Initial Coin Offerings (ICOs) are already a multibillion-dollar strategy for raising capital and are growing in importance. They do, however, present significant and unresolved regulatory and litigation risks that may expose offerers, investors and others to investigation and litigation risks in multiple jurisdictions. Policyholders and directors & officers insurers alike should be cognizant of the risks and consider whether insurance is available to cover them.
What Is an Initial Coin Offering?
An ICO is a way to raise funding outside of the traditional equity markets. Essentially, an ICO is a mix between a traditional IPO and crowdfunding. In an ICO, a business offers buyers “coins” or “tokens” in exchange for capital investment. ICOs allow businesses to bypass traditional markets and maintain equity and ownership. There may also be a short-term benefit from the excitement around blockchain technology and cryptoassets, which could increase the capital raised through an ICO.
Though a relatively new method of raising capital, ICOs have proven to be increasingly important. By some estimates, ICOs have raised over $3 billion from investors—more than all of the venture capital raised in the United States in 2017.
How Does an ICO Work?
An investor in an ICO receives coins or tokens in exchange for their investment, which can take either the form of cash or other currency (such as bitcoin or ether). The coins or tokens issued to investors often are referred to as “Alt-Coins.” In most instances, the Alt-Coins from an ICO work on a blockchain, the same technology developed for and used by bitcoin. A blockchain is an open, distributed ledger that is constantly updated and verified by all participants involved. Every time a transaction is recorded in the ledger, all copies of the ledger are simultaneously updated, which enables blockchain to facilitate and verify transactions, speed up transactions, and prevent fraud.
The nature of an Alt-Coin offered by a company in an ICO can vary. Some Alt-Coins resemble coupons or vouchers that can be exchanged for future services or goods once the company becomes operational (utility tokens). Other Alt-Coins are more analogous to traditional securities and may give investors voting rights in the offering company (albeit without a concomitant equity interest) or a right to receive a share of future earnings (security tokens). The nature of the Alt-Coin is limited only by the terms of the ICO. Regardless, in exchange for the investment, the investor receives a commodity that can be divided and traded as if it were currency.
What Are the Major Risks Associated With an ICO?
The SEC has taken the position that ICOs likely are subject to the requirements of federal securities laws. However, whether a particular ICO involves the offer or sale of a “security” will depend on the facts and circumstances, including the economic realities of the transaction. In the SEC’s view, ICOs more likely than not are security offerings. The SEC has filed criminal and civil actions against issuers arising from the sale of unregistered securities, and currently dozens of investigations involving ICOs are pending.
The SEC is not the only regulator to be worried about. State securities regulators also are watching and taking action against perceived abuses. Notably, states are taking different approaches to regulating ICOs. For example, Wyoming is taking steps to create a friendly regulatory environment for ICOs, while New York is proposing a stricter regulatory regime for cryptocurrency businesses that would include requirements for routine audits and proof of asset ownership.
ICO advocates argue that the capacity to market and sell ICOs without geographical restrictions is a major advantage over traditional equity fundraising, but different countries have adopted vastly different approaches to regulating ICOs. The fundamental issue of whether an ICO involves the issuance of a security can vary. This regulatory uncertainty vastly increases the risk of investigation and eventual litigation by both governmental entities and individual investors.
Compliance with other potentially applicable regulations also should be considered. Like other cryptocurrencies, Alt-Coins normally can be purchased and sold anonymously, and ICOs typically offer investors the opportunity to invest using other anonymous cryptocurrencies such as bitcoin or ether. The U.S. Department of the Treasury has stated that ICO offerers generally will be subject to anti-money laundering and anti-terrorism regulations and may need to register as money-transmitters.
Finally, financial institutions not directly associated with ICOs also may be at risk. When an issuer attempts to deposit funds raised through an ICO, the financial institution needs to ascertain where those funds originated. The fact that ICOs often accept payment in the form of other anonymized cryptocurrencies such as bitcoin or ether only complicates this issue. Although the evidence trails behind transactions may be weaker for cryptoassets and related activities than for traditional transactions, U.K. regulators have counseled banks to assess the sources of cryptoassets and cryptoasset-related activities “using the same criteria that would be applied to other sources of wealth or funds.”
D&O Insurance for ICOs
D&O insurers, who are very familiar with the risks associated with traditional securities offerings, regulatory investigations and investor litigation, may or may not want to extend insurance coverage for ICOs. As described above, issuers of ICOs are subject to regulatory investigations and enforcement actions not just from federal and state regulators in the United States but also in other countries. ICO issuers also face private class action suits by investors—potentially in multiple jurisdictions. In addition, even where an issuer seeks to comply with all applicable regulations, there are risks arising from the marketing of ICOs through social media, which is uniquely ill-suited to providing the kind of reasoned, nuanced communication required by a securities offering.
D&O insurers should carefully vet policyholders engaged in, or considering whether to engage in, ICOs to determine whether the offering is insurable and, if so, properly priced due to the higher risks posed in this new space.