By: Steve Masur
ICOs have become a dominant topic of discussion both within the blockchain community and among securities attorneys and regulators. The US Securities and Exchange Commission (SEC) views an ICO as an offering of securities if it meets all of the elements of the ”Howie test,” based on an old court case which has become familiar to most entrepreneurs in the blockchain/cryptocurrency space. If it meets the elements of the test, an ICO is subject to relevant SEC regulations most of which relate to communications about the ICO.
Further guidance from the SEC seems to indicate that most tokens sold in ICOs, particularly those whose platforms are as yet undeveloped, are securities. A series of recent enforcement actions against companies whose ICOs the SEC deems to have violated the securities laws have come to be referred to as the “Great Rescission” of 2018 because they have resulted, or likely will result, in investors receiving rescission rights from the ICO (i.e., they can get their money back). This can be costly for a company and can disrupt its plans to develop and launch its platform.
Because the ICO market grew exponentially before the SEC could adequately determine how to apply existing regulations, customs emerged in ICO offerings that may not lend themselves to proper SEC compliance. ICO issuers eagerly await further guidance from the SEC in their quest for some certainty about the requirements, and the SEC is hard-pressed to keep pace with emerging issues in this area. For now, as both sides struggle to apply the existing regulations to this new technology, it is clear that if an ICO token constitutes a security, SEC regulations relating to communications apply. So companies need to learn these regulations and adjust their approach to fit them in their ICOs to US investors.
Forms of Communication Subject to Regulation and Related ICO Issues
Offering Documentation and Advertising in General
Offering documents are the materials presented to investors in connection with a securities offering. They differ in length and detail depending on whether the offering is public or private, its size and the nature of the targeted investors.
For a public offering, they generally consist of a prospectus containing a description of the company, the terms of the offering, risk factors, how the proceeds of the offering will be used, audited financial statements, an analysis of the financial statements and other information about the issuer’s securities. This information is filed with and reviewed by the SEC in a registration statement, generally on a Form S-1. Corporate communication, about the offering but also in general, is strictly regulated during the pendency of a public offering. However, because the vast majority of blockchain companies choose to avoid the arduous and expensive process of registering their ICOs as public offerings, this will focus mainly on private offerings which, by complying with certain requirements, are exempt from the registration requirement applicable to public offerings.
For a private offering, three likely scenarios emerge. Under the first two, the company plans to approach a number of “accredited investors” with a proposed offering in mind, generally using a Private Placement or Offering Memorandum (a “PPM” or “POM”). The PPM contains much the same information as a public offering prospectus but without the requirement that the financial statements be audited as long as all investors are accredited. These PPM disclosure standards, while not statutorily mandated, are often followed to protect the company from investor lawsuits alleging fraud and misrepresentation.
In one of these two scenarios (under “Rule 506(c)” of Regulation D under the Securities Act of 1933, as amended), the company may engage in “general solicitation and advertising” of its offering beyond its principals’ circle of acquaintances, but to do so, it must comply with some fairly stringent requirements with respect to verification of its investors’ qualifications. For this reason, many traditional company’s have steered away from Rule 506(c) offerings. However, ICOs seem to favor them.
In the third scenario, the company negotiates a funding arrangement with a relatively small group of sophisticated investors. Often the investors themselves dictate the terms of the deal, and do not require the same level of disclosure as do “friends and family” or a broader circle of investors. As a result, the offering materials in this type of private offering often consist of a simple term sheet with a statement of risk factors. These documents are delivered with a business plan and other materials requested by the investors in their due diligence. These offerings are not advertised and are essentially private deals made with investors who are both accredited and sophisticated and are therefore deemed able to fend for themselves in evaluating the company and requesting information.
In addition to the PPM or term sheet, the private offering materials in all three scenarios contain a subscription or purchase agreement and generally a separate questionnaire under which each investor certifies that it meets the requirements for an investor in a private offering, including the specific factors that qualify it as “accredited”. The offering materials also often accompany or even incorporate the company’s business plan.
