Certain cryptocurrency traders and funds may have recently seen free tokens and cryptocurrencies falling from the sky into their wallets. A newer trend in the cryptocurrency trading arena is called “airdropping”, and fund managers need to be aware of the regulatory and financial implications related to receiving these assets.
Airdropping became prevalent in the later part of 2017 and throughout 2018 as regulators began eyeing stricter enforcement of laws surrounding initial coin offerings (ICOs). When a crypto asset is airdropped, investors will receive a free token or cryptocurrency in their wallets from the creators of the ICOs. These creators will usually send tokens because they want to gain free publicity for their new asset. Investors can either be a willing participant in these airdrops, such as supporting a project related to the airdrop, finding a new opportunity on social media, or retweeting a tweet; or investors will sometimes randomly receive an additional token in their wallets, as a result of maintaining a certain balance of a cryptocurrency. While receiving free tokens seems like a great deal for investors, there are key issues fund managers need to be conscious of related to these transactions.
In August 2018, the SEC issued a cease and desist order against Tomahawk Exploration LLC and its operator for their actions in connection with an initial coin offering of digital assets called “Tomahawkcoins” or “TOM”. The SEC ruled these tokens should have been classified as securities because they met the “Howey Test”. The “Howey Test” refers to a Supreme Court ruling in 1946, which defined what factors in a transaction establish an investment contract. Despite no cash exchanges taking place, the SEC determined the program in which these securities were brought to market constituted the offer and sale of securities because the Company made TOM available to investors in exchange for “services designed to advance Tomahawk’s economic interests and foster a trading market for its securities”. Because the Company did not register with the SEC prior to initiating these transactions, they were in violation of Section 5 of the Securities Act of 1933 (the “Act”).
On top of the legal ramifications of trading and participating in a security possibly subject to SEC violations, there are some significant accounting questions that can arise. If a fund has already traded the security it received which was brought to the market illegally, they could be forced to repurchase the assets under the rescission rights noted in Section 12 (a)(1) of the Act. This can not only lead to a fund having additional costs related to repurchasing these securities, but it can also result in the fund manager having to evaluate the potential financial impact of repurchasing these securities from the buyers.
If a manager determines that a contingency must be recorded, then the fund’s financial statements will be impacted in multiple ways. A fund may face concerns regarding any financial covenants they have with financial institutions or other lenders due to their liabilities increasing. Also, the fund may be required to provide additional disclosures relating to the contingency. Finally, if a fund repurchases these securities, they will be required to include them in their total assets and separately disclose them in their schedule of investments.
If you are a fund manager and have concerns related to receiving or selling securities in an airdrop, we are here to provide guidance related to presenting and disclosing these assets and associated liabilities in your fund’s financial statements.
We Can Help
Need more information? Have questions? Our Investment Companies practice can help.