Initial Coin Offerings and SEC Enforcement: Protecting Investors (Part IA)

July 5, 2018

SEC HQ front.jpg  By Dan Portnov

Last week I had the pleasure of attending a reception featuring SEC Commissioner Robert Jackson, who spoke about FinTech, ICOs and crypto-assets. Jackson’s prepared comments and subsequent Q&A session were a rare look into one Commissioner’s concerns and hopes for cryptocurrencies as ICO quantity and investment set records each quarter. (Disclaimer: Jackson’s views did not reflect those of the Commission).

To the surprise of no one, Jackson echoed SEC Chair Jay Clayton’s views that most ICOs are securities that should be registered unless exempt and that not all ICOs are fraudulent. Among the other key takeaways:

  • Jackson approaches policymaking and enforcement with the guiding principle of protecting investors from fraudulent ICOs and bad actors in the cryptocurrency space.
  • The SEC has not yet pursued US cryptocurrency exchanges (g. Coinbase) that have not registered as exchanges under Section 6 of the Exchange Act, because it does not want these exchanges to move operations offshore, thereby limiting the Commission’s ability to pursue enforcement and remedies on behalf of US investors.
  • Jackson places little to no value in ICO white papers, calling them worthless and no substitute for fulsome disclosure.
  • Just because a coin or token may be a security at time of issuance, it may, over time, lose the characteristics that make it a security and no longer require application of the disclosure regime of federal securities laws. On this point, Jackson repeatedly cited the recent speech by William Hinman, Director of the Division of Corporate Finance.
  • The SEC’s custody rules and safeguards may be unworkable for cryptocurrency investors. Notably, once a private key to a cryptocurrency wallet is known to a third party, the cryptocurrencies held in that wallet are as good as gone, with no recourse for their owner.
  • Development of the analysis of whether coins and tokens are securities will likely take place through requests for No Action letters from the SEC.
  • The Commission is keen for developers, lawyers, investors and others in the cryptocurrency space to share trends they are seeing and become partners in promoting sound policy.

Jackson’s point regarding the difficulty of applying custody rules to cryptocurrencies raises a vital question: How can potential investors confirm that a seller of cryptocurrencies has custody of the underlying assets, services or applications that give (or will give) the coin its value?

Earlier, I wrote about the SEC and other regulators’ efforts in fighting fraudulent ICOs, and noted that investor due diligence is one of the keys to eliminating fraudulent ICOs. For example, the claims that RECoin or DiamondCoin were backed by real estate and diamonds, respectively, should have been easily verified by investors seeking deeds, title documents, independent auditor statements, or a tour of a safety deposit box. Further, as true aficionados will point out, one does not need cryptocurrency’s prime feature, blockchain technology, to invest in real estate or diamonds. Still, these realizations came too late to some, and $300,000 was lost.

Investors’ interest for cryptocurrency remain quite high, just as developers and issuers are keen to raise money through ICOs. Jackson said as much during his remarks and the data seems to bear this out. Though it was left unsaid, the gist of the questions and hypotheticals posed during the spirited Q&A with Jackson was that the robust appetite for ICOs has created an imbalance of power and information between issuers and investors. That is, investors may not know what questions to ask or diligence to perform, and coin issuers know they do not have to be independently forthcoming in order to secure investment.

As promised, my next post on this topic will go through the due diligence checklist first introduced by Chair Clayton, with an eye toward leveling out the ICO information imbalance.

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