I am always amazed at how “business” entrepreneurs ignore enforcement risks in the face of specific warnings from regulators.    The SEC and the CFTC have made it clear to the emerging initial coin offering (ICO) and cryptocurrency markets that they intend to vigorously monitor and enforce securities and commodities regulations against the burgeoning industry.

Yet, the latest vehicle for scams continue unabated, driven by greed and ignorance – a deadly combination.  We have witnessed investment scams throughout our history, and there is nothing new about ICOs and cryptocurrency, other than the technology and relevant buzzwords.

Let’s take a step back and put this story in context.  The SEC has been clear that it intends to regulate ICO offerings when they constitute a “securities” offering.  The definition of a “security” is broad and covers a wide swath of investments and financial instruments.

Last year, ICOs raised nearly $7 billion in capital, and this year they have raised nearly $2 billion in the first two months.

Jay Clayton, Chairman of the SEC, has been very public about his warnings to the ICO industry that the SEC will intervene and prevent illegal ICO offerings that fail to comply with securities laws.  Notwithstanding Chairman Clayton’s warnings, several ICOs blithely went forward with little practical understanding of the SEC’s warnings or, more cynically, with blinders and greed to guide them.

Well, surprise, surprise – the SEC just issued a long list of subpoenas to many of the ICO companies and their promoters who are seeking to raise capital.  The focus of the SEC investigations include: (a) CEOs, board members and senior executives from companies who issued so-called “utility tokens” (a term used to exempt the ICO from registration as a securities offering); (b) promoters who helped market the offerings who may be subject to regulation as broker dealers for ICO securities; (c) advisors who were listed on ICO websites and failed to register as advisors; (d) platforms that listed the ICOs and were compensated through undisclosed commissions; (e) professional who advised their clients on how to avoid SEC regulation.

Those interested in joining the new “gold rush” of ICOs would be well advised to start over with the advice and counsel of an attorney who can help navigate the securities laws.  Many of the ICO companies that failed to heed the SEC’s warnings will end up offering investors a rescission to refund their money that will provide them 30 days to accept the offer and reinvest after the company cleans-up its compliance picture.  Investors may sue the ICO company and those cases will drag on in court.

The line between an ICO triggering the registration requirement and a non-security can be a close factual issue.  Chairman Clayton has outlined this issue.  An ICO that is intended to facilitate a “book-of-the-month club” offering may be an efficient way for the club’s operators to fund future acquisition of books and distribution of books to the members holding ICO tokens.  By contrast, if the ICO offers interests in a yet-to-be-built publishing house with authors, books and distribution networks all to be arranged in the future, such an offering is more analogous to a security than a token to club membership. In these circumstances, if the coin or token can be traded in a secondary market with a potential to increase in value or profit from the sale of these tokens, the offering almost certainly falls into the registered securities basket. And in fact, Chairman Clayton said recently in a Senate hearing, “I believe every ICO I’ve seen is a security.”

The SEC has noted that it is possible to conduct an ICO without triggering the SEC’s registration requirements.  One example of an exemption is use of a Regulation D offering.  Rules 504 and 506, respectively exempt certain offerings from registration.  These include:

• Sale of restricted securities up to a value of $5 million in 12 months and which cannot be sold for at least six months or a year without registering them and requires filing of Form D;
• Sale of securities to an unlimited number of “accredited investors” and up to 35 other purchasers who must meet investor sophistication requirements and receive disclosure documents, so long as ICO company avoids general solicitation or advertising to market the securities; and
• Sale of securities even with broad solicitation and advertising provided that investors are all “accredited investors” and shares are restricted securities meaning that they cannot be sold for at least six months or a year without registering them. Companies that rely on Rule 506 must file a Form D with the SEC after they sell their securities.

Eventually, some ICOs will register their new offerings.  Others may test certain exemptions to registration.  The ICO market is definitely going to grow – the only question is how fast and under what regulatory structure.