Ten years ago the cryptocurrency market did not exist and blockchain technology was unknown to the world. ((See Gaurav S. Iyer, Cryptocurrency Market Cap Can Exceed $200 Bln by the End of 2017, Cointelegraph (Sept. 1, 2017), https://cointelegraph.com/news/cryptocurrency-market-cap-can-exceed-200-bln-by-the-end-of-2017.)) As of the date of writing, the total cryptocurrency market cap stands at $364.5 billion and there are over 1,515 different cryptocurrencies. ((Cryptocurrency Market Capitalizations, CoinMarketCap, https://coinmarketcap.com/ (last visited Feb. 6, 2018).)) The growth in cryptocurrency markets is “without a doubt one of the fastest explosions of wealth in human history.” ((Iyer, supra note 1.)) Initial Coin Offerings (“ICOs”) are responsible for much of this increased activity and growth in the cryptocurrency market. ((See id.)) In fact, in 2017, blockchain companies raised more money through ICOs than venture capital. ((Id.)) With this surge in cryptocurrency market growth, it is no surprise that investors, businesses, and entrepreneurs alike are looking for ways to tap into the market. ICOs have become a primary method for many of these prospective market participants to enter the cryptocurrency marketplace.
So what is an ICO? In the most basic terms, an ICO is an unregulated means by which funds are raised for a new cryptocurrency venture. ((Initial Coin Offering, Investopedia, http://www.investopedia.com/terms/i/initial-coin-offering-ico.asp (last visited Feb. 6, 2018).)) Typically, in an ICO campaign a percentage of the cryptocurrency will be sold to investors in exchange for legal tender or other cryptocurrencies, but usually for Bitcoin. ((Id.)) A prominent example of a recent ICO is Ethereum. ((Shawn Langlois, What is an ICO?, Market Watch (Oct. 12, 2017, 5:52 AM), http://www.marketwatch.com/story/what-are-icos-and-why-is-the-sec-taking-steps-to-protect-investors-from-them-2017-07-27.)) In 2014, the Ethereum ICO raised $18 million in Bitcoin, which was the equivalent of 40 cents per Ether. ((Initial Coin Offering, supra note 4.)) Currently, Ethereum is trading above $774 per Ether with a market cap over $75 billion. ((Ethereum, CoinMarketCap, https://coinmarketcap.com/currencies/ethereum/ (last visited Feb. 6, 2018).))
Startups have become early adopters of the ICO as a method of raising funds because it provides these companies with a way to bypass the rigorous and well-regulated capital-raising process required by venture capitalists or banks. ((See Initial Coin Offering, supra note 4.)) When a cryptocurrency startup decides to use an ICO to raise capital it usually drafts a whitepaper. ((Id.)) The whitepaper details the project, the needs the project will fulfill upon completion, the amount of capital needed to undertake the venture, the amount that the pioneers of the project will retain for themselves, the type of money that will be accepted, and the length of the ICO campaign. ((Id.)) If the capital raised does not meet the minimum funds required, then the money will be returned to investors and the ICO will be deemed a failure. ((Id.))
Considering the unregulated access to capital and potential for exponential growth provided by ICOs, it is not surprising that regulators around the world have taken notice. Governments across the globe have begun putting cryptocurrencies and ICOs under the microscope and developing their own regulatory responses. The actions taken by these governments have ranged from a laissez-faire approach allowing the market to develop uninhibited ((See Jacek Czarnecki, ICOs in the EU: How Will the ‘Slow Giant’ Regulate Tokens?, CoinDesk (July 24, 2017, 11:00 AM), https://www.coindesk.com/icos-eu-will-slow-giant-regulate-tokens/.)) to outright bans of all ICOs ((Tom Zanki, China’s ICO Crackdown Clouds Efforts At Global Consistency, Law360 (Sept. 24, 2017, 9:33 PM), https://www.law360.com/articles/963026.)) Given this notable lack of global uniformity in ICO and cryptocurrency regulation, one thing is clear—the technology is significantly ahead of the current law.
