Initial coin offerings have taken off in 2017.

The SEC took two strong steps this week toward increased regulation of the cryptocurrency markets and specifically regulation of Initial Coin Offerings (“ICOs”). These steps included the halting of an ongoing ICO and a strong statement by the SEC’s chairman regarding ICOs and their status under the Federal securities laws. These steps were the SEC’s strongest actions to date regarding ICOs, but what is the probable long-term result here? This is getting very interesting as you pit the regulators and their application of traditional securities law concepts against an increasing strong demand in the investment community to invest in these cryptocurrency vehicles.

An ICO involves the offering of a token, “coin” or other digital product. In exchange for their investment, investors receive these tokens or coins. The company then uses the proceeds of the ICO for various corporate purposes similar to a regular offering of securities. ICOs have generally not been registered with the SEC.

On December 11, 2017, the SEC halted the ICO that was being conducted by Munchee Inc., a company that developed a restaurant review app. This action was based on the fact that the company had not registered this offering with the SEC. This ICO involved the issuance of MUN Tokens by Munchee, which the company said might increase in value. Munchee planned to raise about $15 million in this ICO. The SEC said that an investor could reasonably expect to earn a return on these Tokens, and accordingly the Tokens issued in the ICO were “securities” and should have been registered under the Federal securities laws. Munchee accepted the SEC’s findings without admitting or denying anything. The company agreed to halt the offering and to return all proceeds that it had received from investors in the offering.

The investigation of this matter was conducted in part by the SEC’s new Cyber Unit (a division of its Enforcement Section). The SEC had also issued other materials regarding concerns with cryptocurrencies and ICOs, including an Investor Bulletin issued on July 25, 2017 and a Report of Investigation issued on the same date.

Also on December 11, SEC Chairman Jay Clayton issued a strong warning to investors and industry professionals regarding ICOs. Clayton’s remarks stated that there may be an increased danger of fraud in ICOs since very little information is normally supplied to investors in an ICO. He also warned investors to be very careful in a situation where the investor is being pushed to quickly invest in and ICO without adequate information. Chairman Clayton also issued a general statement that many of the tokens and other items issued in ICOs may qualify as securities under the Federal securities laws, and accordingly such items must be registered with the SEC or must qualify for an exemption from such registration. He also touched on entities that are trading in cryptocurrencies, saying that these entities may have to register with the SEC.

This SEC action was important because it was not based on any allegation by the SEC of any fraud conducted by the company. The halting of the offering was based purely on the contention that this was an offering of securities that had not been registered with the SEC. The SEC will certainly take steps against an offering where fraud is alleged (as its Cyber Unit recently did in an ICO conducted by Canadian issuer Plexcorps), but in some ways this Munchee action is probably more troubling for ICO issuers because it did not involve fraud but was based purely on technical SEC registration concerns.

So where do we go from here? There is a huge division of opinion of the status and future of cryptocurrencies and ICOs. It’s interesting to note that the People’s Bank of China (China’s central bank) banned ICOs in September 2017 because these offerings would have a disruptive effect on that nation’s economy and financial markets. The SEC’s actions in the Munchee and the Plexcorps matters along with Chairman Clayton’s remarks show that the SEC is ready to step up its regulatory and enforcement posture against ICOs in the US. On the other hand, the sheer volume of ICOs (approximately $3.7 billion so far this year) and the heavy and increasing demand by investors for these offerings creates significant pressure to find some way to let these offerings proceed. This will be a very interesting interface going forward. I understand the SEC’s position, but I would not underestimate the power of cryptocurrencies and ICOs. In my view they are not going away. I anticipate a much higher level of SEC regulation and enforcement in this area, but I also believe that investor interest in cryptocurrencies and ICOs will continue to increase.