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By Robert Kim
Robert Kim is a Legal Editor with Bloomberg BNA. He previously worked for the Securities and Exchange Commission and the Department of the Treasury's Financial Crimes Enforcement Network.
In 2017 there has been a rise in publicity on so-called “ICOs” (Initial Coin Offerings), a method for raising capital used by blockchain startups. These fundraising campaigns, whose name indicates their passing resemblance to IPOs, are sales of digital currency made directly to the public, using blockchain technology to bypass conventional capital markets and regulatory systems and requirements.
They are comparable to the use of blockchain technology for Bitcoin and other digital currencies, which bypass conventional financial institutions and fiat currencies. Like digital currencies in 2013-14, ICOs are currently growing in usage and public attention. They also carry considerable risk of frothiness and fraud and the likelihood of increasing regulator attention.
An ICO is an offering of digital currency issued by a company rather than of conventional shares of equity. The company offers its own digital currency, created specifically for the ICO (an “altcoin,” short for “alternative currency,” a digital currency other than Bitcoin), directly to the public.
Advertising and releases of information occur on the company’s website and on online forums such as Bitcointalk and Reddit, with some offerings reported by cryptocurrency news websites. Investors purchase the altcoins with Bitcoins or other digital currency in most ICOs. Secondary markets for the altcoins exist on numerous digital currency exchanges, where altcoins can be bought and sold for Bitcoin, other altcoins, or fiat currency.
These characteristics have made ICOs especially useful to small blockchain startups. For startups unable to find an angel investor or venture capital firm interested in their business plans, and far from being able to consider the effort and costs of an IPO, with disclosure requirements and other obligations under securities laws and regulations, an ICO may be the best alternative.
Any small startup familiar with digital currencies can create a digital currency, and selling them in ICOs has become a do-it-yourself method of raising capital. An ICO can serve a purpose similar to that of equity crowdfunding, as authorized in the U.S. by Title III of the JOBS Act and its implementing regulations issued by the Securities and Exchange Commission (SEC) in 2015.
The characteristics of ICOs also create downsides for offerors, however, since they result in regulatory uncertainty and lack of disclosure that have limited the appeal of ICOs outside of digital currency fanatics. An unresolved and looming issue has been whether the SEC will consider altcoins issued in ICOs to be securities and ICOs to be offerings of securities, which would subject ICOs to the requirements of the Securities Act of 1933 and secondary sales of their altcoins to those of the Securities Exchange Act of 1934. Companies conducting ICOs have sought to avoid U.S. securities regulation by registering in foreign jurisdictions, among the most popular being Singapore, one of the first jurisdictions to adopt a regulatory sandbox and other regulatory relief initiatives for fintech companies, and Switzerland, whose “Crypto Valley” is a major center of blockchain startups, but foreign registration does not exempt offerors of securities to U.S. persons. Some have structured ICOs to fit within U.S. securities law exemptions, such as the Regulation D exemption for accredited investors and the Regulation S exemption for offshore investors. Regardless of legal status, disclosure in ICOs generally has been limited and lacking verification by disinterested parties.
As a result, liquidity in the market for ICOs has been limited, and ICOs have mostly been small. Before 2017, most ICOs were measured in thousands of dollars, and an ICO raising single digit millions of dollars was considered large.
The first ICO occurred in August 2013, during the period when Bitcoin first rose in price to over $200 and emerged as a subject of mainstream media attention, and the use of ICOs has risen and fallen following the value of Bitcoin and the trendiness of investing in blockchain ventures.
The first ICO, which issued the altcoin Mastercoin, raised approximately $600,000 (5,122.08613664 Bitcoins) for a project to create a Bitcoin exchange and platform for other transactions. ICOs raised an estimated $25 million in 2014, then fell to $10 million in 2015 after the collapse of the price of Bitcoin in 2014. In 2016, ICOs rose to an estimated $225 million, after a resurgence in the price of Bitcoin and a surge in interest in blockchain and Fintech. (These figures are from the research firm Smith + Crown.)
A landmark ICO was that of Ethereum in 2014. The second largest ICO to date, it provided startup funding for the development of the Ethereum platform that has become a significant factor in the market for development of business blockchain applications. Ethereum originated from a white paper published in late 2013 by 19 year old Russian-born programmer Vitalik Buterin, who had dropped out of a university in Canada after receiving a Thiel Fellowship. The white paper proposed the use of blockchain for smart contracts, decentralized autonomous organizations (DAOs), and other applications beyond the initial usage for Bitcoin. Ethereum incorporated in early 2014 as Ethereum Switzerland GmbH and conducted an ICO issuing the altcoin Ether (ETH) from July 20-September 2, 2014, raising approximately $18.4 million (31,529.49 Bitcoins), the largest amount raised by an ICO up to then.
