Is It or Isn’t It? …Only the SEC Knows for Sure!Cryptocurrency, Equity Crowdfunding
ICOs are Hot, Hot, Hot!
As everyone knows, ICOs (initial coin offerings) are all the rage right now. This one raised $100 million in thirty minutes, that one raised $150 million in two days, and the list goes on. Companies all over the globe are engaging in token offerings directly from their websites offering their tokens to the public for fiat currency, that is, cash, or for cryptocurrency – Bitcoin or Ethereum, for example. Token offerings are being conducted for all kinds of purposes – to raise money to fund platform development and roll out, to provide, through the token, access to a network platform and the means of paying for a service or product to be offered on that platform, or, in the more traditional sense, to provide a return on investment. Tokens can also be resold in secondary markets and are sometimes purchased initially for purely speculative reasons.
Is Your Token a Security?
The question of the day is – Is the token a security? The answer to this question has implications for token issuers and token buyers alike. If the token is a security, issuers of tokens must comply with local securities laws. In the United States, where I practice securities law, if a company wants to offer tokens that are securities to the public in an ICO, it must comply with federal and state securities laws – the tokens must be registered federally under the Securities Act of 1933, or there must be an exemption from such registration requirements. Failure to comply with these securities laws can result in civil or criminal liability for the issuers and other participants in the ICO.
Securities Tokens versus Utility Tokens – Does it Matter?
Currently, there is a lot of discussion as to whether a token is a security. A common understanding has developed that this determination hinges on the function that the token performs. If the token offers an ownership interest, a return on investment or a share of profits, it probably is a security. Tokens with these and similar characteristics are being referred to as “securities tokens.” If the token provides access to a platform, or it is used to purchase goods or services, it is being called a “utility token.” Under this framework, securities tokens must comply with local securities laws; utility tokens need not comply and can be offered and sold freely without regard to the laws governing the offer and sale of securities. Other non-securities law regulations may apply to utility tokens, however.
On its face, the securities token/utility token dichotomy seems to make sense; however, it is too simplistic, and in many cases it offers the wrong solution. It does not take into account the broad scope of US federal securities law as legislated, regulated by the Securities and Exchange Commission (SEC) and interpreted by the courts.
The Howey Test – The SEC has Spoken!
Many of you may be familiar with the so called “Howey Test.” In SEC v. W. J. Howey Co., the U.S. Supreme Court indicated that an instrument is an investment contract, i.e., a security, if it involves a contract, transaction or scheme whereby a person invests money in a common enterprise and is led to expect profits solely from the efforts of others. The SEC interprets this Howey framework very broadly, on a facts and circumstances basis, case by case. For example, the SEC recently halted the ICO of Munchee Inc. claiming that Munchee’s MUN tokens were securities because, among other things, the purchasers of MUN tokens had a reasonable expectation of profits from their investments in the Munchee enterprise and the efforts of the Munchee management team. The Munchee ICO was being conducted in the US outside of the SEC’s regulatory framework, and, therefore, according to the SEC, the offer and sale of Munchee MUN tokens violated US federal securities laws.
Jay Clayton, Chairman of the SEC, recently stated that tokens that incorporate features that create a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others are securities, no matter what they are called.
Bottom line: Even with so called pure utility tokens, in most cases it will be very difficult to get comfortable that some component of a token’s value is not derived from the efforts of the platform’s builders and that purchasers do not have a built-in expectation of potential token value appreciation based on that work, even if the work of building the platform has already been completed and even if the token holder has no desire or intent to resell the token rather than use it on the platform.
So even if the token is being sold to finance a future purchase of a product or to allow access to a network, if the buyer of that token reasonably expects that the intrinsic value of the token may increase as a result of the efforts of the entrepreneurs who are building, or have built, the platform on which the token will be used, that token is probably a security, and the ICO in which that token is being sold, if offered in the US, should comply with US securities laws or risk violating those laws.
To avoid the US securities law regulatory regime, some ICO consultants are recommending staying out of the US. This approach, however, restricts access to a very large and sophisticated market.
Regulatory Compliance – There are Options!
Fortunately, there are options under SEC regulations for conducting legal token offerings in the US. ICOs can be sold to US investors under Regulation CF, Regulation A or Regulation D, depending on the circumstances. FileCoin, for example, recently raised $257 million in its ICO in a little over a month, under Regulation 506(c). Not bad for an SEC compliant token offering!
If you have any questions about this post or ICOs in general, please feel free to respond online or contact me directly at 201-233-8974 or at email@example.com.