Has the Cryptocoin Market Met Its Match in the SEC?

Regulators looking into potentially widespread violations in cryptocurrency markets have taken a bite out of the once-soaring investor demand for token deals.

While the pace of new proposed initial coin offerings has remained near record levels, there has been a marked deceleration in the amount of money being raised and a change in the source of the capital being provided.

More than 180 coin offerings are expected to launch in March, according to an estimate from research firm Token Report. That would exceed January’s total of 175 and fall only a bit below February’s 197 offerings. But the March projects are expected to raise only $795 million, a 45% decline from February’s $1.44 billion.

March’s ICO tally, which would be the lowest since August, would be the first data to reflect the state of the booming sector after The Wall Street Journal reported that the Securities and Exchange Commission had sent out dozens of subpoenas and information requests questioning whether investors were being harmed in the lightly regulated market.

Among other claims, the regulators are probing whether companies and key advisers have breached rules that govern how middlemen such as brokers sell investments to the public, according to people familiar with the matter.

In recent months, the SEC has sent at least 80 subpoenas and requests for information to various firms involved in the ICO space. These include not only the firms that are creating the new tokens, like Overstock.com Inc . ’s tZero, but firms that operate as advisers and investors as well. SEC Enforcement Director Stephanie Avakian confirmed at a conference last week that the regulator has “dozens” of investigations related to cryptocurrencies under way.

The SEC is particularly concerned about misconduct related to ICOs that haven’t raised as much money as the top 20 in the market, said Melissa Hodgman, an associate director in the SEC’s enforcement division. “The minute we go beyond that we start to see problems in one way or another,” Ms. Hodgman told the SEC’s investor advisory committee earlier this month.

Despite the March slowdown in completed deals, the first quarter is still on pace for roughly $3.6 billion in ICO fundraising, according to Token Report, which would be more than half of the $6.6 billion raised in 2017.

Another change: more ICOs are limiting their sales to institutions and millionaires, which allows them to avoid most SEC requirements.

In the first quarter, there was a marked increase in how much capital is being raised in what is called a “pre-sale” phase, when firms offer tokens to a small coterie of inside and accredited investors. In the fourth quarter of 2017, such private sales comprised about 15% of total sales, Token Report said. In the first quarter of 2018, that rose to about 24%.

Coin offerings have been marketed as something between a tech-savvy crowdfunding and an early-stage venture capital round. Some deals are structured to avoid SEC regulation and instead emphasize the access or technological utility that comes from owning the token.

Still, some of the sales could be problematic. The SEC’s probes include requests for copies of agreements that spell out financial arrangements between businesses and people who help launch the initial coin offerings, one of the people said. The SEC’s concern is that firms have compensated vendors with a percentage of tokens offered or funds they raised, which would ordinarily require them to register as brokers.

The SEC often looks for signs of “transaction-based compensation”— commissions, bonuses, or other payments based on the value of assets raised—in deals that may evade the securities laws. That pattern is just one of the possible claims the SEC is investigating as part of a broad sweep of how ICOs are structured and sold to the public.

Jay Clayton, chairman of the U.S. Securities and Exchange Commission. Photo: Andrew Harrer/Bloomberg News

SEC Chairman Jay Clayton has warned that “gatekeepers” such as brokers, lawyers and accountants could be swept into the regulatory dragnet if they don’t hew to the same laws that apply to stock and bond sales when raising funds through ICOs.

“They did give a warning to the market, but I don’t think most people focused on it,” said Kenneth Herzinger, a partner at Orrick, Herrington & Sutcliffe LLP and a former SEC enforcement lawyer. “They are looking at actors and entities beyond just ICO issuers.”

The SEC has so far brought a handful of enforcement actions alleging cryptocurrency frauds, as officials have raced to keep pace with token sales in the past 18 months. Many of the cryptocurrency-related subpoenas were issued in recent weeks, likely paving the way for what lawyers and industry insiders expect to be a wave of lawsuits or settlements.

In a securities filing on March 1, online retailer Overstock.com disclosed that the SEC requested information about the ICO of its cryptocurrency-focused subsidiary, in February. The company said in the filing that it is complying with the investigation.

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As bitcoin has emerged from the underground world of nerds and criminals to become a mainstream investment, the risk of hacks and scandals has also blossomed. What’s a government to do? The WSJ’s Steven Russolillo travels the world (sort of) to see how regulators are responding to the remarkable rise of cryptocurrencies. Video: Sharon Shi and Crystal Tai

—Maureen Farrell contributed to this article.

Appeared in the March 21, 2018, print edition as ‘Regulatory Scrutiny Deflates Coin Deals.’

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