Initial Coin Offerings: Buyer Beware

Kevin Cunningham, MJLST Staffer


Initial Coin Offerings, also known as ICOs or token sales, have become a new trend for startup companies raising capital using cryptocurrency and blockchain technology. ICOs are conducted online where purchasers use virtual currencies, like bitcoin or ether, or a flat currency, like the U.S. dollar, to pay for a new virtual coin or token created by the company looking to raise money. Promoters usually tell purchasers that the capital raised from the sales will be used to fund development of a digital platform, software, or other project and that the newly created virtual coin may be used to access the platform, use the software, or otherwise participate in the project. The companies that issue ICOs typically promote the offering through its own website or through various online blockchain and virtual currency forums. Some initial sellers may lead buyers of the virtual coins to expect a return on their investment or to participate in a share of the returns provided by the project. After the coins or tokens are issued, they may be resold to others in a secondary market.


Depending on the circumstances of each ICO, the virtual coins or tokens that are offered or sold may be considered to be securities. If they are classifiable as securities, the offer and sale of the coins or tokens are subject to the federal securities laws. In July 2017, the Securities Exchange Commission (SEC) issued a Report of Investigation under Section 21(a) of the Securities Exchange Act of 1934 stressing that any ICO that meets the definition of a security in the United States is required to comply with the federal securities law, regardless of whether the securities are purchased with virtual currencies or distributed with blockchain technology.


Since the SEC issued its July Report regarding ICOs, the Commission has charged two companies with defrauding investors. In the pair of ICOs purportedly backed by investments in real estate and diamonds, the SEC alleged that the owner of the companies, Maksim Zaslavskly, sold unregistered securities. In one instance, the SEC alleges that, despite the representations to investors of Diamond Reserve Club, Zaslavskly had not purchased any diamonds nor engaged in any business operations.


Issues with Initial Coin Offerings continue as the Tezos Foundation was hit with its second class-action lawsuit over its Initial Coin Offering after an ICO contributor alleged breaches of securities laws. The two cases have been filed in the California Superior Court in San Francisco and United States District Court in Florida. The Tezos ICO raised over $232 million just months ago and plaintiffs in the suit say that they have not received the promised tokens. Infighting amongst the owners of the company has led to a significant setback in the venture, which aims to create a computerized network for transactions using blockchain technology. The lawsuit alleges that contributors to the fundraiser were not told that it could take more than three years to purchase the ledger for the project’s source code. Additionally, the plaintiffs allege that the time frame was not disclosed to investors despite it being a material fact.


It is likely that many issuers of virtual coins and tokens will have a hard time convincing the SEC and other regulators that its coin is a merely a utility rather than a security. For many of the firms, including Diamond Reserve Club, the problem is that the tokens they are selling for the projects only exist on paper, and so they have no other function than to bring in money. Likewise, most investors currently buy tokens not for their utility, but because they are betting that on an increase in the value of the virtual currency. It seems that this will not be an issue that will be resolved quickly and it is likely that heightened regulatory scrutiny will come due to the continuing claims against ICOs for companies like Tezos.