Early funding from the ICO enabled the development of the Ethereum platform, which has become one of the leading platforms for development of blockchain applications by both startups and large established businesses. The Enterprise Ethereum Alliance, a nonprofit organization formed in March 2017 to facilitate the development of open source standards by Ethereum users, included Microsoft, Intel, JPMorgan Chase, Santander, and other leading technology and financial industry firms at its launch and has recently added 86 more members including Deloitte, the Illinois Department of Financial and Professional Regulation, ING, Mitsubishi UFJ Financial Group, National Bank of Canada, Samsung SDS, and Toyota Research Institute.
The largest ICO to date also involved Ethereum, but soon afterward it became the largest failure of an ICO. The fate of this ICO and the response to it demonstrate two significant problems inherent to ICOs and digital currency generally: the special vulnerability of blockchain-based financial transactions to cyberattack, and the arbitrary nature of the valuation of digital currency.
In April-May 2016, an Ethereum-based project called The DAO conducted an ICO to capitalize what was intended to be an investment fund without a manager, in which all investors would participate directly in investment decisions using The DAO’s Ethereum blockchain application to communicate and coordinate – a DAO, as envisioned by Ethereum’s founder. The ICO raised approximately $150 million, the most by far of any ICO to date and approximately two-thirds of the estimated volume of ICOs in 2016. The funds raised represented approximately 15 percent of the then-market value of Ether in circulation, an indication of the significance of the project to Ethereum investors and adopters. Problems soon emerged by mid-June 2016 after a hacker exploited a software vulnerability in the smart contract of The DAO and succeeded in stealing over $40 million (3.6 million Ether) from The DAO. The theft brought the project to a halt and caused the value of Ether to plummet from over $19 to below $12 in four days.
Since Ethereum was a significant venture whose digital currency was at the time second largest in total market value behind only Bitcoin, it undertook corrective action to enable investors in The DAO to recover their funds. In July 2016, Ethereum executed what was called a “hard fork,” which replaced the original Ethereum blockchain with a new blockchain which reversed the theft. The original blockchain remained in existence, however, and many continue to consider it to have value and hold and trade it under the name Ethereum Classic. The “hard fork” split the Ethereum community and a minority of the community continue to support Ethereum Classic and give it value. The original Ethereum continuing to have market value even after its creators discontinued it is an extreme example of the arbitrary nature of digital currencies and their valuation, already demonstrated by the more widely known wild volatility of Bitcoin in 2013-17 .
Despite the issues demonstrated by The DAO, ICOs surged in 2016 and have advanced further in 2017. As of mid-May, ICOs raised more than $150 million in 2017, according to Smith + Crown. Moreover, more established and sophisticated issuers and investors have become involved in them in 2017.
Blockchain Capital, a small venture capital firm founded in 2013 that specializes in blockchain projects, used an ICO to capitalize a new investment fund in April 2017. Blockchain Capital conducted a $10 million sale of an Ethereum-based digital currency named BCAP on April 10, to fund the Blockchain Capital III Digital Liquid Venture Fund, named for the ability of investors to liquidate their investments by selling BCAP through digital currency exchanges. Showing a higher level of awareness of U.S. securities laws and regulations than most predecessors, Blockchain Capital designed its offering to ensure that it would be exempt from registration with the SEC, making it to U.S. investors under Regulation D and to offshore investors under Regulation S.
Tezos, started in 2014 to create a blockchain competing with Ethereum by Arthur Breitman and Kathleeen Breitman, formerly of Goldman Sachs, Morgan Stanley and Bridgewater Associates, is planning an ICO after already obtaining venture capital funding several months earlier. Polychain Capital, an investment fund focused on blockchain ventures started in 2016 that received $10 million in funding from Andreessen Horowitz and Union Square Ventures in December 2016, announced an investment in Tezos in February 2017. Tezos then planned an ICO of its digital currency Tez (XTZ) which was scheduled to launch on May 22.
Venture capitalist Tim Draper of Draper Fisher Jurvetson and Draper Athena, an early investor in Skype, Baidu and other successful tech startups announced in early May that he would participate in the ICO as a purchaser of Tez, an announcement that generated considerable media attention. Tezos announced on May 22 that it was delaying its ICO until June because of issues created by overwhelming demand at the regulatory authority of the Switzerland-registered Tezos Foundation, so the results of this ICO remain to be determined.
