Over US$7billion is reported to have been raised this year, with over US$5billion raised in 2017, by way of token offerings popularly known as initial coin offerings (ICOs).
A summary and seven key questions answered in this guide to the legal and regulatory tratment of ICOs in the U.S.
At present, there is little international convergence of regulation in relation to token offerings, though over the first half of 2018, certain jurisdictions have taken steps towards a more focused and coordinated approach to regulation. It is still too early in the development of this market to predict what the settled or common regulatory approach will be. However, in the current environment of heightened regulatory concern and scrutiny, issuers and advisers of token offerings need to consider the regulatory requirements, and risks of non-compliance, across multiple jurisdictions.
1. Where should the offering/generating entity be established and do any other laws apply?
A number of token offerings to date have involved an entity incorporated or established in the Cayman Islands, Gibraltar, Singapore, Switzerland, the UK or the US. There are many factors that drive the choice of jurisdiction, which vary on a case-by-case basis. A question frequently asked, however, is whether any law other than that of the jurisdiction of incorporation of the entity generating or offering the tokens needs to be considered in relation to a token offering.
The short answer is yes. In addition to the laws of the jurisdiction in which the entity issuing or generating the tokens is incorporated or established, the laws of each jurisdiction within which the tokens could be considered to be offered or sold, or in which a regulated activity may be deemed to be carried out, will also be relevant. Most jurisdictions regulate the conditions under which certain investments may be offered (if at all) within that jurisdiction.
There are also generally restrictions on the ability of certain persons to carry out certain (regulated) activities in relation to such investments and the carrying out of such activities is often subject to conditions (such as licensing or authorisation requirements). Depending on the structure of the token, other restrictions or requirements may also need to be considered.
2. Are tokens regulated investments?
Each token and token offering is different: there is currently no generally accepted, standardised model and tokens may fulfil differing commercial functions. Thus, the regulatory analysis must be conducted on a case-by-case basis.
Furthermore, what it means to be a “regulated” investment or instrument differs from one jurisdiction to another. In addition, the terms “security token” and “utility token”, although frequently used in the context of token offerings, are not recognised legal or regulatory concepts or categories in many jurisdictions. It is also important to recognise that whether tokens are “securities” is not the only relevant question: there may be other regulatory consequences, even if the tokens themselves are not “securities”.
Whether (and, if so how) a token will be regulated in the United States depends largely upon whether it is classified as a security (called an investment contract) under US securities law. This determination depends primarily on the test set out under SEC v. W.J. Howey Co., (Howey Test) and subsequent case law. The Howey Test holds that an arrangement is an investment contract (notwithstanding the fact that it is not a traditional equity or debt security) if four key elements are satisfied. In regards to the capital-raising entities that use distributed ledger or blockchain technology to facilitate capital raising and investment, the United States Securities and Exchange Commission (SEC) analysed the applicability of both registration and exchange trading requirements in SEC Release No. 81207 (DAO Report). In the DAO Report, the SEC focused primarily on the last prong of the Howey Test, i.e. whether investors in the DAO tokens had an “expectation of profit, solely from the efforts of others” before ultimately concluding that the DAO tokens were securities. The SEC followed a similar line of reasoning in a cease and desist order (MUN Order) against Munchee Inc, a restaurant review app, which had offered tokens for use within its app through token offering (Munchee ICO). The SEC, in finding that the tokens were investment contracts, pointed to statements made by representatives of Munchee Inc. during the marketing of the offering outlining how initial investors in the Munchee ICO stood to earn profits on their initial investment. Given the novelty of the technology, it seems reasonable to assume that many tokens will have ongoing involvement from their sponsors throughout their life cycles. Therefore, it is possible for the SEC to construe investment in tokens as speculative activity seeking capital appreciation from resale on a secondary market which would make them securities, as they did in the DAO Report and the MUN Order. In June 2018, SEC Director of Division Corporation Finance, William Hinman, delivered a speech at the Yahoo Finance All Markets Summit: Crypto, entitled “Digital Asset Transactions: When Howey Met Gary (Plastic)”. In his speech, Hinman said that, in his opinion, Bitcoin and Ether are not securities. The speech included a list of several factors to consider in assessing whether a digital asset is offered as an investment contract and some guidelines for promoters and their advisers to consider. Significantly, Hinman expressed the view that if the network on which the token is to function is sufficiently decentralised and purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts, the token may not represent an investment contract. The Hinman speech drew a bright line separating Bitcoin and Ether from other securities but should not be viewed as providing certainty for other tokens, particularly where ownership is concentrated in the hands of a few sponsors or promoters. Instead, the speech merely adds another piece to the overall picture painted in the DAO Report and the MUN Order, and throughout the dozens of enforcement actions which have been resolved to date by the SEC. To the extent that tokens are deemed to be securities offered and sold in the United States, then under the US Securities Act of 1933 (US Securities Act) they must either be registered with the SEC or qualify for an exemption from registration. The basic dichotomy is that the token offering has characteristics of a public offering but can only be carried out under a non-public offering exemption. This creates potential issues around compliance with the various requirements of these private offering exemptions. The chair of the SEC, Jay Clayton, provided guidance on the SEC’s approach to token offerings in February 2018. Speaking before the US Senate Banking Committee, Mr Clayton stated that “every initial coin offering I have seen so far is a security”, but that the organisations on which the SEC relies to enforce securities regulations have not been vigilant enough in properly policing token offerings. These remarks followed the SEC’s issue of subpoenas in early 2018 to individuals and companies that have been involved in token offerings, seeking information on the investors in such offerings, marketing materials used, structures used and amounts raised. In addition, any entity or person engaging in the activities of an exchange must register as a national securities exchange or operate pursuant to an exemption from such registration. Therefore, for any trading of tokens to occur following issuance, a registered venue must be identified. One frequently-used exemption is available for an alternative trading system (ATS) which, although technically an exchange, is regulated as a broker-dealer, and must be registered as such with the SEC. However, at of the time of writing, no exchange or ATS is available for this purpose. It is equally noteworthy that, in May 2018, private litigation was filed by a purchaser of Ripple coin (XRP) against Ripple Labs, Inc. which alleges that XRP sold to investors were unregistered securities. While the amount at issue in this case is small, a ruling that XRP was sold as an unregistered security would create liability not only for Ripple Labs but for the exchanges which facilitated trading in XRP. If XRP was a security, then these exchanges would have been required to register with the SEC as either a national securities exchange or an ATS. Finally, while some tokens may not be securities, it is incorrect to assume that this is the only US regulation which would be relevant to analyse. Others which may apply are US state securities laws, commodities laws, state and federal money transmitter and consumer protection laws and US federal income tax laws. Even if a token-based platform is decentralised and the tokens are used for commercial purposes on that platform, they may be subject to US regulation.
