines across crypto asset and blockchain technology sites and spurring a precipitous price drop across all crypto markets. While not entirely unexpected by crypto-professionals, nevertheless the community is scrambling to find their footing amidst the depth and breadth of the Commission’s actions.
If you haven’t been following the story, earlier this month it was reported that the SEC had issued dozens of subpoenas and information requests to technology companies and advisors involved in cryptocurrencies.
In the weeks that have followed, there has been a great deal of speculation as details of the extent of the probe and its consequences continue to emerge. Here’s what we know so far.
First, how did we get here
Initial Coin Offerings (ICOs) attracted global attention in the latter part of 2017 when the number of companies using the fundraising method sky-rocketed to the point that more than several billion dollars had been raised (popularly referred to as the “ICO Boom”). At this time it was common belief that so-called “utility” tokens issued by companies during an ICO did not constitute an offering of securities and as such were exempt from U.S. Securities legislation. The SEC’s subpoena sweep is a clear indication that as far as the regulator is concerned, this is not so.
The SEC’s first significant pronouncement was on July 25, 2017, when they ruled that the DAO constituted an offering of securities and indicated that “some” crypto offerings would be viewed similarly. In the months leading up to the current probe, there was growing concern and speculation surrounding the actions the SEC would take against token-issuers – with calls from both sides for clarity on the issue. And indeed, the surge in ICO activity had not passed unnoticed. During this time the SEC issued a number of statements putting companies planning to hold ICO’s on notice. In a written statement issued on December 11, 2017, SEC Chairman, Jay Clayton, announced:
I have asked the SEC’s Division of Enforcement to continue to police these markets vigorously and recommend enforcement actions against those who conduct ICO’s in violation of the federal securities laws.
At the same time, stakeholders watching the relatively light-handed enforcement actions pursued by the regulator – for example against the DAO – believed that the SEC would be gentle in its enforcement of the emerging area, and only pursue issuers that had clearly engaged in fraud. And for this reason, the SEC’s wide-ranging sweep caught a sizeable chunk of the sector by surprise.
The SEC’s probe comes at a time when the sector is facing additional pressure from the Financial Crimes Enforcement Network (FinCEN) division of the U.S. Treasury Department, who have announced that ICO coins or tokens will be considered a “money transmitter” and will be subject to the Treasury’s registration, anti-money-laundering (AML), regulatory and licensing requirements – breach of which may result in significant penalties, including imprisonment.
What’s happened and who has been targeted
We received a subpoena. Every [crypto]fund I’ve talked to has received one.
– Michael Arrington
At this stage the details surrounding the sweep continue to be hazy. We’re not sure when the sweep began, how many subpoenas have been issued, or precisely what the SEC is looking for. To date, both the SEC and those targeted by the sweep have been understandably reticent to discuss the issue on the record, with the regulator only confirming last Friday that numerous offical investigations into ICO’s were indeed underway. However, with the industry’s biggest names continuing to hold their silence, a lot of the uncertainty surrounding the sweep is likely to remain.
What is clear from the few details that have been confirmed is that the SEC has cast its net deep and wide.
1. How many subpoenas have been issued?
Last Friday the SEC confirmed that “dozens” of investigations into ICO campaigns were afoot. The number of documents issued by the regulator, however, has been estimated at a much higher figure, with rumors of up to 80 subpoenas and requests for information being issued to various individuals and entities, while other sources say the actual figure may be closer to 200.
2. Is there an underlying theme to the subpoenas? If so, what is the SEC targeting?
Many believe the SEC is targeting fraudulent ICO behaviour. But lately an alternative theory has gained traction: that the regulator is actually conducting an investigative probe of the SAFT fundraising method, which, ironically, was designed to enable token issuers to comply with securities law, by issuing coupons for tokens at a future date when a platform is complete. A source for CoinDesk reported as follows: “The SEC is targeting SAFT’s. The new approach of the SEC is to consider tokens as both utility and security at the same time, meaning a token can bring utility to a platform but at the same time can be considered as a security if you sold it to parties that mainly looked for profit on its increase in value.”