The rise in ICO investments and publicity about them has begun to evoke comparisons to the 1999-2000 dotcom bubble, but that concern may greatly understate their risks. The overvalued IPOs of that period had at least some grounding in existing financial industry business practices and securities laws and regulations, while ICOs fundamentally depart from them. As a result, ICOs have recapitulated the risks that the U.S. financial industry has spent over 80 years addressing since the Securities Act of 1933, with additional risks created by their unique characteristics. They include:
The rapid rise in ICOs in 2016-17 shows some of the typical characteristics of a bubble, with a rising pool of assets chasing investments whose actual value often is difficult to determine and may often prove to be nonexistent. Two trends have converged during this period to drive up the number of ICOs and the assets invested in them:
As a result of these trends, ICOs have placed high valuations on some startup companies that appear arbitrary and disconnected from any actual economic value of the startup – classic behavior in a bubble. For example, these ICOs in the second quarter of 2017 each raised over $10 million in a single day for a company with a questionable value proposition, with the amounts raised escalating:
Possibly further increasing valuation risks in some ICOs is that the value of a digital currency does not always correlate to the value of a company and its blockchain. Altcoins issued in ICOs are not shares of ownership in the company, like conventional equity, and they vary considerably in how they relate to the company and its blockchain, as shows by the examples of Gnosis and Aragon. The impacts of variations in equity ownership structures are familiar and understood, but how variations in digital currencies relate to their worth is a risk factor that is new and not well understood.
The apparent frothiness has occurred while conventional investments in blockchain startups have risen. Venture capital investments and acquisitions by technology giants such as IBM and Microsoft and large international banks such as JPMorgan Chase and Santander are making ICOs less necessary for many startups with commercially viable projects. This trend may make ICOs attractive more to startups on the fringes of digital currency fanaticism and economic viability, with a high likelihood for value destruction.
ICOs have unsurprisingly proven to be subject to the same flaws of human behavior that gave rise to the characteristics of existing financial markets and their regulations. Lack of disclosure and reliable information is a significant issue, with offerings announced and advertised on unsupervised online forums in which potential buyers can have little confidence in the reliability of information. Fraud has inevitably become part of the ICO market, with accusations of inaccurate information and false promises following some ICOs. As a result, there has been at least one instance of a digital currency exchange emulating a stock or commodity exchange by “delisting” an issuer accused of fraud.
Cybersecurity, of increasing concern to all businesses, is an especially significant problem for ICOs. The ICO of The DAO is the most noteworthy example, involving the loss of approximately $40 million worth of digital currency and an existential crisis for Ethereum as a result of security weaknesses in the smart contact of The DAO, not in the Ethereum platform itself. The lesson of this experience may be that ICOs avoided exploitation of their vulnerabilities while they were small, but becoming large enough to be worth the attention of cyber criminals makes their inherent reliance on technology into a potentially significant liability that requires a high level of security precautions and auditing that will drive up the cost of larger ICOs.
Regulatory risk is a further concern for ICOs. ICOs have not been the subject of any actions by the SEC or other regulators, but scrutiny by regulators in the United States or abroad is likely, especially if ICOs continue to grow in scale or cases of alleged fraud emerge. ICO sales of digital currency may fall under the Securities Act of 1933, and the ability to resell them on digital currency exchanges could invoke the Securities Exchange Act of 1934. The Investment Advisers Act and Investment Company Act of 1940 may be relevant in the event of investment company involvement in ICOs. The SEC and FINRA, among others, have issuedwarnings about the risks of investments in Bitcoin and other digital currencies; , and they and other regulatory and law enforcement agencies may decide to focus on ICOs if they become a significant part of the market for investments and a triggering event occurs. Companies issuing digital currency in ICOs, digital currency exchanges, and investment companies attempting to invest in ICOs all could become subject to regulatory and enforcement action.
To address the regulatory uncertainty surrounding digital currency and blockchain technology, in March 2017 a broker-dealer/fintech company submitted a request to the SEC that it clarify its position on the regulation of issuers of digital currency that may be deemed to be securities. The SEC has not yet responded to this request.
Blockchain startup companies generally are aware of the possibility of regulatory scrutiny of ICOs. As a result, digital currency issuers often avoid calling their actions ICOs and instead call them “crowdfunding,” “token sales,” “presales” or other names that do not suggest activity similar to that of regulated financial institutions. Mere terminology would not protect them from scrutiny in the event of interest from the SEC or other regulators, however, so taking into account U.S. securities laws continues to be a necessity whenever U.S. persons are either issuers or buyers in an ICO.
Startup companies using ICOs have only begun to figure out their regulatory risks and how to address them. In April 2017, Blockchain Capital used the approach of designing its ICO to make it eligible for the Regulation D and Regulation S exemptions to the Securities Act of 1933. The applicability of these exemptions and other provisions of the securities laws and regulations to differently structured offerings remains to be determined.
How ICO issuers address the possibility of regulatory scrutiny, and how they and buyers react to the market correction that is likely to be inevitable, will in large part determine whether ICOs become a significant factor in raising capital for technology startups or prove to be a fringe and possibly short-lived development. As long as the risk that digital currency may be considered to be securities exists, issuers of digital currency in ICOs will have to take precautions in order not to risk potential liability under the securities laws of the U.S. and other countries. Moreover, ICOs have yet to demonstrate that they can raise large amounts of capital without the currently rising and apparently artificially high valuations of Bitcoin, Ethereum and other digital currencies used in them. The resolution of these issues will determine whether ICOs end up being a short-term fad or a long-term development.
Copyright © 2017 The Bureau of National Affairs, Inc. All Rights Reserved.
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