Regulation of ICOs

Blockchain & E-Transactions Law

This is Part 2 of a seven-part series of posts looking at some broad legal issues affecting crypto-currencies.

State and federal regulators, especially the SEC, have moved aggressively to halt unregistered initial coin offerings ("ICOs") as unregistered securities sales, where the tokens involved have the attributes of equity in return for money, goods, or services. The SEC first asserted its jurisdiction over token ICOs in its § 21(a) Report on The DAO. Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Rel. No. 34-81207 (SEC, July 25, 2017), here.

The touchstone is the long-standing Howey analysis to determine whether a transaction involves an "investment contract" that is a "security" subject to registration and regulation under the Securities Act of 1933 ("'33 Act") and the Securities Exchange Act of 1934 ("'34 Act"). The Howey "Investment Contract" test looks past buzzy terminology to examine the "economic realities" of a transaction, asking it involves:

(1) An investment;

(2) In a common enterprise;

(3) With an expectation of profits;

(4) Derived from the efforts of others.

SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946); see also United Housing Found., Inc. v. Forman, 421 U.S. 837, 852-53 (1975) (The "touchstone" of an investment contract "is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.").

It doesn't matter if the newly-"minted" tokens are distributed as a sort of payment-in-kind - or "bounty" - for goods or services, instead of sold for cash or crypto-currency. See In the Matter of Tomahawk Exploration LLC, Rel. No. 34-83839 (SEC Aug. 14, 2018)("bounty program" coins for marketing in ICO were securities under Howey and The DAO as equity in return for services in oil and gas drilling venture)

If an ICO or other token distribution is a "security," then the consequences include (among others):

  • Required registration of the offering, or compliance with requirements for offering exemptions, under the '33 Act and accompanying regulations;
  • Disclosure Requirements required in either case;
  • Anti-Fraud Rules applicable under the '33 and '34 Acts; and,
  • SEC Enforcement Jurisdiction.

The SEC even set up a fake ICO website, HoweyCoins (here), with a "Buy Now" click-through to an investor education page (here).

The SEC's various enforcement actions involving ICOs are listed here.

More recently, the SEC Staff has suggested that some tokens (theoretically) might "mature" away from status as a "security" if and as the DAO ("decentralized autonomous organization") becomes sufficiently decentralized that it no longer relies upon the "entrepreneurial or managerial efforts" of the organizers. W. Hinman, Dir. Corp. Fin., Digital Asset Transactions: When Howey Met Gary (June 14, 2018), here.

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