– August 23, 2017

The Securities and Exchange Commission has tossed a wet blanket on initial coin offerings just as they were soaring as an alternative financing vehicle for young companies.

ICOs have raised more than $1 billion this year, with more than half of that coming in June alone. Such eye-popping growth was bound to be noticed by the authorities. Whether the SEC’s intervention is a stabilizing reality check or the beginning of the end for the entire concept remains to be seen.

The SEC used results of an investigation of a “virtual” entity known as the DAO to claim that coin, or token, sales are akin to offerings of securities and thus subject to securities law. “Issuers of distributed ledger or blockchain technology-based securities must register offers and sales of such securities unless a valid exemption applies,” the SEC said in a July 25 press release.

Absence of licenses is what made the DAO and its “crowdfunding contract” run afoul of the regulatory agency. “It would not have met the requirements of the Regulation Crowdfunding exemption because, among other things, it was not a broker-dealer or a funding portal registered with the SEC and the Financial Industry Regulatory Authority,” the agency said. The DAO was ultimately an unsuccessful venture that because of unforeseen programming challenges and hacking risks ended up deciding to liquidate and return its investors’ money.

Other coin offerings look like more traditional companies and seek to raise money without jumping through the hoops required by the SEC. Often a company publishes a white paper, akin to a prospectus used in an initial stock offering except the disclosures are not anywhere close to as detailed as the SEC requires for an IPO.

New companies now have access to funding they would not have had access to. By contrast, traditional initial public stock offerings bring in a whole lot of additional people and entities, all of them with their hands out. Therefore, costs are much higher.

According to Money-zine.com, traditional IPOs require various professional fees, which include fees for attorneys and certified public accountants; sales commissions and commissions from underwriters placing securities with investors and charging fees for this service; clerical expenses associated with administrative work needed to prepare regulatory filings and registration statements; filing fees associated with submitting materials to the SEC; and marketing costs from advertising, mailing, and promoting the securities.

The SEC’s underlying assumption is that adults are incompetent to judge between a good investment and a bad one. In the SEC’s words though, the licensing apparatus is “designed to protect investors and the integrity of the markets,” said Stephanie Avakian, co-director of the SEC’s Enforcement Division.

The SEC’s concerns are not inappropriate, with many investors viewing registration with the SEC as a stamp of approval, said Fred Carstensen, a finance and economics professor at the University of Connecticut School of Business. “I think there will be either a very high level of fraud – thus most investors will learn to quickly stay out – or there will be fairly strict regulatory oversight,” he said. “That seems to be the direction things are going: the framework just invites misrepresentation and deceit in its current form.”

In pulling the punch bowl away from the hot ICOs market, Carstensen concludes, “proper” oversight will likely mean tokens and coin offerings will have a role in financial markets but won’t be the dominant form of financing.

Worse for the future of initial coin offerings and the companies that use them is that the SEC is creating a moving target, saying some tokens and offerings may be judged securities while others will not be. Unpredictability can be a killer. SEC Chairman Jay Clayton “encourages market participants to engage with us,” but young entrepreneurs can be excused for finding that less than comforting.

Some market players say an increased SEC presence will make little difference, but others aren’t so sure. Despite the wet blanket from Washington, entrepreneurs and investors see coin offerings as the future of finance and a challenge to venture capital firms, American Banker said in a recent article.

ICO funding was $550 million in June, marking the first month ever that it topped angel and early venture capital funding, Goldman Sachs said in a research note. Angel and early VC was $300 million in June. The trend continued into July with ICOs around $300 million and angel and early VC at about $200 million.

Surging interest in blockchain, which is digital ledger technology that publicly records transactions and is highly impervious to tampering, and cryptocurrencies such as Bitcoin, which grew from blockchain, is a major factor in the increasing number of coin offerings. The coins used in ICOs are often paid for with cryptocurrency.

Blockchain, Bitcoin, and ICOs are part of the movement away from centralized institutions such as government-controlled currency and securities laws. American Banker views the trend profoundly changing the internet, thought to be the most decentralized of things. “This new funding model, and the projects taking advantage of it, may herald the dawn of even something more radical: a decentralized internet powered by applications that blur the line between owners and users,” it said.

Coin offerings are special in that they usually do not convey an equity interest to the purchasers of the coins. The coins are more often a call on future use of a product being developed by the company. This route enables the entrepreneurs to keep control of their company rather than diluting ownership through a traditional stock offering.

The young company also faces the danger that its unique product or service will be detailed publicly for imitation by others. “Once a company goes public, its finances and almost everything about it, including its business operations are open to government and public scrutiny,” the website Investopedia says. “A careful reading of these reports can accurately determine a company’s cash flow and credit-worthiness, which may not always be perceived as positive.”

Time is sometimes not on the side of young companies. Thus they resort to initial coin offerings. A standard Wall Street–type initial public offering can take a year or more to prepare as investment bankers, accountants, lawyers, and outside consultants are brought on board. “During this period, business and market conditions can change radically, and it may not be a propitious time for an IPO, thus rendering the preparation work and expense ineffective,” Investopedia says.

In trying to avoid regulatory oppression, ICOs might leave the U.S. securities market, but it’s unclear where they might go. Other countries may adopt the SEC’s guidelines, lawyers say. With less room to maneuver, ICOs and the young companies that benefit from them might benefit most from studying the SEC’s exemption rules and positioning themselves accordingly.

Sadly, the road to decentralization just got a bit longer.

James Mosher


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