Companies engaged with digital assets, particularly those companies without a track record, are finding it to be a struggle to procure broad directors & officers (“D&O”) liability coverage. Specifically, insurance underwriters are spooked by the regulatory uncertainty surrounding digital assets, particularly Initial Coin Offerings (“ICOs”), which have emerged as an alternative to traditional equity offerings, e.g., the sale of stock in a venture. The reality, however, is that many companies engaged with “coins” or “tokens” or other digital assets also raise capital through traditional securities offerings, and they need protection for those activities. But many underwriters are not willing to sell coverage for those traditional activities, merely because the company also is engaged in the digital asset space.
Indeed, mainstream companies that wished to raise funds from the public would begin to do so by selling shares through an Initial Public Offering (“IPO”). In the cryptocurrency world, the ICO is the rough equivalent to the mainstream IPO. Although there has been some debate as to whether the term “Initial Coin Offering” is a misnomer, suffice it to say that, by and large, the “offering” is used as a way to raise money by selling “coins” or “tokens” to investors that want to have a stake in the enterprise, whether it be a new type of cryptocurrency, an app, or some other related service, such as an exchange for trading cryptocurrencies.
Over the past several years, the use of ICOs has increased dramatically, from less than 10 in 2014 to more than 600 in 2018. The increase in ICOs has raised concerns among regulators, who feared that the ICOs could be used to take advantage of an unwary or uniformed public. One of the earliest regulators to get involved was the Financial Crimes Enforcement Network (FinCEN), which became concerned about, among other things, whether the cryptocurrencies were being used for money laundering and thus violated the Bank Secrecy Act. In 2015, the Commodity Futures Trading Commission (CFTC) determined that cryptocurrencies—possibly including digital tokens sold through ICOs—were commodities, and therefore sought to regulate them as such.
But perhaps the most dominant question as of late is whether coins or tokens sold through ICOs constitute the sale of securities. Accordingly, in 2017 the Securities and Exchange Commission (SEC) entered the fray issuing what has become known as its “DAO Report,” which investigated whether tokens issued by “The DAO”—an acronym for Decentralized Autonomous Organization—were securities. The SEC described the DAO as a “for-profit entity that would create and hold a corpus of assets through the sale of DAO Tokens to investors, which assets would then be used to fund ‘projects.’” The SEC continued by explaining that the “holders of DAO Tokens stood to share in the anticipated earnings from these projects as a return on their investments in DAO Tokens.” Ultimately, the SEC concluded that DAO Tokens were securities under the Securities Act of 1933 and the Securities and Exchange Act of 1934. From this, the SEC advised all entities that use distributed ledger or blockchain-enabled means for raising capital to ensure compliance with federal securities laws.
Even with this guidance, there is still a general sense in the insurance industry that companies that deal in any way with “coins” or “tokens” are not good risks. This may stem from the belief that many ICOs still do not comply with securities laws and, therefore, do not provide protections to investors. Insurance underwriters also seem wary that ICOs are still a means to fraud, money laundering, and other illicit activity.
So what this means is the following: companies that are in any way engaged with tokens or digital coins are finding it to exceedingly difficult to procure D&O coverage that provides protection for any liabilities arising out of any securities activities, even in traditional activities such as offering shares to accredited investors or otherwise. This is true even if a company does not issue a coin or token for the purposes of fundraising at all. For example, a company may raise all of its capital through traditional means, while issuing tokens or coins for some other purpose, such as as tickets to concerts or sporting events. Some companies may issue tokens or coins that can be used to buy something at a discount that will be released in the future, such as a case of reserve wine.
Specifically, when faced with a company that in any way handles digital coins or tokens, some insurers are insisting on what they call a “Full Securities Activities Exclusion,” which, as its name implies, is very broad and purports to bar coverage for such things as “any allegation that any prospectus, interim statement or public announcement…contains an untrue statement of material fact, or…omits a material fact…,” among other things. At the same time, insurers are also seeking to tack on a “Full Coin Offering Exclusion,” which is meant to bar coverage for any liability “based upon, arising out of, directly or indirectly resulting from or in any way involving a Coin Offering” which, in turn, is defined as, in general, “an actual sale of tokens by the company” to the public.
If it is the regulatory uncertainty surrounding digital coins and tokens, and/or any perceived prospects of fraud, etc., which are making insurers uneasy, they should focus on that, and not broadly bar coverage for traditional securities activities. Companies engaged with blockchain technology, cryptocurrencies, and other digital assets that also raise capital through traditional means, should make sure that the insurers from whom they are hoping to procure coverage understand this distinction. This probably will require teaming up knowledgeable brokers with the transactional and regulatory attorneys that provide advice and counsel to the company, and making a presentation to the insurance underwriters so that they can fully understand the business and feel secure that the company is acting responsibly and seeking to be compliant. Protection for securities activities is important for any company that hopes to grow and thrive, and time should be taken to make sure that insurance underwriters do not have knee-jerk reactions as soon as they hear of digital assets.