The SEC: IEOs are a pile of red flags
On January 14, 2020, the Securities and Exchange Commission (the "SEC") issued an investor alert urging investors to use caution before investing in initial exchange offerings ("IEOs").
In contrast with an Initial Coin Offering ("ICO") or Security Token Offering ("STO") where the tokens or assets are purchased directly from the issuer, in an IEO the assets are sold through an online trading platform operated by a third party. An IEO may become a regulatory minefield if the regulatory treatment of the asset being distributed is unclear. If the asset being offered in the IEO is a security, the offering must comply with the securities laws, meaning that the IEO may be subject to registration requirements or meet the criteria for an exemption from such requirements. In addition, the trading platform must have the necessary approvals to conduct a securities offering, meaning that it may need to be registered with the SEC as a national securities exchange or operate pursuant to an exemption, such as an alternative trading system ("ATS") that must also be a registered broker-dealer. Further, the trading platform may also be acting as a broker or dealer, meaning that it is required to register with the SEC and become a member of a self-regulatory organization, typically FINRA.
Specifically, the SEC warned of the following signs of fraud or illegal behavior:
1. It is a red flag if the IEO and the online trading platform do not address or discuss the applicability of the U.S. federal securities laws.
2. It is a red flag if any offering purports to avoid the U.S. federal securities laws because it is occurring on an overseas trading platform but otherwise allows persons from the United States to invest.
3. It is a red flag if the IEO claims to be vetted by the trading platforms. If the asset offered in the IEO is a security, the offering may violate U.S. federal securities laws regardless of any "vetting" done by the trading platform.
Lastly, the SEC cautioned that there is no such thing as an "SEC-approved IEO." The bottom line is that if the assets being offered are securities, both the issuer and the trading platform need to be careful to comply with the U.S. federal securities laws which may require limiting the group of allowed investors and taking ongoing steps with respect to secondary trading to keep such assets outside of the hands of U.S. persons, or obtaining regulatory licenses or approvals.