Initial Coin Offerings, or ICOs, have emerged at the intersection of cryptocurrencies and blockchain. Compared to a traditional equity offering in the United States where a company issues stock to investors in exchange for U.S. currency, in an ICO, a company issues a digital token created on a blockchain in exchange for cryptocurrency or virtual currency such as Bitcoin. The digital tokens may also be another type of digital currency or can represent rights to assets that are tangible. According to the Coindesk ICO Tracker, a database that helps track and analyze digital token sales and ICOs, there were only seven ICOs in each of 2015 and 2015, 43 ICOs in 2016, but then 343 ICOs in 2017 and in 2018, that number grew to 650. But as the number of ICOs has expanded, concerns have emerged about a cryptocurrency bubble and cryptocurrency regulation.

Advisors who encounter questions about investments in ICOs need to understand how virtual currencies are viewed by regulators. Even in the early years of ICOs, regulators have taken positions about the regulation of ICOs. The Financial Crimes Enforcement Network (FinCEN) issued guidance in 2011 and 2013 regarding the application of the Bank Secrecy Act to transactions involving cryptocurrency. In 2015, the Commodity Futures Trading Commission (CFTC) determined that virtual currencies are commodities. However, as the number of ICOs increased, the question surfaced regarding whether or not ICOs constitute sales of securities.

In response to this question, the Securities and Exchange Commission (SEC) entered the ICO regulatory landscape in July 2017 when it issued a report of investigation considering the application of federal securities laws to an ICO by a virtual organization known as “The DAO”. In its report, the SEC determined that the tokens offered and sold in the ICO were securities under the Securities Act of 1933 and the Securities Exchange Act of 1934. As a result, the SEC found that the ICO should have complied with the federal securities laws relating to offers and sales of securities and that secondary sales of the tokens, and exchanges trading the tokens, must also comply with applicable securities laws.

More recently the SEC has begun to take action against issuers and promoters of ICOs. In November 2018, the SEC settled charges against Floyd Mayweather and DJ Khaled related to their paid promotion of ICOs. The SEC also settled charges against two companies selling digital tokens through ICOs in November 2018: a company offering an investment in digital assets in December 2018 and an issuer conducting an unregistered ICO in February 2019. Many states, including North Carolina, are also taking action under state securities laws against parties involved in ICOs.

Finally, FINRA has issued an investor alert that highlights several important facts for potential ICO investors: (1) most ICOs do not comply with securities laws and, therefore, do not provide investors with the protections underlying these laws; (2) there is significant ICO fraud; (3) online token trading platforms are not registered exchanges; (4) investors are losing significant amounts of money in ICOs; (5) the ability to receive future tokens as part of an ICO is not guaranteed; and (6) the use of a Simple Agreement for Future Tokens, or a “SAFT” contract, does not mean that the tokens underlying the agreement are not securities.

Although the ICO market may see some cooling as regulators take a harder look, there are still many market participants who are not aware of the regulators’ positions on ICOs or the underlying tokens or who otherwise look to ICOs as a way to fraudulently raise funds. In addition to evaluating the merits of an investment in an ICO, advisors should stay alert to the developing regulatory framework for ICOs. If an ICO is not being made in accordance with the securities laws, that should be a red flag for advisors and other investors.