Aaron Kaplan, securities attorney at Gusrae Kaplan Nusbaum PLLC and COO of Prometheum, where he has focused on blockchain and securities regulation. He is guest author for this Opinion/Editorial.
Initial Coin Offerings (ICOs) have become the investment du jour while the understanding of what ICOs are has become desperately convoluted. Every huckster, scammer and opportunist has tried to hop on the bandwagon. (I’m talking to you, Casey Ryback) Many of these ICOs were a means for scammers to raise money over the internet from unsophisticated investors whose “FOMO” outweighed the obvious red flags associated with such offerings.
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Identity Crisis for Initial Coin Offerings
The rapid growth of the ICO industry ($6+ billion) and the inherent scams and related investor losses forced the SEC to consider ICOs in the context of the Federal Securities Laws (FSLs). The SEC’s recent broad subpoena sweep marked the SEC’s official declaration that ICOs are securities. Now that ICOs must comply with the FSLs, it should come as no surprise that a new type of trickster is trying to hijack the innovation through either a) selling illiquid tokens to wealthy investors or b) selling traditional securities that are registered on a blockchain.
To set the record straight, and provide much needed clarity, here is a condensed description of ICOs and their intended benefit. ICOs are an innovative means of capital formation. Issuers offer a securitization of user interest in an ecosystem as an investment to the general public. Assuming the issuer has reasonable token economics, then the greater the user interest in the ecosystem, and the utility of the underlying token, the more the value of such token should increase. It’s supply and demand, but the price is not reflected in the common stock; rather, it is reflected in the cryptographic token representing the user interest.
Furthermore, an ICO should have two key features:
1. It should be available to the general public, and
2. It should be able to freely trade on the secondary market when the token is issued.
The securities of ICOs to date have not and cannot achieve both those goals. Such securities are illiquid and only available to accredited investors/institutions.
As the industry matures through compliance with all relevant rules and regulations, I fear we are losing the spirit of ICOs, which some argue may not be sustainable under the FSLs.
Issue 1: Reg D/SAFT ICOs
The Filecoin Reg D token offering in mid-2017 was an important point for honoring the Federal Securities Laws. Reg D ICOs raise capital with proper offering documents (a requirement under the FSLs) by selling tokens that have proposed utility in an ecosystem. While such ICOs are legal by nature, companies conducting ICOs in a Reg D (or a SAFT) offering forgot how an ICO was supposed to function.
These Reg D and SAFT ICOs inherently contradict the spirit of an ICO- a token sale that should be open to all investors (both accredited and non-accredited), and freely trading in the secondary market. Reg D and SAFT issuers’ token sales are only open to accredited investors (i.e. wealthy individuals and institutions) and are restricted securities (meaning they can’t trade freely on the secondary market until the issuer files current public information and essentially registers such securities with the SEC).
These issuers, while understanding that ICOs are securitizations of user interest, missed the mark. Their ICOs are illiquid and limit participation to the wealthy. Investors won’t have the ability to trade those tokens, and are stuck with illiquid (untradeable) securities that have the same issues as those associated with traditional venture funding – waiting for a buyout event or going public (which is extremely rare) before investors can realize a return on their investment.
Issue 2: ICOs vs. Traditional Securities Issued Over a Blockchain
Opportunistic companies are also trying to use the concept of an ICO, turning an innovative method of monetizing an ecosystem into a cheap marketing ploy. The most frustrating example of this practice are companies who say they are raising capital for an ICO, but in reality they are just issuing traditional equity or debt securities that are represented by a cryptographic token. These aren’t ICOs, but rather traditional securities registered (like a transfer agent’s log) over a blockchain. While many (including me) believe blockchain securities are the future of securities ownership, a preferred equity token is not an ICO. It is a traditional security that is issued over a blockchain.
Securities issued over a blockchain MUST be distinguished from ICOs. An appropriate definition of an ICO in 2018 is the following: an ICO is a securitization of user interest. It is not a debt or equity security, but rather a new type of security – an investment whose value is related to the user’s interest in an ecosystem and the utility of the actual token in that ecosystem. It is essential that the industry understands the difference.
In late March, a company tried to issue a blockchain security for a building. Such cryptographic tokens represent ownership in the building and trade over blockchain. That is a traditional Reg D security, and not an ICO. The company received news coverage for being the first company to sell interests in a building using a blockchain. However, many companies have sold interests in real property online. This company is doing the same thing – basically putting lipstick on a pig.
So how do we define an ICO?
ICOs are innovative ways to unleash/monetize potential value from the user interest in an ecosystem. ICO tokens represent a new type of security whose value is related to the user appetite in that ecosystem (daily average use, recurring use, etc.). Ideally, an ICO should be available to all types of investors (accredited and non-accredited) and be freely tradable when the underlying network goes live.
With ICOs officially coming under the FSLs regime, the industry should take a moment to reflect on what an ICO is and will be under the FSLs before it morphs from a genuine innovation into a marketing ploy.
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How do you define an ICO? Share your thoughts in the comments section below.
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