In each of the above scenarios, the company will generally limit its offering to “accredited investors” which is defined under the regulations based on income and asset tests for various types of investors. Note, that for a private offering involving non-accredited investors, the financial statements must be audited as with a public offering, and the company must comply with other specific disclosure requirements, which is part of what prompts companies to steer away from non-accredited investors.
The most commonly used form among ICOs appears to be under Rule 506(c) employing general solicitation and advertising. This, however, is subject to change as various trends emerge in this area. A growing contingency within the blockchain community is calling for a different offering structure under a relatively new SEC regulation, “Regulation CF.” in this context, CF stands for “Crowdfunding.”
Before an offering under Regulation CF is launched, communication about it is limited. An issuer can only engage in communications that do not mention the offering or raise public interest in the offeror. General advertisement of the company and its products or services is permitted, but any heightened advertising may raise suspicion that you are seeking out investors for your company. After the company has launched its offering by filing a Form C with the SEC the company may only engage in the following communications outside of the crowdfunding platform: communications that don’t mention the “terms of the offering”, and communications that just contain “tombstone” information. (Tombstone information is limited to just a limited set of hard factual information: (1) a statement that the issuer is conducting an offering pursuant to section 4(a)(6) of the Securities Act the name of the intermediary through which the offering is being conducted and a link directing the potential investor to the crowdfunding platform; (2) the terms of the offering (the amount of securities offered, the nature of the securities, the price of the securities and the closing date of the offering period); and (3) factual information about the legal identity and business location of the issuer, limited to the name of the issuer of the security, the address, phone number and Web site of the issuer, the email address of a representative of the issuer and a brief description of the business of the issuer. Despite the general prohibition on advertising the terms of an offering, an issuer may communicate with investors and prospective investors about the terms of the offering through communication channels provided by the crowdfunding platform, as long as the issuer clearly identifies itself in all communications so as not to be misleading and persons acting on behalf of the issuer identify their affiliation with the issuer in all communications on the crowdfunding platform.
Offering materials, regardless of which type of offering is conducted, must be prepared in order to avoid the issuer saying either too much or too little. On the one hand, they should not include statements that amount to “puffery” which potentially overstate the merits of the investment or risk making false promises to investors. On the other hand, they must include all relevant information to the offering and the company, including risks of making an investment and any other statements that might be necessary to make other information “not misleading.” Also, any statements that are forward-looking or predictive of future events or probabilities should be couched in appropriate disclaimers and meaningful cautionary language.
ICO Offering Materials and Whitepapers
Many ICOs are conducted using “whitepapers” which describe the company, its blockchain solution and the tokens or coins being generated and ultimately issued. These whitepapers are often presented on a company’s website alongside of POMs or simple term sheets describing the terms of the token generation and sale, whether it is to be direct or through “Simple Agreements for Future Tokens (SAFTs),” the types of investors, the process for investing, detailed risk factors and standard cautionary language and disclaimers.
As long as the whitepaper has all of the legally recommended information or is accompanied by a standard POM or term sheet containing it, it should suffice to satisfy all of the offering material requirements and standards. However, because whitepapers are modeled more after the tradition of business-to-business marketing documents rather than securities offering materials, they tend to stretch the rules a fair amount, particularly when it comes to “saying too much.” Any language that purports to guaranty a return on investment or assure any appreciation in value should be avoided. Also, whitepapers should have their own disclaimers and cautionary language.
Some issuers and their attorneys seem to have difficulty conforming the language of the traditional POM to fit the token/coin issuance model. Tokens can be analogous to shares of stock in a corporation, but the analogy is not perfect and can break down in certain key areas such as governance and equity ownership. The description of the tokens in an ICO and all rights conferred (or not) upon investors must be clear and accurate. To achieve this, the company should retain counsel who understands blockchain and the nature of tokens and the ICO process to review all offering materials, including the whitepaper.
