Under the increasingly harsher scrutiny of the Securities and Exchange Commission, some experts now say the initial coin offerings market could face a precipitous downturn.

They believe investors will be more cautious amid the SEC’s increased efforts to root out fraudulent activity. Blockchain entrepreneurs could also feel the impact, particularly as China and South Korea adopt a more stringent approach to the nascent industry.

“The SEC has certainly put a wet blanket over prospects for ICOs in 2018,” says Mark T. Williams, a professor of finance at Boston University. This year “is shaping up to look like a bear market for ICOs.”

The trend follows a record-setting 2017, dubbed “The Year of the ICO” by MIT Technology Review, in which the ICO market raised more than $4 billion.

To be sure, many investors remain intrigued by ICO potential. Last month, Morgan Creek Capital announced it would raise $500 million to create a hedge fund targeting cryptocurrencies and blockchain investments.

Moreover, a number of blockchain projects have raised significant capital. For example, the Moonlite Project, which will create a green blockchain mining data center in Iceland, raised much of the $35 million it had targeted earlier this year.

Still, expect new U.S. offerings to come with SEC certification as registered securities – at a significant extra expense – or with intricately constructed arguments for non-security exemptions (such as a token being a “utility token,” with intra-company value, rather than a security, increasing in value and salability on secondary markets).

The Soft Approach

The SEC had taken a distanced approach toward ICOs, but in February SEC Chairman Jay Clayton, responding to numerous complaints about fraudulent activity, told the U.S. Senate Banking Committee that ICOs should be treated as securities. “I believe every ICO I’ve seen is a security,” Clayton said.

“If we don’t stop the fraudsters,” Clayton Says, “there is a serious risk that the regulatory pendulum – the regulatory actions – will be so severe that they will restrict the capacity of this new security.”

Within weeks, the SEC issued dozens of subpoenas to tech companies dealing in cryptocurrencies and their advisers. To date, according to various reports, about 80 subpoenas have been issued.

States Are Acting

Meanwhile, state attorneys general have taken actions to ensure that offerings within their jurisdictions comply with state securities laws. In Massachusetts, for example, as 2017 came to a close, the state’s Securities Division announced it would conduct an “ICO sweep” to force those who initiate initial coin offerings to register them with the state as securities.

In January, Massachusetts brought its first enforcement action against an unregistered offshore company called Caviar for failure to employ appropriate safeguards to prevent U.S. investors from buying in.

The IRS has not been especially receptive to exemption claims from ICOs. For one thing, ICO funds raised for capital ventures have been ruled to be taxable income, unlike other methods of raising capital.

Tax Bills

If the funds were raised prior to the formation of a start-up corporation, those offering the ICO will be personally responsible for paying taxes on the proceeds. If there are partners involved in these unincorporated endeavors, each partner is responsible for an equal share of net income, which can result in huge personal tax bills.

A spokesman for SEC told ThirtyK the shift in focus on ICOs was not the result of a new policy but of increased enforcement of an existing policy.

“We started talking about it more last year when there was this proliferation of initial coin offerings,” says spokesman Kevin Callahan.

Despite all the implied criticism, Clayton acknowledged that some ICOs are not securities. The distinction is in the uses to which funds raised by ICOs are put.

A Token Isn’t Just a Token

In a recent speech, the SEC chairman offered the example of a book club token. “A token that represents a participation interest in a book-of-the-month club may not implicate our securities laws, and may well be an efficient way for the club’s operators to fund the future acquisition of books and facilitate the distribution of those books to token holders,” Clayton said.

“In contrast, many token offerings appear to have gone beyond this construct and are more analogous to interests in a yet-to-be-built publishing house with the authors, books and distribution networks all to come.”

When tokens are pitched to buyers based on their potential for increasing in value (“with the ability to lock in those increases be reselling the token on a secondary market”), that’s when the ICOs show “key hall marks of a security and a securities offering.”

A Positive Impact

The result of the new emphasis on policing the ICOs is ultimately a positive one, says Williams of Boston University. “The positive side is ferreting out the fraudsters. Unfortunately, the bad actors have been ruining it for legitimate entrepreneurs with meaningful ideas.”

Clayton said during a recent speech at Princeton University that tough policing by the SEC can help the ICO market. By ridding the market of fraudsters, the crypto market avoids more extreme measures that could stifle the new industry.

“Is the approach taken in Washington by the SEC adversely affecting distributed ledger technology in other areas? My hope is that it’s actually helping, because this technology is being used for fraud,” Clayton stated. “And to the extent that it’s being used for fraud, history shows that government comes down harshly on that technology later.”

“If we don’t stop the fraudsters,” Clayton added, “there is a serious risk that the regulatory pendulum – the regulatory actions – will be so severe that they will restrict the capacity of this new security.”