Initial coin offerings are all the rage these days as cryptocurrencies continue to attract enthusiasts and speculative investors, but for each credible ICO, there may be at least 10 shady ones. The Securities and Exchange Commission has shut down numerous fraudulent ICOs over the last couple of years. Regulators have also been issuing guidance for investors who are captivated by cryptocurrencies and ICOs, but despite all the information that’s available now, many investors are still being tricked by fraudulent ICOs.
So how can you tell if an ICO is a legitimate investment or a scam that just aims to steal your money? There are several things to look out for.
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What is an ICO?
In order to recognize the danger signs associated with initial coin offerings, we first must establish exactly what they are. Most investors who are thinking about diving into digital currencies have a vague sense of what ICOs are and that they have something to do with cryptocurrencies, but the details are generally sketchy for many investors.
ICOs are essentially a form of crowdfunding that involves the use of cryptocurrencies. They've become a trendy way for startups to get capital from the general market rather than relying on venture capitalists or involving other intermediaries in the funding process. Companies that are conducting ICOs sell tokens for cash or established cryptocurrencies, such as bitcoin. When the funding goal for the ICO is net, the project should launch, and then the tokens that were sold become a new cryptocurrency.
Regulators discuss cryptocurrency classification
Unfortunately, scammers have preyed upon uninformed investors who are crypto enthusiasts, and as a result, regulators have had to step in. The SEC has also been working to classify cryptocurrency and its related products, including ICOs, and one of the debates has been whether or not they are considered securities, making them subject to federal securities laws.
William Hinman, who leads the Corporate Finance division at the SEC, weighed in on that very topic recently in a speech at the Yahoo All Markets Summit: Crypto. Essentially, he said that what makes a cryptocurrency a security is actually how it is sold rather than what it is. In other words, initial coin offerings are often considered to be securities because of the nature of the transactions, even though the cryptocurrency itself that comes out of the ICO isn't necessarily a security—because the nature of the sale of it is different.
Thus, ICOs are generally subject to federal securities laws in the U.S. because investors buy into them and receive a financial interest in the project in return. However, selling a token on the secondary market later as a one-off transaction without a financial interest in return does not constitute the sale of a security.
How the Howey test can help you spot fraudulent ICOs
The SEC has selected the case SEC v. Howey to use as precedent when it comes to determining whether a crypto product is subject to federal securities laws or not. The case can also help investors cut through all the marketing talk around an ICO as they try to figure if it's a scam or not.
The Howey case revolved around a hotel owner that was selling interests in an orange grove and recording the transactions as sales of real estate rather than securities. Most of those who bought interests in the grove had the hotel owner's other company care for the trees, pick the oranges, and earn them a profit from their interest in the orange grove.
The Supreme Court ended up ruling that the transactions actually constituted sales of securities and not real estate, as two lower courts had ruled previously. The result of the Howey case was that regulators now often use what's called the "Howey test," which is used to determine whether a transaction is a sale of securities or of something else.
An investment contract or security constitute an investment made in "a common enterprise with profits to come solely from the efforts of others." If that requirement is fulfilled, then it doesn't matter whether the common enterprise is a speculative investment or whether a sale of some kind of property with intrinsic value (in the case of ICOs, tokens).
It's important for ICO investors to understand the Howey test because it can help them determine if the ICO they're considering is indeed a security. That's the first step to protecting yourself from fraudulent ICOs because securities laws should offer some protection, but there's no better protection than education.
The best protection from fraudulent ICOs: education
The SEC has been working hard to educate investors about the dangers of ICOs and help them make informed decisions when it comes to investing in them. It continues to be an uphill battle against the many scammers who find eager investors to be easy prey, but those who absolutely have their mind set on investing in initially coin offerings learn how to spot fraudulent ones.
It's important to approach every ICO with the mindset that the vast majority are scams, and even those that aren't present a risky investment. In order to help consumers understand what fraudulent ICOs look like, the SEC launched its own fake ICO called HoweyCoins to demonstrate the red flags consumers should look out for. Generally, fraudulent ICOs are easily recognizable by the claims that sound too good to be true and promises of "guaranteed returns." The reality is that no investment product can offer an investor guaranteed returns because they can't know with certainty how well their product will go over.
Other key features of fraudulent ICOs include vague language or heavy use of jargon, so much that their website basically says nothing of importance. Everything about the product remains unclear after you read the site. ICOs generally always include a white paper explaining the crypto network that they plan to build and its potential uses. If you can't understand what the tokens you're investing in will be used for, it's probably not a good investment.
Questions to weed out fraudulent ICOs
If you're seriously considering a particular ICO right now, here are some questions you should be asking before handing over your cold, hard cash, based in part on some of the commentary by SEC Chairman Jay Clayton.
- Who is behind the ICO? Typically, offerings include details on the team that's building the crypto network. In some cases, fraudulent ICOs have invented people with excellent qualifications, while in others, they claim qualified people are involved when they actually aren't. Even in the case of legitimate ICOs, it's important for you to know who is selling the tokens so that you can judge their ability to build a successful crypto network.
- What happens to your money when to buy in? What's it going to be used for? Is it going to actually build the network, or will it be used to pay back others?
- Has there been any documentation on what the team that's running the ICO has done so far? If there isn't, then their white paper should be perfect because they have no proof of concept yet.
- What rights will you have when you buy into the ICO?
- Are there audited financial statements available?
- Can you sell tokens back to the company to get your money back? Or can you resell the token to someone else? What kinds of limitations are there on getting your money back out?
- What will be the purpose of the blockchain that's being created through funding from the ICO? Does it sound like a viable product? Has the blockchain code been released yet?
- Does the ICO comply with all securities laws? What steps have they taken to ensure that they are complying with the law?
Perhaps the biggest reason so many scammers have been able to rake in millions of dollars via fraudulent ICOs is because cryptocurrency seems like some mysterious form of technology that enthusiasts are convinced will be the goldmine of the future. It's just generally not a good idea to invest in something that you don't understand—unless you know someone who understands it very well and you trust their judgement on it.