When BitTorrent launched its token offering on January 28th, 2019, the team was optimistic they would raise the $7.2 million they needed to improve speed on their torrent service. 

What they didn’t expect was that all the tokens they were offering would be sold out in just 14 minutes after launch.

BitTorrent’s token sale was the first Initial Exchange Offering (IEO) held by Binance on its new Launchpad platform. In the year since, over a dozen other projects have followed suit to raise millions of dollars through the platform.

Though the other IEOs may not have sold out as quickly, it is still clear that companies and investors are very eager for action.

Two years ago, incredible fortunes were being made through the Initial Coin Offering (ICO) craze. Now that this type of token offering has been wiped out by the SEC, IEOs are a very welcome opportunity for crypto projects to raise funds again. 

In the time since, a number of other exchanges have followed Binance’s lead, from Bitfinex to Huobi Prime. And just this month, Poloniex has just announced the release of its new token launching platform, LaunchBase. 

While this might sound like something you should act on as quickly as possible, as your unofficial crypto counsel, I strongly suggest that you think twice. 

Read on to learn 3 reasons why you should be cautious when considering an IEO. 

What is an Initial Exchange Offering?

Before we get started, let’s cover the basics. To fully understand IEOs, we need to first cover their predecessor, the ICO. You may know much of this already, but bear with me as it gives context for the rest of my case.

In 2017 and 2018, the crypto world was taken over by the rise of ICOs, which gave projects a brand new way of raising money digitally. 

If a company wanted to raise funds for its latest project, it could offer potential investors ‘tokens’ rather than shares in exchange for their investment. 

Since these investment products weren’t being conducted through traditional securities exchanges, many projects thought they could sidestep the SEC’s registration requirements.

Unfortunately, the SEC didn’t share that view. 

Many of the projects that took advantage of this new way of raising money were completely legitimate companies. However, there were many scams and ponzi schemes that also leaped at the opportunity to raise cash without complying with SEC regulations. 

It took the SEC a few years to take action. But as soon as it did, the agency began hammering down on crypto companies that had held ICOs. Nearly all of which, the SEC considered to be unregistered securities offerings. 

For the past year and a half, the SEC has been on the hunt to take down one company after another. This bankrupted some key players in crypto and completely wiped out the ICO industry. 

Security Token Offerings vs Initial Exchange Offerings

From the ashes of ICOs, two new token offerings arose: Security Token Offerings and Initial Exchange Offerings. 

Security Token Offerings are quite straightforward. They apply the same regulatory procedures of a traditional IPO to digitized tokens, which means full compliance with the SEC’s regulatory requirements.

SEC compliance is no small hurdle. It requires a team of lawyers and accountants, which can easily cost a project hundreds of thousands or more in professional fees. Not to mention the extraordinary amount of time and effort needed by the project’s executive team to oversee the process. 

This is a solid option for bigger, more established companies. But can be out of reach for the majority of crypto companies. 

This is where Initial Exchange Offerings come in. 

Initial Exchange Offerings aim to provide a middle ground between the total absence of regulatory compliance associated with an ICO and the overbearing costs of conducting an STO. Theoretically, the best of both worlds.

To investors, IEO platforms promise to vet token offerings to root out scams and fraudulent projects. 

For companies looking to raise capital, IEO platforms offer to cover the bulk of their marketing and due diligence costs. 

That said, just like ICOs, IEOs are still unregulated and unapproved by the SEC. Though no IEOs have been targeted yet, it won’t be long before they are fully on the SEC’s radar. 

IEO platforms claim to be safe by arguing that 1) they are in jurisdictions outside of the US, 2) they are not accepting US investors, and 3) that they only deal with ‘utility tokens’. 

Read on as I break down each of these claims and the risks that exchanges and projects face in issuing IEOs. 

IEO Jurisdiction

In the discussion of token exchange platforms, many commentators highlight a distinction between ‘onshore’ and ‘offshore’ exchanges. 

For example, Binance (which everyone thought was based in Malta until recently) is based in the Cayman Islands and Poloniex recently moved to Bermuda

As non-US companies these exchanges shouldn’t be subjected to US regulations… right? Not quite. 

