Beware of Initial Exchange Offering (IEOs) Scams: New SEC Alert Warns Investors

Most people would agree that investing in new ventures and innovative technologies can be exciting. At the same time, investors might wonder: Is this offering for me?

One example of a new type of investment opportunity is the initial exchange offering (IEO), a digital asset similar to the initial coin offering (ICO). Both of these raise funds through tokens, coins, and other digital assets. The difference is that ICO investors typically purchased interests from the issuer’s initial sale not on an exchange and then subsequently could trade those interests on secondary exchanges that supported those interests.  IEO investors, on the other hand, are typically buying the interests directly on a secondary exchange which is conducting the sale of interests for the issuer and then also enabling secondary transactions on that exchange. In both cases, most of these ICOs or IEOs were conducted through online trading platforms or "exchanges" not registered with the Securities and Exchange Commission (SEC). In January, the SEC issued an alert warning investors and issuers about some common IEO pitfalls.

Do IEOs Have Legal Protections?

Unlike registered and exempt securities offerings, some IEOs do not have much legal protection, and they may violate federal and state securities laws. In fact, the SEC HAS NOT approved any individual IEOs at all, so don’t believe an issuer that claims that their IEO is “SEC-approved”.

One red flag is when both IEO issuers and the online trading platforms that offer IEOs don't discuss federal laws and regulations that apply to securities offerings. Many IEOs are actually subject to SEC registration requirements because they represent the sale of securities and none of the registration exemptions apply to them. Issuers of registered SEC offerings, including digital assets, must disclose details about themselves, their companies, and their offering terms to prospective investors. 

The SEC announcement stated, “Noncompliance with the federal securities laws means the IEO and/or trading platform may be operating unlawfully and the investor and market protections and remedies these laws are intended to provide may be absent,”.

Do Online Trading Platforms Vet Their Offerings?

When issuers claim that an online trading platform has vetted their offerings, or when the online trading platform refers to supposed quality assessments of IEOs, this is another red flag according to the SEC. The concern here is that these claims may mislead investors to expect high returns. If an IEO trading platform offers securities, the SEC often requires it to register separately as a national exchange or utilize exemptions such as those for an alternative trading system (ATS). To operate in the U.S., an ATS needs to be a registered broker-dealer adhering to all the relevant rules and regulations. Registered broker-dealers must be members of self-regulatory organizations like the Financial Industry Regulatory Authority, Inc. (FINRA). Both ATS and national securities exchanges provide legal protections designed to prevent fraud and safeguard investors.

Are Offshore IEOs and Trading Platforms Exempt from SEC registrations?

Overseas IEOs or online trading platforms that allow U.S. investors may still be subject to U.S. securities laws because they conduct business with persons from the United States. The SEC warns U.S. investors to keep away from scammers claiming they don't have to register IEOs with the SEC simply because the transactions are occurring overseas.

How Can Issuers Avoid Registration with the SEC?

Issuers involved in securities sales must typically register with the SEC, with certain exceptions. Rule 506(c) of Regulation D of the Securities Act offers a legal exemption to this registration requirement while still protecting investors. It’s important to note that when utilizing the registration exemption under Rule 506(c), although issuers may broadly advertise and publicize their offerings to anyone including non-accredited investors, they may sell only to accredited investors. To become an accredited investor, an individual must meet one of the accredited investor tests, and the issuer must take “reasonable steps” to verify that all of the investors in their Rule 506(c) offerings are accredited investors.