The United States took its first step toward the regulation of ICOs on July 25, 2017, when the SEC released a report detailing its investigation of the DAO. ((See Gregory J. Novak & Joseph C. Guagliardo, Blockchain and Initial Coin Offerings: SEC Provides First U.S. Securities Law Guidance, Harv. L. Sch. F. on Corp. Governance & Fin. Reg. (Aug., 9, 2017), https://corpgov.law.harvard.edu/2017/08/09/blockchain-and-initial-coin-offerings-sec-provides-first-u-s-securities-law-guidance/.)) The DAO was the first attempt at fundraising for a new cryptocurrency using Ethereum. ((What is an ICO?, Bitcoin Magazine, https://bitcoinmagazine.com/guides/what-ico/ (last visited Feb. 6, 2018).)) The goal of the DAO was to create a decentralized organization to fund other blockchain projects. ((Id.)) It was unique because the governance decisions were to be made entirely by the token holders themselves. ((Id.)) Although the DAO ICO successfully met its funding requirement by raising over $150 million, an unknown attacker stole millions of investor dollars because of “technical vulnerabilities” in the organization. ((Id.)) The failure of the DAO provided occasion for the SEC to take an official position on the controversial issue.
In its official Report of Investigation of the DAO, the SEC indicated that, depending on the facts and circumstances, the virtual tokens that are offered or sold through an ICO may be classified as securities. ((See Novak & Guagliardo, supra note 15.)) Consequently, any ICOs deemed to be dealing securities must be compliant with federal securities laws. ((See Investor Bulletin: Initial Coin Offerings, SEC (July 25, 2017), https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_coinofferings.)) This requires that the securities either be registered with the SEC or qualify for an exemption from registration. ((See id.)) The SEC’s report concluded that the DAO tokens were in fact securities under federal law, and because the tokens were not registered with the SEC, the DAO was in violation of federal securities law. ((See Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO 1-2, SEC (July 25, 2017), available at https://www.sec.gov/litigation/investreport/34-81207.pdf.))
The SEC reached its conclusion that the DAO tokens were securities by implementing the “investment contract” rubric first established by the Supreme Court in SEC v. W.J. Howey Co., commonly referred to as the Howey test. ((See Novak & Guagliardo, supra note 15.)) Under Howey, an investment contract is defined as an investment of money, or other tangible definable consideration, in a common enterprise with a reasonable expectation of profit to be derived from the entrepreneurial or managerial efforts of others. ((See Report of Investigation, supra note 23, at 11.)) Federal securities laws classify investment contracts as securities. ((Id.)) The SEC concluded that the purchase of DAO tokens with Ether cryptocurrency satisfied the “investment of money” prong of the Howey test. ((Id.)) Next, the SEC found that the DAO tokens satisfied both the “common enterprise” and “reasonable expectation of profit” prongs of Howey because the promotional materials disseminated by the DAO and the statements made by DAO co-founders to investors made it clear that the DAO’s objective was to make a profit through a pooled investment. ((Id. at 11-12.)) Each prong of the Howey test previously mentioned is likely to be satisfied by most, but not necessarily all, ICOs. ((See Novak & Guagliardo, supra note 15.))
The critical inquiry is whether the potential future profits will be “derived from the entrepreneurial efforts of others.” ((Novak & Guagliardo, supra note 15.)) The SEC did not accept the contention that the DAO was autonomously operated. Instead, the SEC concluded that the DAO co-founders and Curators exerted significant control over and actively monitored the DAO. ((See Report of Investigation, supra note 23, at 12-13.)) The efforts of these individuals, and not the token holders, were undeniably significant and essential to the overall success and profitability of any investment into the DAO. ((Id.))
Thus, in the United States the key determination of whether the tokens offered in an ICO are considered to be securities is made by implementing the Howey test. ((See Novak & Guagliardo, supra note 15.)) This test will not necessarily include all tokens sold in ICOs, but the SEC has made it clear that the responsibility for making this determination falls on the offeror of the token. ((See id.)) The SEC Report, which was released in July, is just one approach in a wave of recent ICO regulatory responses announced by governments around the world.
The regulatory positions taken by governments in Asia have generally been unfavorable to ICOs. China, for example, has issued an outright ban on all ICOs in the country ((Zanki, supra note 14.)) This announcement was coupled with reports that Chinese authorities were also preparing to shut down all Bitcoin exchanges to prevent capital from fleeing to digital currencies. ((Id.)) The ban inhibits the rapidly growing ICO market in China where about sixty-five ICOs raised nearly $400 million through the first seven months of 2017. ((Id.)) Chinese authorities cited fraud concerns as the reason for the ICO ban. ((Id.)) However, it appears that the ICO ban will only be a temporary measure until the government introduces its own regulatory framework. ((Id.))
