Introduction: What are ICOs?

An initial coin offering (“ICO”) is the process of raising capital for a business by issuing a new coin or token. These funds are used to develop the company´s platform or other business projects. While ICOs are on the rise, the SEC has observed that the technology behind them—the blockchain—is still in a novel stage with little to no regulation. As a result, ICOs represent a high potential for fraud due to the lack of consistent regulation compared to traditional capital markets. Further, in 2019, the SEC released its “Framework for ´Investment Contract´ Analysis” which helps companies determine whether they may have any registration obligations. If you are considering launching an ICO, then you need to consult an experienced ICO attorney to conduct a comprehensive evaluation of your compliance obligations under federal law. This article, drafted by the ICO attorneys at Oberheiden, P.C., considers these points.

5 Considerations Before Hiring an ICO Attorney 

An experienced lawyer can help guide you through your initial coin offerings (ICOs) launch in a way that is compliant with federal law, especially the federal securities laws. Below are five considerations to evaluate for your ICO:

1. Your ICO project may involve SEC registration obligations if your coin or token passes the “Howey Test.”

This is probably the most important consideration. You will first need to determine whether your coin or token satisfies the SEC´s definition of security and therefore has to be registered or exempted. The SEC and courts use something called the Howey Test, which was developed from a Supreme Court opinion, to determine whether a digital asset or digital asset project is an “investment contract” or a “security” under federal law. This test has four prongs:

1. an investment of money, 

2. in a common enterprise, 

3. with the expectation of profits, and 

4. derived solely from the efforts of others. 

All four prongs must be satisfied for the coin/token to be regulated as a “security.” Once the coin or token is a security, many companies proceed under a registration exemption such as Regulation D by completing Form D or Regulation S (where the coin or token is offered and sold outside the United States). Where one or more prongs are not satisfied, the coin/token is not a security but instead deemed one of “utility.” Utility tokens do not require registration because they are not securities in the first place. 

2. If your project involves coins or tokens that are deemed “securities,” you may have a host of other federal registration obligations.

In addition to the stringent registration obligations that may be possible for your coin or token (digital currencies), the ICO project could entail additional registration, reporting, and other federal obligations. Once the coin or token is considered a “security,” the individual involved in launching the coin needs to evaluate whether their services to the public may require registration as a broker-dealer or investment adviser. This will depend on various considerations such as whether the individual is facilitating coin/token trades or providing investment advice for a fee, respectively, but are nevertheless critical considerations every individual or company launching an ICO needs to thoroughly evaluate. Lastly, some companies use their online platform for launching and issuing ICO. In such cases, the platform itself may have to be registered as an exchange.  

3. ICOs represent an area of increased federal regulatory interest and scrutiny due to the novel technology and potential for fraud involved.

The SEC´s Enforcement Division continues to aggressively investigate blockchain companies involved in ICOs for allegedly engaging in fraudulent behavior, market manipulation, and other instances of misconduct under the federal securities laws. Most commonly investigated topics include those under the antifraud provisions or those regarding the offer and sale of unregistered securities.

Ancillary issues involve acting as unregistered investment advisers, failure to obtain a federal money transmitter license or failure to register the ICO platform as an exchange. SEC Chair Gary Gensler in August 2021 compared cryptocurrencies to “the Wild West” which requires an enhanced and reinvigorated investigative approach by the Commission. As a result, the SEC is using greater scrutiny concerning ICOs.

4. You will likely need an experienced ICO attorney to help you structure your ICO under the law and assess other more complicated issues before launch.

ICOs are complicated projects. They involve significant time, money, and manpower before launch, during launch, and after the token or coin´s launch. The registration obligations—from the coin/token and individuals involved to the platform itself—require a thorough examination. Additionally, drafting and assessing legal services agreements and miscellaneous expansion plans can change the entire equation of “registration required” versus “registration not required.” An attorney can assist blockchain companies with their ICOs in the following ways, as examples:

• Structuring and restructuring the offering to your business needs;

• Conducting a comprehensive legal, regulatory and compliance review;

• Assessing whether the coin or token is a security token or a utility token;

• Advising on compliance, including AML/KYC obligations under the BSA;

• Drafting complex legal service agreements, PPMs, investment contracts, stock certificates and subscription agreements;

• Defense work including defending against federal investigations; and

• Assisting with tax preparation regarding the ICO.

If you think your project may involve one or more of these services, then it is time to contact an experienced ICO attorney for legal guidance.

5. ICOs contain a very high risk of liability exposure due to the nature of ICOs and other federal provisions that may be involved.

ICOs are offered to the public to fund new business operations. Whether the issued coin or token is one for “utility” or “investment” purposes, the technology behind them is still novel and presents many risks. The blockchain is the public distributed ledger that records all crypto transactions in a manner that is transparent, secure, and immutable. That said, because many crypto transactions are virtually untraceable, the potential for fraud, money laundering, market manipulation, and other crimes is still high. As a result, many federal agencies such as the SEC—or the FBI/DOJ where criminal conduct is involved—have taken a keen interest in companies issuing ICOs. 

Further, federal legislation such as the Bank Secrecy Act and the PATRIOT Act imposes various obligations on certain companies to maintain reports and records for their customer´s transactions as well as more enhanced requirements such as compliance programs, training requirements, and annual reviews or audits. Some crypto companies may also have registration and licensing requirements such as those for MSBs under FinCEN for engaging in money transmission services.

“Certain ICOs involve coins or tokens that would satisfy the SEC´s definition of a “security.” In such cases, the company would be required to register its coins or tokens with the SEC or qualify for an exemption. The failure to do so could lead to substantial civil and criminal penalties, injunctions, disgorgement orders, and reputational harm. To determine whether you have any registration obligations under the federal securities laws or other federal provisions, you should contact an attorney experienced in ICOs right away.” – Dr. Nick Oberheiden, Founding Attorney of Oberheiden P.C.

Conclusion 

Initial Coin Offerings (ICOs) present great potential for small businesses and start-ups to raise capital quickly and with few entry barriers. That said, ICOs are inherently a risky endeavor due to the novel technology behind their operation—blockchain technology—and the lack of consistent and comprehensive federal regulation in the crypto/blockchain industry. This presents an increased risk of fraud and manipulation. Before launching an ICO, consider the five points in this article and seek out the services of an experienced ICO attorney to advise you on federal compliance obligations. The lawyer's knowledge of ICO will also play an important factor in launching ICO.