Also, because many companies seek to conduct ICOs on their own websites, they comply with the requirements of Rule 506(c), mentioned above, in order to employ general solicitation and advertising without having to limit their contacts with potential investors. However, they often issue public POMs that have strict confidentiality language in them, in several cases even requiring that investors return the offering materials to the company if they choose not to invest. This language comes from a private offering model in which the POM is considered a confidential document and the company does not engage in “general solicitation.” It makes no sense to post a document publicly on a website and claim that its contents are “strictly confidential.” Again, careful review by a qualified attorney is key.
Similarly to offering materials and whitepapers, any supplemental materials used to promote or advertise offerings of a cryptocurrency or other token that constitutes a security should avoid any sort of puffery or overstatement of the potential for profit. Although supplemental materials need not contain all of the information in the offering materials, any information must be accurate and cannot omit anything that would render it misleading. Because of the general excitement and media attention surrounding cryptocurrency and ICOs, examples of puffery and unqualified promises of great appreciation in value abound. These are amplified by celebrity endorsements and the use of social media.
In addition, there are specific rules regulating the timing, nature, and content of soliciting and advertising materials in both public and private offerings. With respect to public offerings, specific rules under the Securities Act detail what can and cannot be said about an offering prior to the initial filing of offering materials with the SEC, while the SEC’s review is pending and after the SEC has declared the offering effective and it has commenced. For private offerings, general solicitation and advertising are only permitted in limited circumstances.
Press Releases, Social Media and Celebrity Endorsements
Press releases have a long history of being used by both public and private companies to announce major events and important news. For any entity engaged in offering securities, press releases should be carefully reviewed by an attorney to ensure they do not contain exaggeration or statements that could complicate or delay the offering. The same applies in the ICO context.
The same guidance applies to posts on social media. However, the ease with which posts can be made to social media, versus issuance of a traditional press release, poses certain risks in and of itself. Offhand remarks on social media have become the norm and, in many contexts, have replaced carefully thought out, planned communication strategies. The nature of social media also gives access and voice to a wide number of participants in a company’s ICO, many of whom favor social media over traditional means of communication partly for the very reason that they are disruptors themselves and favor more modern, open processes.
Celebrity endorsements, particularly over social media, pose even greater risks. They present the usual risks of overblown promises and exaggeration but also must be reviewed for accuracy by the person giving the endorsement or a representative and should only be used with written permission under a carefully drafted agreement. They may also be subject to heightened scrutiny because of the weight a celebrity’s voice can carry, rightly or wrongly.
Only one or two individuals in a company should have the ability to post about its tokens and, in particular, a token offering, on social media accounts. A process should be in place to review and approve each such posting, regardless of how insignificant it may seem. Also, any claims of celebrity endorsements or quotes should be vetted and approved in writing before being released by the named celebrity or another expert.
I recently had a conversation with a blockchain/crypto client who told me that after talking to eight different attorneys about the application of American securities laws, he had not received the same advice twice. This cannot continue. We need to get our arms around how these existing regulations apply. But more than that, we need to advocate. In some ways, existing regulations simply don’t fit. In those cases, we need to figure out what does and demand that lawmakers and regulators act on it. Eventually, a consensus will emerge around how cryptocurrency and ICOs should be regulated in the US, and experienced, thoughtful securities attorneys will be part of forming that consensus. Until then, best practices have less to do with concrete guidance and more with making the best decisions and using the best judgment in an uncertain environment.
First, find an experienced securities lawyer whom you trust. It should be someone who understands blockchain and cryptocurrency but also is willing to learn and consider innovative ways to apply long-standing rules to entirely new issues. Your attorney should be able and willing to keep abreast of developments as they unfold and to inform you of and explain any changes to prior advice.
Second, once you have secured the counsel of a good lawyer, use it. Regardless of how excited you are about your ICO, pause for a moment before issuing any form of public or private communication and discuss it with your lawyer. Consider whether it is forward-looking, whether it is supported by documents or other evidence, whether it is premature or requires disclaimers. Make sure you include your attorney early in the ICO process to avoid going down the wrong path.
Finally, document your honest attempts at compliance. In a regulatory climate where the laws and regulations are lagging the technology, regulators will be less likely to bring harsh enforcement actions against those who have sincerely endeavored to comply with laws and regulations and can demonstrate it.