Shortly after the Chinese ICO ban was announced, South Korea followed suit. ((Rachel Rose O’Leary, South Korean Regulator Issues ICO Ban, CoinDesk (Sept. 29, 2017, 10:30 AM), https://www.coindesk.com/south-korean-regulator-issues-ico-ban/.)) Specifically, the South Korean Financial Services Commission (“FSC”) stated that it will prohibit all forms of the blockchain funding methods “regardless of technical terminology.” ((Id.)) The FSC views ICOs as overly speculative and a violation of South Korea’s capital markets laws. ((Id.)) In its statement, the FSC cited recent arrests and shutdowns of companies involved with marketing fake cryptocurrencies. ((See id.))
On the other hand, some countries in Asia have been receptive of ICOs and cryptocurrencies. Taiwan recently announced that it will not follow China and South Korea in issuing a ban on ICOs. ((Joshua Althauser, Challenging China: Taiwan Supports Mainstream Adoption of ICOs and Bitcoin, The Cointelegraph (Oct. 10, 2017), https://cointelegraph.com/news/challenging-china-taiwan-supports-mainstream-adoption-of-icos-and-bitcoin.)) Taiwan went further and announced that it will support innovators experimenting with blockchain and virtual currencies and will pass a bill that will allow these startups to operate freely in the industry. ((See id.)) The chairperson of Taiwan’s Financial Supervisory Commission stated that the country is seeking to emulate Japan by treating cryptocurrency as a highly regulated, highly monitored industry like securities. ((Id.))
Japan has been an early adopter of cryptocurrencies. The Japanese government recognizes Bitcoin as legal tender and its regulators have endorsed eleven cryptocurrency exchanges. ((Elaine Ramirez, An ICO Ban in Japan is Still a ‘Definite Possibility’, Forbes (Oct. 15, 2017, 11:31 PM), https://www.forbes.com/sites/elaineramirez/2017/10/15/japan-ico-ban-indiesquare-higashi/#5497affc213e.)) Additionally, Japanese investors are responsible for 63% of global Bitcoin trades. ((Id.)) Japan clearly has a heavy influence on cryptocurrency markets and some are concerned that a regulatory crackdown on ICOs may be in store for the future. ((See id.)) Koji Higashi, co-founder of digital token wallet IndieSquare, believes that an increase in fraudulent ICOs in Japan could lead to stricter regulation and that an ICO ban is a “definite possibility.” ((Id.)) However, there is still cause for optimism in Japan given that the country’s government and businesses have been very receptive to cryptocurrencies and, as of now, there are no indications from officials that the country will crack down on ICOs.
In contrast to Japan, the cryptocurrency market in the EU is not developing as a result of governmental action, but rather from governmental inaction. The European Securities and Market Authority (“ESMA”) has not proposed any formal regulations of ICOs or cryptocurrencies nor has it provided any guidance on whether tokens offered in ICOs will be considered securities. ((See Czarnecki, supra note 13.)) There is no EU equivalent to the Howey test when evaluating ICOs. ((See id.)) Consequently, the laws of the EU member states will provide the legal framework for individual cases. ((See id.))
However, EU regulators have indicated that they are aware of the global ICO trend and will take a laissez-faire approach to fintech ((See Mark Taylor, EU Weighs ICO Risk-Reward to Ease Capital Markets Pain, Law360 (Sept. 15, 2017), https://www.law360.com/articles/964285/eu-weighs-ico-risk-reward-to-ease-capital-markets-pain.)) The emergence of ICOs is being viewed by many as the “unlikely answer to jump-starting Europe’s sluggish capital markets.” ((Id.)) Accordingly, it is possible that ESMA will seek to include cryptocurrencies in its plan to inject life into European capital markets through legal tweaks and a focus on the benefits of fintech ((See id.)).
As governments around the world begin to forge regulations in the world of ICOs, the market for these token offerings continues to expand rapidly. There is a clear lack of uniformity in regulatory responses and it seems that regulators will continue to play catch-up as the ICO market shows no signs of slowing down. The “genie is out of the bottle,” and many lawyers agree that the solution is to fit the innovation into the existing framework rather than trying to contain it or stop it entirely. ((See Taylor, supra note 54.))
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