3. Who has received subpoenas
Few projects have publicly revealed whether they have received SEC correspondence as part of the sweep. CoinDesk reached out to 14 of the biggest issuers. Few responded. Arrington XRP Capital, the cryptocurrency investment fund launched by Michael Arrington (who also launched TechCrunch), has confirmed that is has received a subpoena. tZero has confirmed that it is under investigation by the SEC, and is now willingly working with the regulator, but reportedly did not receive a subpoena. Quoine has stated it has not been subject to a subpoena or request for information, and Bancor has stated that it has “nothing to report” re: any SEC contact.
There have, however, been reports of issuers, advisors (yep, lawyers included), exchanges and even investors receiving subpoenas. And, from a legal perspective, the pool of individuals and entities that the SEC could potentially target as part of its sweep is quite significant indeed. The rules are complicated, but this group may include the following:
- Company CEOs, executives and board members
- Promoters who helped market the offerings and received tokens in payment
- Advisors who endorsed an ICO on their website and received tokens in payment
- Platforms who listed an ICO and received tokens in payment
- Professionals who may have advised their clients on how best to avoid regulation
What’s actually contained in the subpoenas and requests for information
To add to the uncertainty, accounts as to what is actually contained in the SEC’s subpoenas and requests for information have also been varied. There have been alarming reports of hyper-detailed 25-page documents requesting all communication around token launches, including lists of investors, marketing materials, organizational structures, amounts raised, the location of funds, and people involved and their locations. With many still in their startup stages, concerns have been raised of the ability of a number of token issuers to respond to such requests, which are normally made of larger financial institutions.
Consequences, both short-term and long-term
With more questions than answers, issuers are justifiably concerned about what the outcomes of the SEC’s probe will be and what will happen to those who invested time and money if SAFT’s do not satisfy securities law.
Amid the growing uncertainty, there have already been reports of projects reconsidering their fundraising strategies, with one company (Stream) halting their scheduled airdrop. Advisors are recommending token issuers proceed on the assumption that the SEC will treat virtually all tokens as securities, and ensure their ICO’s are compliant with all Federal securities laws, registration forms and reporting requirements. As these were designed for circumstances very different to an ICO and may be a poor fit, in the longer term, it may be beneficial for ICO issuers to work with the SEC to develop reporting and trading procedures better suited to their needs.
The regulator’s actions have also not been without broader consequences. There is now growing speculation that the SEC’s move could cause the token economy to leave the U.S. – or, as CoinDesk’s Brady Dale put it: “whether a whole new tech economy could come up outside a firewall around the U.S.” Stream, for example, is now looking at whether it can distribute free tokens under the SEC’s Reg S, which permits distributions of securities not registered with the SEC outside of the country.
Steps to ensure your ICO is compliant with U.S. securities legislation
1. Companies who have already issued tokens via an ICO to unaccredited investors
It may be possible to reduce potential liability by offering a rescission – where proceeds of an investment are returned to the investors. It may also be possible to consider forking or burning certain tokens. These are costly, complicated processes and for a startup, a significant step and should only be contemplated with the assistance of reputable counsel.
2. Companies planning to hold an ICO in the future
It is important to ensure that all investors are accredited or that they qualify under an exemption sought and received from the applicable federal and state regulators, and that there is a well-structured disclosure and risk-factors document in place. The whole framework around ICOs is evolving rapidly and a host of ICO launch and compliance companies such as iComplyICO, tokensoft.io, saftlaunch.com and coinlist.co promise whitelisted compliance solutions. However, regulations are evolving rapidly and a clear one-size fits all solution is far from self-evident.
3. Companies wanting to make their tokens freely tradable and available to retain investors
In the U.S., tokens will need to be registered via a traditional public offering, or to register the tokens under Regulation A+ and wait out the 12 month lock up period until the tokens may become freely tradable if certain conditions are met.
Finally, an issuer, could of course, take the SEC to court over the issue. But this would involve a herculean expense. With no guaranteed success, the project would be unable to proceed until litigation had been finalized. And remember, just because a court rules that one token is not a security, does not mean it will decide the same way for all tokens. All rulings are situation-specific and will be decided on a case-by-case basis.
Clearly the days of cowboy capital formation are over. Crypto startups and savvy investors will be closely observing the evolution of investor regulations and ensuring that they are guided by qualified, experienced professionals.
The content in this article is provided for general information purposes and does not constitute legal or other professional advice or an opinion of any kind. We advise our readers to seek out qualified legal or professional counsel before making any decisions.