Initial Coin Offerings (ICOs) have become an integral part of the crypto industry. They are one of the most effective instruments for raising money for crypto startups. Over the past 5 years, crypto projects received more than $15 billion thanks to ICOs. And now the US Securities and Exchange Commission is putting it all at risk.
An ICO is the most popular financial instrument for raising investments among crypto companies. According to ICOdata, in 2018 alone, crypto startups received over $7.8 billion. In total since 2014, they have raised a stunning $15.1 billion. To put this in context, this number was almost equal to the market capitalization of cryptocurrency Ripple, which as of June 11, 2019, was $16.6 billion
Yet in spite of the huge sums raised, crypto crowdfunding is a flawed process. Scams are the market’s Achilles heel. ICOs were begun as an analog of Initial Price Offering (IPO) for traditional markets. Yet, unlike IPOs, ICOs almost do not fall under the authorities’ regulation at all, which means that fraudsters can embezzle money and get off scot-free. BitConnect, for one — a Ponzi Scheme that lured investors to contribute billions of dollars — held a successful ICO without anyone becoming any wiser as to the founder’s true intentions.
ICOs were in the gray regulatory area until 2018 that the US financial watchdog- the Securities and Exchange Commission (SEC) – began to take action on the crypto market. At that point, the Commission decided that the tokens of some ICOs could be considered as securities and should be regulated to the full extent of the law.
Soon, the SEC showed its teeth and began fining projects. The story came to a head in 2019 when the regulator opened a case again Kik messenger, which had an ICO of $100 million, of securities law violations.
Issues with Kik and SEC
In early June, the Securities and Exchange Commission announced that crypto startup Kik, which is developing its own messenger, had violated Section 5 of the Securities Act of 1933.
By law, companies have to register securities offerings with the regulator. SEC considers the Kik app tokens to be securities, but the project did not register them as such; neither did they disclose the required information to investors.
This happened at a point at which Kik was running out of money, according to the SEC. Kik Messenger held an ICO in 2017 that raised more than $100 million. More than half of this amount was contributed by US investors.
The project was losing $30 million a year to develop its product, the court filing by SEC shows. The company even planned to merge with a larger tech firm to attract money. But these plans did not materialize, as 7 potential buyers refused the deal.
The company’s problems worsened when the price of the Kik token collapsed not once, but twice after the ICO. This means that investors have already lost money, and in the future, they may lose more.
Considering all this, the Securities and Exchange Commission believes that Kik not only violated the rules for an unregistered securities offering, but also did not provide investors with the sufficient information they needed to make informed decisions.
The company behind Kik does not admit any wrongdoing. According to the founder and CEO of the project Ted Livingston, the messenger did not hold a securities offering and contends that, in general, the very concept of securities regulation is too broad to be used to convict the company of any wrongdoing.
While already facing significant financial difficulties, Kik messenger has spent $5 million on disputes with the Securities and Exchange Commission. Undeterred, the startup has organized a separate crowdfunding campaign to cover the litigation costs.
The court hearings on this matter are currently taking place.
Why the SEC considers some of the ICOs as security offerings
One of the fundamental laws that still regulates the issuing and circulation of securities in the United States was approved by the authorities back in 1933. It is called the Securities Act, and it is this law that the SEC accuses the Kik app of violating.
16 years later, the Securities Act introduced the Howey test, which provides companies a clear rubric for understanding if the assets they are issuing qualify as securities. According to the test, if a firm promises a profit on investments in the future, then their offering could be considered as a security.
The SEC maintains that Livingston’s promises to investors that the Kik app will bring profit causes it to fail the test.
The crypto industry has often criticized the Howey test because it was created long before the blockchain and cryptocurrency and its criteria, therefore, can be interpreted in different ways when applied to these types of assets.
In 2018, the Securities and Exchange Commission decided to dot all the i’s and cross the t’s and began developing detailed regulatory guidelines “in plain English.” In April 2019, the SEC published its work.
According to the guidelines, tokens can be considered as securities in several cases:
Investors can expect returns on investments. There are some exceptions: As stated in the guidelines, if the investor makes a profit from a rise in the price of the token, then the cryptocurrency is not necessarily security. The rule applies only if value growth depends solely on external, market factors like the ratio of supply and demand
One or a group of people is responsible for certain tasks within the network
A group of project representatives create or maintain a market for a digital asset
The investor relies on the efforts of others who have a significant impact on the development of the project. For example, if at the time of the token sale the blockchain of the project has not yet been finalized, the buyer relies on the company in the development of the network
The SEC notes that the guideline is not legally binding. Its primary purpose is to clarify the logic of the law. Ultimately, projects will be assessed by the Howey test and held accountable to the 1933 Securities Act.
Although the industry has long been waiting for specifics from the SEC, the new guidelines haven’t fulfilled their expectations. Hailey Lennon, head of legal and regulatory affairs with bitFlyer, said to CoinDesk that most of all, their company is waiting for the answer to the question: “When are tokens not considered securities?”
So far, the Securities and Exchange Commission has not been able to answer it.
The most prominent cases when SEC punished crypto projects
Amounts raised by ICOs grows from year to year, as does the number of projects that hold them. Last year, 1,253 projects raised $7.8 billion through ICOs. This is a huge contrast to the mere 29 projects holding ICOs in 2016 for a total of $90 million.
Data from ICOdata
Regulators also are paying more and more attention to the ICO, and Kik isn’t the only project that has issues with SEC over allegedly making an unregistered security offering.
In May, the SEC imposed a fine on Alex Tapscott, the founder of NextBlock investment company, for violating the rules for issuing securities. NextBlock, however, did not hold an ICO. The firm used the debt instrument called convertible debentures to raise $20 million. The consequence of this was a $25,000 fine for Tapscott and a further $520,000 for the company.
Prior to this, the SEC had gone after the crypto project Gladius Network. Gladius Network held crowdfunding in 2017 and raised $12.7 million. Allegedly, its ICO was a security offering, which the company had failed to register with the commission. In the face of criminal proceedings, the startup agreed to return the money to investors and to register the securities issuance, as required by law.
In early 2018, the SEC fined the crypto project CoinAlpha Advisors for the same offense. The startup also agreed to return $600,000 of raised investment to contributors and to pay a $50,000 fine.
In November, the Securities and Exchange Commission ruled on two more startups — Airfox and Paragon Coin — and forced them to return the money to investors and pay a fine for an unregistered issue of securities. Airfox had to return the $15 million raised during their ICO, Paragon $12 million. Both projects were required to pay on top of this a fine of $250,000.
The law is the law and business must obey it — be they traditional or crypto.
The real problem here is the difficulty of adhering to a law that is so flexible in its interpretation.
Therefore, the SEC should clarify current legislation so that crypto projects can ensure that their projects are in line with the law.