When Joachim Sandgaard set about building a new blockchain system to protect medical records, the opportunity to raise funds from an initial coin offering made a lot of sense.
After all, hundreds of ICOs had already raised billions to help fund blockchain-based ideas worldwide — with mixed results. Some, including Filecoin, raised over $200 million and plan to use blockchain to reinvent how files are stored online. Others also raised millions, only to be shut down by regulators for misleading claims or outright lies, such as the boxer Floyd Mayweather-backed Centra Tech that said it had partnered with Visa and MasterCard when it hadn’t.
Sandgaard, whose company MedChain’s offices are at Innovation Pavilion in Centennial, realized he needed to approach the sale of his MedCoin cryptocurrency strictly by the book, even though the book hasn’t been written. His team sought advice from Gerald Rome, the state’s securities commissioner. He treated it like a security, as the SEC recommends. During its pre-ICO in January, MedChain opted for federal crowdfunding, allowing non-accredited investors to invest up to $1 million. The company raised about a half-million dollars and now plans a full-blown ICO to raise $15 million.
“Nobody really had any guidance on how things worked. and there were definitely concerns on whether we could market this to U.S. investors at all,” said Sandgaard, who at 16 years old was soldering circuit boards at Zynex Medical, his father’s medical-device company in Douglas County. “So we went with the approach that we had to adhere to all the rules and regulations of a security.”
While blockchain projects and ICOs seem to go together like ones and zeroes, the notion that someone created a new digital currency from computer code has concerned regulators and confused lawmakers and the general public for a while. Finding the right balance between regulation and innovation appears to be getting closer. The new funding route has offered startups a way to bypass traditional venture capital and raise cash to build the next big thing in blockchain. Rome applauds the effort. He said he just wants to make sure investors are protected.
“There is a lot of enthusiasm and creativity going on in this industry. People are excited about it, and we think that’s a good thing. We support new innovation and new business in Colorado,” Rome said. “I’ve been around a long time and I know that when there’s a lot of excitement and a lot of energy in a certain sector, like the dot.com bubble, there’s the potential for a lot of fraud and a lot of investors getting harmed and getting caught up with the enthusiasm going on. From our point of view, we just need to be a little careful with how we approach these things.”
Companies are finding their way into the cryptocurrency market, which is still in true speculator mode. According to ICO tracker site CoinSchedule, there have been 343 ICOs that have raised a combined $8.9 billion since Jan. 1. Thirty-three ICOs were added in the past week. Most aren’t open to U.S. residents to avoid regulatory scrutiny.
Many of the SEC’s actions against ICOs have targeted fraud and violations of securities rules. In September, two ICOs touting the cryptocurrency backed by real estate or diamond investment were shut down after the SEC said neither was true. An ICO to create a decentralized bank was halted in January after the SEC said Dallas-based AriseBank failed to disclose the criminal backgrounds of key executives and falsely claimed it offered bank accounts insured by the Federal Deposit Insurance Corporation.
Fraud is possible in any industry, says Emily R. Garnett, a lawyer who represents cryptocurrency companies at Brownstein Hyatt Farber Schreck in Denver.
But she said companies are becoming more appreciative of the evolving federal and state regulations. She hasn’t seen many fraudsters, but, she admits, “They’re probably not seeking legal advice.”
A recent Wall Street Journal analysis of 1,450 recent ICOs found that nearly one in five showed fraud, with plagiarized investor documents, the promise of guaranteed returns, and fake executive photos and fake executives. Yet, the 271 suspicious coin offerings managed to attract $273 million, according to the newspaper. Last month, the SEC even set up a fake ICO to educate investors at howeycoins.com.
“(Fraudsters) are just going out there, promoting their ICOs. That’s getting the attention of the SEC. Another company that is getting the attention of the SEC is Titanium Blockchain. They said they had a relationship with the Federal Reserve and GE. And lo and behold, none of that is true,” Garnett said. “It’s the worst-case scenarios that hurt the reputations of legitimate individuals in this space. From a legal perspective and a startup perspective, we’re relieved to see that federal regulators are taking action against fraudsters because it will allow legitimate players to be in the space.”
Complicating the debate are utility tokens, which aren’t intended to have any value except on a specific platform — much like arcade game tokens at Chuck E. Cheese. There’s little value for the tokens outside of Chuck E. Cheese. But the problem with cryptocurrency utility tokens is that they are created before a platform is built, so there’s some anticipation that the value will go up. As the SEC sees it, calling it a utility token doesn’t mean it’s not a security. In a December statement, SEC Chairman Jay Clayton said any token that relies on someone’s effort for “the potential for profits” is a security.
The lack of clarity has frustrated investors such as David Gold, a managing director at Access Venture Partners in Westminster.
“Utility tokens are not a new idea. Like stamps. You pay for it, it sits in your drawer. The stamp is there for a purpose, the utility of sending a letter,” he said. “I can sell you a postage stamp, and in some cases, I can sell you a (concert) ticket or a postage stamp for a lot more, but that doesn’t make it a security.”
Gold supported a Colorado bill that would have more clearly defined whether cryptocurrency was a security or not.
“The current environment of uncertainty is a toxic environment for innovation,” Gold said. “It’s better to have clear guidelines, even if they are bad guidelines because entrepreneurs can understand that better than the current environment of ambiguity.”
Rome, who recently told Florida-based Linda Healthcare to stop selling its Linda Health Coin to Coloradans, didn’t support the Colorado measure. He was neutral on the House’s version, but it changed in the Senate. He winced at the new language and ultimately did not give his blessing, which caused the Senate to approve and then, within minutes, reject the bill.
“It was vague and, from our point of view, not well thought out,” Rome said. “It exempted utility tokens from the definition of a security. … If that law had passed, we could not have filed the case against Linda Healthcare.”
That said, Rome feels that existing securities law is adequate to determine what’s a security and what isn’t.
“We’re happy to see (blockchain and cryptocurrency entrepreneurs) here, but we just think there needs to be guardrails to ensure that investors are protected,” he said. “If you have a question about utility tokens, give us a call. We’ll be happy to talk about it.”
Sandgaard, 34, opted for an ICO instead of more traditional venture funding or angel investors because he wanted to get the community involved in ownership — not just hand equity to venture capitalists. Investors who participated in the pre-ICO round received common stock in MedChain.
“Getting a community involved on the ground level of a project is a lot more powerful to me and this project is a success so far because of them not because of a few ultra-wealthy individuals,” he said in an email.
MedChain’s documents warn investors that an investment is a risk and that “you should not invest any funds in this offering unless you can afford to lose your entire investment.” Sandgaard said he just wants to be extra careful.
“There are a lot of use cases out there for utility tokens, but when someone starts raising money, it’s clearly a security,” he said. But since MedChain plans to also have utility tokensl, he said, “I think it would be very helpful if there was some clarification on utility tokens and what is and isn’t a utility token.”