United States: FINRA Cautions Investors About Initial Coin Offerings

FINRA issued an Investor Alert about the potential risks of investing in "initial coin offerings" ("ICOs"). The Alert also listed questions and potential indicators of fraud to consider before investing in an ICO.

The FINRA Alert followed an SEC Investor Alert on microcap fraud in relation to ICOs (see previous coverage). In the new Alert, FINRA described how companies increasingly use ICOs to raise capital, and how ICOs differ from initial public offerings of securities. FINRA explained that ICO tokens confer no (or unclear) ownership rights in the offering company, and ICOs typically are promoted through online forums and "whitepapers" rather than through the delivery of prospectuses. FINRA emphasized that ICOs involve products that are often complex and technical, and present a heightened risk of financial losses for investors.

FINRA cautioned investors to take the following steps when evaluating whether or not to invest in an ICO:

• confirm whether or not the ICO is a securities offering;
• verify whether the party offering an ICO is a registered financial professional;
• examine the rights and benefits conferred by an ICO purchase, including whether a purchase results in an ownership stake;
• determine resale permissions and restrictions associated with an ICO purchase;
• understand how an offering company operates and conducts due diligence;
• inquire about cybersecurity protections for the ICO; and
• look for warning signs of fraud, such as high-pressure sales tactics.

Commentary / Jeff Robins

One odd aspect of this FINRA Investor Alert is that it advises potential investors to ask whether an ICO is a securities offering. The question is one for the regulators in the first instance. Investors would have difficulty answering it. As the Alert highlights, the "rights" that come with an ICO token can be poorly defined relative to most securities, as much a product of the code on which they operate and their functions within an evolving technological system as on formal legal rights. Further, while investors in many ICOs are clearly hoping to profit from the appreciation of tokens, the sources of their value may be disparate and complex.

Presumably, what FINRA means is that investors should know whether an ICO is being run as a securities offering with the attendant financial professionals, disclosures and safeguards. The question is a rhetorically clever way to set up a comparison of securities and non-securities offerings, foster caution in approaching ICOs and signal to the market that the regulators are themselves paying attention. Fair enough for FINRA, but ICOs are a paradigm-shifting development whose place in the legal landscape is poorly defined. Sooner or later, these deeper questions will need to be addressed.