Guest post contributed courtesy of Todd R. Kornfeld and Irwin M. Latner from Pepper Hamilton LLP. This article was first published online on February 1, 2018 at Crowdfund Insider. It is reprinted here with permission.
Initial coin offerings (ICOs) have recently become very popular, causing investors of all levels of sophistication to consider buying ICO tokens (or coins). Regardless of whether you view ICO tokens as “investments,” or whether you want to buy tokens for their utility function to make software operate or to access some type of service, remembering your ABCs will help guide you through the diligence process.
Many of these questions will look familiar, as they are the same as, or similar to, questions that should be asked when participating in conventional investments or asset purchases. Unfortunately, these queries are often overlooked and/or misunderstood, particularly during the excitement of an ICO.
As a law firm advising prospective ICO investors and ICO issuers, we suggest that participants in an ICO not abandon the fundamentals of making a smart purchase. They need to ask questions — the who, what, where, when, why and how with respect to the underlying company or organization and its founders or sponsors, the products and services, the token and expected token economics, and the legal and regulatory framework.
Potential ICO participants should consider the following ABCs as a guide before they buy:
- Always ask: Do you understand the ICO that you want to participate in? If you do not, that suggests that you should be cautious. Always ask questions. Why is the description so complicated and hard to understand? Is someone trying to hide something? Where is your money going, and what will it be used for? Is your money going to be used to “cash out” others? Consider the possibility that the ICO is in fact a Ponzi scheme, a fraud or run by bad actors. ICO fraud is still fraud; it just has a new wrapper. Every purchaser must take steps to protect his or her own assets. That includes asking the tough questions and only buying when the benefits outweigh the potential costs and losses. And even if the ICO is not a fraud and the sponsor is sincere and well-intentioned, that does not mean that the promised blockchain network will ever be successfully developed or that a functional product or service will ever be completed.
- Background check: Who are the people involved in the ICO? Do they have a background that suggests the ICO could be successful? The fact that the sponsors have a successful track record is not a guarantee that this new ICO will be successful.
- Buyers should run a FINRA record check (using BrokerCheck, which is available on the FINRA website) to see if the ICO sponsors have troubling records or any disciplinary history as brokers. Additional research on the ICO sponsors will be helpful in making your decision. If the ICO marketing materials do not tell you who the sponsors are, meaning who structured and is running the ICO and the enterprise the ICO represents, it will be hard for you to conduct due diligence on the ICO, and you may view this as problematic when deciding whether to participate in the ICO.
- Commercial use/need: What can you do with the token or coin? Does the investment proposition or product purchase make sense as a commercial matter, and does the blockchain/cryptocurrency use case address an unmet need as compared to traditional databases/fiat currency? Why is this better as an ICO?
- Demonstration of existence: Can you see a demo of the product or service? Does the so-called “minimally viable product” exist at the time of the ICO, or is the product, ecosystem or service being developed using the proceeds of the ICO? Does the promotor have the ability to actually execute the business plan? Do they have disclosed financial backers with the wherewithal to see the project through? Does the software actually do what it is supposed to do? Has the promotor disclosed the names of the members of the development team? Remember to background check the team.
- Economics: What are the economics of the ICO? Is there a cap on how many tokens or coins will be issued or sold? Will other participants get the same token or coin for free or at a reduced price? What are the motivations of the ICO’s sponsors? Will they make money and, if so, how much? Who controls the ICO issuer?
- Fraud: Does the investment proposition, product or service — that is to say, the opportunity, the potential size of the market for the service or product, the projected number of users, the projected returns (for an investment), etc. — seem too good to be true? The SEC and CFTC have helpful materials on their websites with pointers for spotting fraudulent investments, including fraudulent ICOs. From time to time, they add additional materials on these topics. Spotting a potentially fraudulent or highly risky ICO is no different from spotting fraud or high risk in anything you buy or a business arrangement that you enter.
- Gut feeling: Purchasing tokens or coins in an ICO is partly an intuitive determination. Do things look right? Do they promise you unreasonably high returns in a short period of time? Has the ICO sponsor utilized recognized law firms, accountants, brokers and other reputable service providers? Do the ICO materials (such as a white paper) explain clearly the business proposition for what you are buying, or has the company given you a one-page document filled with grammatical errors? Does the company’s website look like it was done for free? Polished, professional websites and materials do not, in and of themselves, mean that an ICO is legitimate, but they indicate access to resources, which is more likely to mean that the company is a legitimate business. In addition, even if materials plainly state that a given investment or product purchase is risky, that disclaimer alone does not validate the business or the business model. Conversely, if the materials include a lot of puffery and do not present a balanced description of the risks, that is likely a bad omen. While any one of these factors is not damning or validating in and of itself, it is important to consider the totality of the facts and circumstances.
- High risk: You need to determine not only whether the ICO is legitimate and of interest to you, but also whether the ICO is suitable for you. Perhaps the business plan, while interesting, seems very high risk. Perhaps you feel that the implementation team lacks experience. Perhaps there are other factors that you uncover that make participating in this ICO a risky proposition. In those cases, you need to decide if that risk is too much for you to accept or if it is acceptable. In short, is participating in the ICO suitable for you? Does it fit your risk profile?
- Investment: Does the ICO sponsor suggest that an investment in the tokens will be profitable for the investor or that the tokens will become more valuable over time? If so, what will cause the tokens to appreciate in value? Will it be the “network effect” of future prospective users of the sponsor’s blockchain network clamoring to purchase tokens from a limited maximum available token supply on a secondary market? If an ICO issuer or sponsor is touting the potential profitability of an investment in the tokens, this alone may cause the offering to be deemed to involve the offer and sale of a security, which requires either registration under federal and state securities laws or an exemption from registration. And if the ICO issuer or sponsor does not undertake securities law compliance steps, ICO participants may have the right to seek rescission or damages for any losses suffered as a result of their ICO purchase.
- Junky endorsements: Was the ICO endorsed by a celebrity, such as an actor known for his award-winning biopic but not necessarily for his financial acumen? Was the celebrity paid to make the endorsement? The endorsement may not represent a fair and unbiased evaluation of the ICO. The SEC has urged potential participants in ICOs to carefully consider celebrity and other public endorsements of ICOs. The SEC recently stated, “It is never a good idea to make an investment decision just because someone famous says a product or service is a good investment.”
- Legitimate: If you do decide to purchase tokens or coins in an ICO that you think is legitimate, you should also consider a number of additional administrative and other matters. How will the tokens or coins be held in a wallet, and how secure is that wallet? Who has access to the wallet? What are the tax implications when you sell or use the tokens or coins? If you are buying the tokens or coins for third parties (such as a fund), do you have the authority to do so, e.g., is an ICO within your investment guidelines? If you are managing a pool of tokens or coins for third parties, do you need to be a registered investment adviser or commodity pool operator? Will your auditor be able to audit the pool of tokens or coins? Who will have custody of the tokens or coins?
- Securities: Remember that if you are purchasing an investment, you are may be buying a security. An ICO structured as a securities offering should be offered in compliance with applicable securities laws.
- Wherewithal: Do you feel the sponsor and the other people behind the ICO have the wherewithal and ability to see the ICO through to competition? And do you think that once the ecosystem is complete, they will have the ability to keep it running so that the token or coin has a use going forward?
In short, the risks of buying tokens or coins in an ICO are similar to the risks of conventional investments and purchases of goods and services. Fraud and disappointment are always a possibility. If you want to buy tokens or coins in an ICO, we suggest that you remember your “ABCs” and carefully consider the risks of that purchase and whether the purchase is suitable for you.