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Securities Liability and the Role of D&O Insurance in Regulating Initial Coin Offerings

We are in the midst of a revolution in financial markets, as cryptocurrencies based on blockchain technology promise a smart, decentralized, secure, and flexible means of conducting transactions. Since Bitcoin was introduced in 2009, cryptocurrencies have been steadily gaining in prominence and economic significance, shifting from fringe instruments linked to illicit drug marketplaces and money laundering to mainstream financial products used across the globe to store wealth, facilitate marketplaces, and provide platforms that support the development of new technologies. Bitcoin can now be readily converted to cash through a growing network of “Bitcoin ATMs,” can be hedged against using Bitcoin Futures that trade on derivatives markets, and is forcing major banks to adapt through direct investments in blockchain technologies and policies regarding the use of their funds in consumer cryptocurrency investments.

The year 2016 brought major changes to the cryptocurrency market, including the rise to prominence of utility‐focused blockchain applications that offer greater functionality such as the operation of smart contracts. The most prominent of these, Ethereum (and its currency “Ether”), has become the second most widely traded cryptocurrency, with a market capitalization of approximately $53 billion (as compared to Bitcoin’s $117 billion) as of June 2018. Around this time the industry also saw the rise of Initial Coin Offerings (ICOs), funding mechanisms that resemble a hybrid of crowdfunding and venture capital (VC) financing, in which a set number of “coins” or “tokens” in a new crypto venture are offered for sale to the public. Individuals can then buy in using fiat currency or other cryptocurrencies such as Bitcoin and Ether. While in 2015 an exceptionally successful ICO might have raised only a few million dollars, in 2016 ICO raises of $150 million or more began appearing, conducted by what were essentially seed‐stage companies that would have been unlikely to raise more than a few million dollars from venture capital firms or angel investors (the typical fundraising sources for such companies). In 2017, total ICO funding topped $3 billion, exceeding the total amount of VC investment in early stage Internet companies for the year.

However, despite the meteoric rise of ICOs as the funding method of choice for cryptocompanies, ICOs have been afflicted by a number of problems, including regulatory hurdles, fraudulent activity, and negative public perception. While reliable estimates are lacking, informed observers have repeatedly warned that many ICOs are fraudulent; with nothing but “a swanky website and an official‐looking whitepaper,” dozens of ICOs have raised money for what have later turned out to be Ponzi schemes or fake companies whose owners steal the money and disappear. There are a number of factors that have contributed to these concerning circumstances. The decentralized nature of the technology means that large amounts of money can flow through ventures without a central financial institution present to act as a guarantor. The targeting of ordinary people, rather than sophisticated VC firms or wealthy individuals, means that few investors have the expertise or the financial incentive to engage in costly due diligence to ensure the veracity of a firm’s claims. The absence—until very recently—of significant regulatory oversight has meant that the ICO process is largely nonstandardized, giving firms significant latitude to include false or misleading information in their investment solicitation materials or to omit important information. Finally, the frothiness of the cryptomarket has meant that investors have at times been willing to accept significant risk of being defrauded in return for the potential for astronomical returns.