Investor Alert: Risky Coin – Risks Associated With Initial Coin Offerings

By Eric Peters, Fall 2017 IAC Student Intern

The SEC recently issued an Investor Alert about Public Companies Making ICO-Related Claims, as did FINRA in an Investor Alert entitled Initial Coin Offerings: Know Before you Invest.   Some startup companies looking to raise capital are using initial coin offerings (ICOs) by creating a new virtual coin or token that the company offers for sale using technology similar to the bitcoin network that creates and tracks transactions in virtual currency.  Similarly, ICOs are also conducted online where purchasers can use U.S. currency (such as the U.S. dollar) or virtual currencies (such as bitcoin) to pay for the ICOs.  It is important to note that if the offer and sale of these coins and tokens in an ICO is a security offering, then the ICO must be registered with the Securities and Exchange Commission (SEC) and is subject to the federal securities laws unless they qualify for an exemption from registration.  In order to be exempt from registration, offerings are limited to accredited investors that typically meet certain net worth thresholds in excess of $1 million or maintain certain income levels to be eligible to invest. 

Investors should verify whether a company has registered an ICO with the SEC by searching the SEC’s EDGAR SystemIf the ICO is registered, then check the professional background of the individuals involved in the offering by using BrokerCheck since they are required to maintain certain licenses and registrations under state and federal securities laws and FINRA rules.  Since the rights and benefits will vary depending on the ICO offering, an investor should read and understand the terms and conditions the ICO, as well as any published white paper describing the ICO, and business plans offered by the company.  The investor should understand what they are receiving in exchange for their investment: any ownership rights, voting rights, the company’s governance, and how will the funds be used.  Since most ICOs are offered by startup companies the information available may be incomplete, subject to change, and difficult to verify resulting in inadequate due diligence prior to investing.

Investors should also be aware that secondary market liquidation venues are not guaranteed.  Information provided to investors about the ICO should clearly state how the investor will get their money back: can they cash in coins or tokens for a refund, are they permitted to resell coins or tokens in a secondary market, are there restrictions to any resale.  Investors should also note that ICO purchases may be subject to liquidity issues since it is possible that there will not be a market to sell or exchange coins or tokens in a secondary market or on an online virtual currency exchange.  ICOs are highly technical and complex and investors can lose some or all of the money they invest in these offerings.

Finally, ICOs may be susceptible to possible hacking, malware, and fraud given the virtual platforms used by companies issuing ICOs.  Investors should avoid anyone that makes guarantees that an investment will perform a certain way or encourages an investor to “act now.”  In addition, other third-party vendors that store digital tokens for customers online, payment processors, and virtual currency exchanges may be fraudulent, located overseas or operating unlawfully.  Investors should use caution when considering investing in an ICO since new technologies such as this are often used as an opportunity to dupe investors.