Recently, the U.S. Securities and Exchange Commission (SEC) issued an Investor Alert (the Alert) warning investors to use caution before investing in initial exchange offerings (IEOs) through online trading platforms.1 The SEC’s Investor Alert was issued by its Office of Investor Education and Advocacy, which periodically issues investor alerts and bulletins to provide investors with additional information regarding new investment schemes or to notify investors of certain fraudulent business practices. While written primarily for investors, the Alert may serve as a helpful reference for broker-dealers and investment advisers with respect to activities in which their representatives may be engaged.
The initial coin offering (ICO) market has come under regulatory scrutiny in the last few years, including multiple SEC enforcement actions alleging violations of various federal securities laws.2 More specifically, the SEC’s ICO enforcement actions have alleged, among other things, that companies deliberately sought to raise capital through ICOs without properly registering the offering in accordance with the securities registration requirements of the Securities Act of 1933 (the 1933 Act).
The Alert warns investors that IEOs are being touted as an “innovation” on ICOs, but they still present many of the same risks of violating the federal securities laws that existed (and continue to exist) for ICOs.
ICOs versus IEOs
The Alert notes that ICOs are similar to IEOs in that they are both initial offerings of digital assets, typically in the form of “coins” or “tokens,” to raise capital. However, ICOs and IEOs differ in how the digital asset is offered. Whereas ICOs involve the company raising capital and offering its digital assets directly to investors, IEOs are offered by online trading platforms, commonly called “exchanges,” on behalf of companies.
IEOs are offered through these online trading platforms in order to provide immediate trading opportunities for digital assets, with the online platform typically assessing a fee for conducting the offering. Although IEOs may refer to themselves as “exchanges” or “cryptocurrency exchanges,” they are typically not registered with the SEC as a “national securities exchange” in accordance with the requirements of the Securities Exchange Act of 1934, as amended (the 1934 Act).
Another distinction is that the online trading platforms conducting IEOs may claim to perform certain customer due diligence, such as anti-money laundering or “know-your-customer” reviews, before allowing customers to purchase and trade digital assets on their platforms. By comparison, ICOs are typically offered directly by the company seeking to raise capital and may not rely on third parties such as an online trading platform to perform any separate customer diligence.
IEOs and Potential Violation of Federal Securities Laws
Section 5 of the 1933 Act generally prohibits securities from being offered unless a registration statement has been filed and declared effective by the SEC. Among other things, a “security” is defined in Section 2(a)(1) of the 1933 Act to mean an “investment contract,” where the U.S. Supreme Court has generally interpreted an investment contract to mean an investment of money in a common enterprise with the expectation of profits derived from the efforts of a promoter or third party (commonly referred to as the Howey test, a reference to the U.S. Supreme Court case adopting the applicable interpretation of an investment contract).3
The digital assets underlying IEOs share many of the same characteristics as ICO offerings and, depending on the facts and circumstances of a particular offering, may meet the definition of an investment contract and therefore be deemed a security under the 1933 Act. If the IEO is deemed an offering of securities, then the Alert notes that the offering may be subject to the registration requirements of the 1933 Act.
National Securities Exchange Registration
Section 5 of the 1934 Act generally prohibits national securities exchanges from operating without first registering with the SEC in accordance with Section 6 of the 1934 Act, where a “national securities exchange” is broadly defined in Section 3(a)(1) of the 1934 Act as a market place or facility for bringing together purchasers and sellers of securities. In addition, Rule 3a1-1 under the 1934 Act exempts certain “alternative trading systems” from regulation as a national securities exchange, provided certain conditions are met, including compliance with Regulation ATS under the 1934 Act and filing a Form ATS or Form ATS-N with the SEC before commencing operations.
IEOs are conducted through online trading platforms that connect purchasers and sellers of certain digital assets traded on the platform. To the extent that the digital assets trading on the IEOs constitute securities (see the Howey test discussed above), then an online trading platform conducting IEOs may need to register with the SEC as a national securities exchange or operate pursuant to an exemption, such as an alternative trading system. The Alert warns investors that many online trading platforms may falsely represent to investors that they are properly registered with the SEC when, in fact, these claims mislead investors about their protections under the federal securities laws.
Section 15(a) of the 1934 Act generally requires anyone engaged in the business of a “broker” or “dealer” to register with the SEC. A “broker” is broadly defined in Section 3(a)(4) of the 1934 Act as anyone engaged in the business of effecting securities transactions for the accounts of others, and a “dealer” is broadly defined in Section 3(a)(5) of the 1934 Act as anyone engaged in the business of buying and selling securities for its own account. In addition, registered broker-dealers must become members of a registered securities association, such as the Financial Industry Regulatory Authority, Inc. (FINRA), or become members of a national securities exchange.
The online trading platforms involved in IEOs may be deemed to be effecting securities transactions for the accounts of others, especially if the digital assets trading on their platforms are considered securities. This may subject IEOs to broker-dealer registration requirements, and IEOs then would need to comply with applicable SEC and FINRA requirements.
IEOs may be offered by offshore entities or persons seeking to avoid application of federal securities laws. However, the Alert notes that IEOs conducted on offshore trading platforms may still be subject to the federal securities laws if they are offered to persons in the United States.
The SEC’s Alert flags many of the potential securities law violations posed by IEOs. Noncompliance with the federal securities laws means that IEOs may be operating unlawfully, which concerns the SEC because investors may not be adequately protected or have adequate remedies available to them.
The SEC’s Investor Alerts often serve as a gauge of future regulatory, exam, and enforcement activity. If IEOs do indeed pose many of the same securities law compliance deficiencies that exist for ICOs, then we may see a flurry of enforcement activity related to IEOs in 2020, similar to the ICO enforcement actions brought by the SEC over the past several years.
Given this, SEC-regulated entities, including broker-dealers and investment advisers, should carefully supervise the activities of their associated persons and supervised persons, respectively, to ensure they are not recommending investments in IEOs without proper oversight by the firm and also to ensure that the registration requirements noted above are satisfied.