The SEC’s stated mandate is to protect US investors. So as long as an investment product is offered or marketed to US investors, it is subject to the SEC’s rules.

This is not just an obscure legal detail, but something we see used regularly. 

In fact, some of the SEC’s biggest cases today are against ‘offshore’ companies, including Kik, which is a Canadian company, and Telegram, which is based in the British Virgin Islands. 

The bottom line is, it does not matter if an exchange is an ‘onshore’ or ‘offshore’ exchange. All are subject to the SEC’s rules to the extent they target US investors.

Geofencing US Customers

Though no company is out of the SEC’s reach, technically the SEC only has jurisdiction when an investment product has been offered to US persons. 

To navigate this, both Binance and Poloniex clearly stress that their platforms are not available to any citizens or residents of the United States or even US-sanctioned countries. 

If these platforms can sufficiently do their due diligence on investors and block any US investors from receiving investment solicitation or purchasing the IEO tokens, then theoretically it is possible that the offering would be exempt from the SEC’s compliance requirements. Theoretically.

In reality, this is a very risky approach. 

First off, how thorough are the platform’s geofencing practices? 

For example, could a US citizen with a second passport use a VPN to create their account and then only show their second passport for verification?

Traditional financial institutions learned long ago that this level of due diligence is not enough for US regulators. 

Over the years, banks have incurred billions of dollars in regulatory fines for insufficient customer due diligence. Now, they know they must review much more than just a passport or customer-provided address. Most banks conduct their own background checks to really ‘know their customer’ and cover their backs.

I highly doubt that either Binance or Poloniex are taking such measures to ensure that they are restricting US persons from their platforms. In fact, Poloniex recently decreased its general KYC AML requirements, allowing users to sign up for basic accounts with just a name and email. 

Sure, they probably have stricter requirements for their IEO investors, but how much so?

Second, even if a platform’s geofencing practices are sound, if a token is purchased on an IEO exchange and sold off-exchange it may violate US securities laws. 

Obviously, IEO platforms will try and limit a user’s ability to transfer tokens off exchange. However, this defeats one of the main purposes of crypto, which is easy transferability to anyone in the world with a click of a button.

Utility tokens

Last but not least, some IEO platforms assert that they are exempt from US securities regulations because they only offer utility tokens. These platforms claim to vet all token offerings to ensure they do not pass the Howey Test, the SEC’s standard for determining a security. 

In theory, that’s a nice idea. 

The trouble is, the SEC has yet to officially accept the idea of so-called ‘utility tokens’. 

It is possible that the SEC will eventually accept the differences between tokens, but so far this is just wishful thinking. 

Both Kik and Telegram have spent millions of dollars fighting the SEC to make the case that their tokens were utility tokens. Neither has been able to successfully prove their case. 

If that weren’t enough, at the end of January, the SEC officially issued warnings against IEOs. The agency stated that it views IEOs like ICOs.

In addition, the SEC reminded all players in the industry that any platforms that hold token offerings must also be registered with the SEC as broker-dealers if those offerings target US investors. Any unregistered platforms could be subject to severe penalties. 

This was a clear warning to both exchanges and companies that the SEC does not view IEOs differently than its predecessor. 

What does this mean for Crypto Law Insiders?

As always, I love to see new innovations in the crypto space. 

However, when it comes to IEOs, this is less of an innovation and more of a re-packaging of an old idea with a new name. 

There is nothing in an IEO structure that exempts a company from SEC compliance.

So for Insiders with projects of your own, don’t be fooled into thinking an IEO is risk-free. Launching an IEO puts your project at risk for securities violations.

My advice is to either play it safe and register with the SEC, or be absolutely positive that the token offering does not pass the Howey Test before trying to raise money. 

Do not make the same mistake as Kik and argue that a utility token is exempt from registration. And do not make the same mistake as Telegram and rely on legal technical loopholes. As we’ve seen, those arguments will not get you far against the SEC.

Once the SEC ticks off all the major ICOs on its list, it will likely move on to IEOs. Make sure that your project does not land on its blacklist.

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