Cryptocurrency is having a powerful moment. Once a niche concern, digital currencies like Bitcoin and Ethereum are now known quantities even among casual investors and news readers. Skyrocketing values, the hallmark of 2017’s crypto boom, made for great headlines as pundits declared that digital currencies were here to stay.
But mainstream recognition and acceptance has led to an unintended, if inevitable, side effect for a system predicated on decentralization, anonymity, and rewriting the banking and investment status quo. That side effect is increased federal oversight.
Governments around the world have been forced to confront the reality of cryptocurrency while simultaneously trying to understand its ins-and-outs. As they grapple with exactly how to supervise crypto markets and investment activity, one type of investment has drawn outsized scrutiny: initial coin offerings, or ICOs. Investors and companies are bullish on the possibilities they offer, but government officials are notably concerned. Below we explore both sides of the issue.
The Promise of ICOs
The premise of an initial coin offering is innocuous enough. ICOs work like initial public offerings, but instead of making shares available to investors, startups offer a percentage of a cryptocurrency of their own creation. The crowdfunding process typically begins with a startup creating a whitepaper, which outlines their goals for the project, the resources they believe it will require, the timeframe for the ICO, and more. Interested parties can then purchase the distributed cryptocurrency, called a token, using both fiat or virtual currency (like Bitcoin). A smart contract records the transaction, stores the funds, and distributes the new tokens when ready.
Many investors and companies have responded positively to the format. ICOs allow startups to raise money from a global pool of investors, vastly increasing the amount of cash they can take in. It also enables companies to sidestep the labor-intensive process of raising money from venture capital and maintain autonomy in their operations. Meanwhile, investors enjoy the opportunity to potentially collect hefty returns in a booming space, with the benefit of the immutable blockchain ledger recording each transaction.
ICOs enjoyed a massive popularity increase in tandem with 2017’s cryptocurrency gold rush, raising a total of $9 billion through March 2018. But the idea is not a new one. Ripple and Ethereum had successful ICOs in 2013 and 2014, respectively, paving the way for the current investment frenzy. Subsequent offerings began to raise questions—and caught the US government’s attention.
One prominent example involves a 2016 ICO from a company called The DAO (short for decentralized autonomous organization), who built a token on the Ethereum blockchain. The company, devoted to creating a stateless business model run only by shareholder input, held a hugely successful ICO, raising $120 million – the largest in history at the time. But one month later, users discovered and exploited a weakness in the code to siphon one-third of the company’s funds into a separate account. The incident caught the government’s eye not for security, but for reasons related to securities. The SEC launched an inquiry in June 2017 to examine if the DAO token ICO violated federal securities law.
The SEC’s findings determined that DAO tokens were indeed securities, and subject to regulation as such. “The innovative technology behind these virtual transactions does not exempt securities offerings and trading platforms from the regulatory framework designed to protect investors and the integrity of the markets,” said Stephanie Avakian, Co-Director of the SEC’s Enforcement Division. Steven Peikin, also a co-director, echoed Avakian’s comments, adding “as the evolution of technology continues to influence how businesses operate and raise capital, market participants must remain cognizant of the application of the federal securities laws.”
Some companies have attracted additional legal scrutiny. Centra, a virtual currency endorsed by boxing icon Floyd Mayweather, raised $32 million in a 2017 ICO. Centra promised investors that a Centra token “would give investors access to a new virtual currency exchange and a virtual currency debit card that would operate on the Visa and Mastercard networks.”
But the SEC halted the project for fraud- and securities-related charges—according to the complaint, Centra listed numerous fake executives on their website, had never received approval from Visa and Mastercard for the advertised connection, and committed other infractions. The company’s co-founders, Sam Sharma and Robert Farkas, were arrested for “[selling] investors on the promise of new digital technologies by using a sophisticated marketing campaign to spin a web of lies about their supposed partnerships with legitimate businesses,” said Avakian. The Southern District of New York brought additional criminal charges against the co-founders. Among them, the conspiracy to commit securities fraud, securities fraud, conspiracy to commit wire fraud, and wire fraud. The New York Times reported that the Centra founders are the first people arrested in connection with an ICO.
Centra and the DAO’s respective run-ins with the SEC are not unique. A Wall Street Journal report analyzed documents for 1,450 ICOs and red-flagged 271 of them for plagiarized documents, fake team listings, and ambiguous or deceptive claims. The SEC has subpoenaed documents for dozens of coin offerings, with more on the horizon.
ICOs are unlikely to disappear, but the message from recent SEC actions is clear: investors must take the time to perform due diligence, and companies need to register with regulators—or face legal consequences.