As Initial Coin Offerings (ICOs) roar across the globe with billions of dollars flowing into new coins embedded in blockchain technology, regulators in every financial center struggle to police the cryptocurrency and blockchain token market. Increasingly they are resorting to warnings to ICO issuers, insiders and potential investors that existing regulations apply to this emerging technology. In the United States, the Securities and Exchange Commission (SEC) has issued several statements warning issuers, investors, and even celebrities about the risks associated with their involvement in ICOs. For an analysis of the recent SEC statement, see here. The most recent warning came on Monday, November 13, 2017 from the European Securities and Markets Authority (ESMA), which cautioned investors of the risks of ICO investments while it reminded firms involved with ICOs of the regulations that may impact their activities. See this press release and the accompanying statements to firms here and to investors here.
Because cryptocurrencies and other blockchain tokens generally reside on the internet, offers and sales cross borders with ease and promise to accelerate the development of global capital markets. In the face of tightening US restrictions, some issuers based in the US or targeting US capital have flocked to other jurisdictions like Europe in search of more flexibility. But ESMA is following suit with the SEC, issuing its own warnings to firms involved with ICOs and ICO investors.
ESMA’s statement to firms involved in ICOs reminds them that they must meet relevant regulatory requirements and provides a summary of key applicable European Union (EU) legislation. ESMA warns: “Firms involved in ICOs must give careful consideration as to whether their activities constitute regulated activities. If their activities constitute a regulated activity, firms have to comply with the relevant legislation and any failure to comply with the applicable rules would constitute a breach.” Although it would appear to be common sense that current laws still apply, ESMA’s statement is likely motivated by the fact that many ICOs simply ignore current regulations.
Monday’s statement to ICO issuers and participants highlighted four areas of EU law that may apply:
- ICOs may be subject to the Prospectus Directive – analogous to the US requirement of filing a registration statement containing a prospectus and clearing it with the SEC before selling securities to the public – which “aims to ensure that adequate information is provided to investors by companies when raising capital in the EU.” Depending on ICO structure, a token could fall within the definition of “transferable security” which would require the publication of a prospectus that must obtain approval from governmental authorities.
- If a token qualifies as a financial instrument, then the Markets in Financial Instruments Directive (MiFID) could be implicated. In particular, ESMA noted that “the process by which a coin or token is created, distributed or traded is likely to involve some MiFID activities/services, such as placing, dealing in or advising on financial instruments.”
- ICO activities fall under the Alternative Investment Fund Managers Directive if the ICO is deemed to manage or market alternative investment funds (AIFs). If an ICO is used to “raise capital from a number of investors, with a view to investing it in accordance with a defined investment policy,” then the ICO could face regulation as an AIF.
- ICOs could be subject to the Fourth Anti-Money Laundering Directive – an analog the United States’ Anti-Money Laundering rules under the Bank Secrecy Act – which would require firms to conduct due diligence on customers, have in place appropriate record-keeping and other internal procedures, along with having an obligation to report suspicious activity and to cooperate with any investigations by relevant public authorities.
The second part of ESMA’s statement targets investors, alerting them of the inherent risks in ICOs. ESMA notes that ICOs are “extremely risky and highly speculative investments” and warns investors to be aware of the following five risks when investing in ICOs:
- Depending on how an ICO is structured, it may fall outside of EU laws and regulations. Consequently, investors lose the benefits of the protections that these laws and regulations are designed to provide.
- A vast majority of ICOs are launched at a very early stage of development and thus have an inherent high risk of failure. Even if the ICO projects are ultimately successful, the eventual benefit relative to invested capital is difficult to assess at such an early stage.
- Not all coins are traded on virtual currency exchanges, so they can be highly illiquid. For those coins that are listed on exchanges, their prices can be extremely volatile.
- Most ICOs are launched based on a white paper, which “is in most cases unaudited, incomplete, unbalanced or even misleading.” ESMA notes that white papers typically put “the emphasis on the potential benefits but not the risks” which is in stark contrast to prospectus statements for public offerings which are peppered with risk disclosures.
- Finally, ESMA warns that the “distributed ledger or blockchain technology that underpins the coins or tokens is still largely untested” and that investors might not be able to access or control their tokens, or worse, they can be stolen by hackers.
Despite warnings from the SEC and now ESMA concerning the risks of investing in an ICO, the cryptocurrency market continues to boom, and new tokens are launched every day. The ease of raising capital in an ICO is a double-edged sword as new technologies allow for fast and easy capital formation but with little regulatory oversight to protect investors. “Virtually anyone who has access to the Internet can participate in an ICO,” presenting ICO issuers with billions of potential buyers worldwide. Although regulators are charged with protecting investors, they must simultaneously avoid mistakenly overregulating this new market to avoid having their own jurisdictions fall behind the rest of the world. As the SEC, ESMA and regulators across the globe continue to watch and devise plans for more robust regulations tailored to ICOs, today’s issuers and investors have only these broad statements of guidance that current laws still apply in the virtual currency realm.
By Charles Kaufman and Michael B. Saryan
Charles Kaufman is an attorney and shareholder of Homeier Law PC, a leading law firm advising clients in both traditional and non-traditional financing. With over 23 years of experience advising growing businesses, providing leadership in crowdfunding, corporate finance, legal and strategic affairs and global compliance, Charles is a key advisor in the cryptocurrency and ICO space helping companies navigate the ever-changing regulatory landscape.
Michael B. Saryan is an attorney and counsel at Homeier Law PC, where he advises clients in securities law matters and corporate transactions, including cryptocurrency transactions and ICOs with a focus on keeping at the forefront of new regulations for compliance and best practices in the ICO space.
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