The New Digital Wild West: Regulating the Explosion of Initial Coin Offerings

Randolph A. Robinson, II is visiting assistant professor at the University of Denver Sturm College of Law. This post is based on his recent paper.

In 2017, initial coin offerings or ICOs raised a collective $4 billion for blockchain entities. While the rise of bitcoin has brought cryptocurrencies and the blockchain into recent media headlines, you could be forgiven if you are unfamiliar with concept of an ICO, as this funding mechanism only reached mainstream audiences in 2016 with the launch of an entity called The DAO. The DAO was formed as a decentralized venture capital fund, intended to fund the development of new blockchain companies and applications. But, before fully operational, The DAO suffered a cyber-attack that drained over one-third of its funds, putting an early end to the ambitious experiment. Although no longer operational, The DAO’s completely unregulated nine-figure fund raise would give rise to widespread duplication of this controversial corporate funding mechanism.

Initial coin offerings (also called token sales) are a new funding mechanism in which entities (or sometimes individuals) sell crypto-tokens to raise funds for blockchain companies or applications. At least 235 ICOs were launched in 2017, including numerous offerings that raised in excess of $100 million. Many of these offerings were based not on established business models or proven products, but on little more than a white paper expressing an idea and a few lines of sample code. All of this was done without a single registration statement being filed with the SEC, and largely without private placement memoranda or other common securities disclosures. In the absence of meaningful regulation, the current ICO marketplace is rife with pump-and-dump schemes and all varieties of fraud and abuse. Welcome to the new Digital Wild West.

With the explosion of both the number of ICOs and the steep increase in the funds being raised, many both within and outside the blockchain space began questioning whether governmental regulators should continue to sit on the sidelines. In July 2017, the United States Securities and Exchange Commission (“SEC” or “Commission”) answered that question by issuing a report detailing its investigative findings on The DAO. Relying on the seventy-year-old Howey test, the SEC characterized DAO tokens as securities. So after months of speculation and billions of dollars raised without any supervision, the SEC has now planted its regulatory flag. Finally, U.S. investors and blockchain entrepreneurs have an answer: ICOs are securities subject to regulation by the SEC and the antifraud provisions—well, maybe.

Although the SEC’s report gives insight into its view of one specific ICO, both the legal conclusions and their general applicability to other ICO structures raise more questions than answers. The Commission presents a problematic analysis that neither explains how The DAO structure satisfies Howey’s “common enterprise” and “efforts of others” requirements, nor provides a full factual picture of the entity’s operation. More troubling, the SEC’s report rushes past a critical threshold question: are the traditional rules governing securities offerings—rules established in the early part of the last century—the best legal framework to regulate this new technology-driven funding mechanism?

Despite the overnight success of this new funding mechanism, there is little legal scholarship addressing ICOs and the appropriate form of regulation. As the problems with the SEC’s report on The DAO illustrate, our current securities law framework is ill-equipped to handle this new world of decentralized, global, pseudonymous fund raises on public blockchains. While the investor protection concepts that have developed over past eight decades have proven effective in reducing fraud and giving investors some protection against bad actors, it is time to rethink the way in which we deploy these protections. Going forward, governmental regulators should work with core development teams to build a regulatory framework that integrates investor protections directly into the computer code governing these systems. By embracing “code as law,” both regulators and core development teams can protect the innovation funded by ICOs, while at the same time injecting some much needed investor protections into this new ecosystem.

In order to provide the necessary context to understand this new decentralized world, this paper provides a non-technical legal audience with a foundational understanding of how public blockchains work. The paper begins with an introduction to the coming decentralized world, including an overview of both public blockchain technology as well the Ethereum platform, the primary public blockchain upon which ICOs are being deployed.

Central to this introduction is an explanation of how the decentralization and disintermediation brought by the blockchain has the potential to reshape our economic and social systems. Next, the paper explores the recent explosion of ICOs, discussing how these offerings are structured, and how this new funding mechanism, if developed properly, can democratize opportunities for economic innovation. The paper then examines the SEC’s report on The DAO to illustrate the potential problems with applying a dated legal framework to this new technology.

Finally, the paper concludes that the traditional securities law framework is ill suited for the coming decentralized world because the SEC’s enforcement power over global blockchain platforms is limited. Recognizing that external legal frameworks cannot be forced upon public blockchain platforms, the paper argues for a collaborative process where governmental regulators work with core development teams to build a regulatory framework into the very fabric of these platforms, thereby providing investors protection, while at the same time embracing our new ability to truly use code as law.

The complete paper is available for download here.

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