3. Are pre-sale arrangements themselves regulated investments?
Pre-sale arrangements (if any) vary significantly from one token offering to another. In some cases, a separate instrument is intentionally created (which may or may not itself be a token), which gives rights to, or is convertible into, the main token, once created. In others, the pre-sale is intended to amount to no more than a sale of property that will come into existence at a future date (the tokens). As for tokens generally, the variety in structures therefore requires any pre-sale arrangements to be considered on a case-by-case basis. Broadly speaking, for most jurisdictions (e.g. Belgium, France, Germany, Hong Kong, Indonesia, Japan, Singapore, the UAE in respect of the ADGM and the DIFC, and the UK):
- if the main token is itself a regulated investment, security or other regulated product, pre-sale arrangements that amount to an instrument, certificate or agreement giving rights to the main token will generally amount to a separate regulated investment; and
- even if the main token is not itself a regulated investment, security or other regulated product, pre-sale arrangements that have characteristics of a derivative, structured product or other financial instrument may nevertheless amount to a separate regulated investment.
For Thailand, the SECT is working internally to issue a regulation to govern the pre-sale arrangements of digital tokens and expects to publish a draft regulation for public consultation soon. However, based on an unofficial statement of the SECT competent officer, any type of pre-sale arrangement of digital tokens would at present be considered a public offering of digital tokens (where the delivery date thereof is scheduled for a future date) which is subject to the approval requirement, and requires the registration statement and draft prospectus to be filed with the Office of the SECT. Therefore, it remains to be seen how the new SECT regulation will facilitate the pre-sale arrangements of digital tokens. For the US, pre-sale arrangements will generally be deemed securities because their value will be primarily dependent upon the sponsor of the tokens developing and marketing the tokens and the platform on which the tokens will be used. This is a classic example of “efforts of others” which, if coupled with an expectation of profit, will fall squarely within the definition of investment contract laid out in the Howey Test. One of the more prominent attempts to create a legal framework for compliance with US securities law is the “simple agreement for future tokens” (SAFT). The idea is that the parties will assume that the SAFT is an investment contract (and therefore a security under the Howey Test) and as such the token sponsor will structure the token sale in order to ensure that it can rely on an exemption from registration under the US Securities Act, such as limiting availability of the token to investors to those who qualify as “accredited investors”. As the authors of the SAFT acknowledge, their argument hinges on the assumption that the tokens (once issued) are not securities. However, this may not be possible to determine at the outset, as it remains possible that the value of the token continues to depend significantly on the efforts of the token sponsor or third parties. This assumption appears even less likely to be true in light of SEC chair Jay Clayton’s assertion that he considers all ICOs he has seen to be securities. If it transpires that the tokens are indeed securities, the fact that the tokens were purchased on a delayed basis through a SAFT does not particularly affect the analysis.
4. Is a prospectus (or other offering document) required?
Certain jurisdictions mandate that an offering document be made available before certain investments or instruments may be offered to certain classes of investors (such as retail investors). In the context of token offerings, this may apply, depending upon the structure, to either or both of the main token and any pre-sale arrangements that amount to such an investment or instrument. It is important to note that even if an offering document is not strictly required from a legal perspective (for example, because an exemption applies), in most cases it will be advisable, with a view to limiting potential future disputes, amongst other things, to prepare documentation that clearly describes, for example, the tokens, any right(s) attaching to the tokens, the relevant platform, the principal legal relationships, the terms of the token offering (including selling restrictions) and relevant disclaimers (including risk factors). It should also be borne in mind that disclosure documentation other than a prospectus may be required. In the EU, for example, the PRIIPs Regulation may apply to a token offering. Depending on the circumstances, tokens may constitute “packaged retail investment products” (PRIIPs) under the PRIIPs Regulation where the product is such that “the amount repayable to the retail investor is subject to fluctuations because of exposure to reference values or to the performance of one or more assets which are not directly purchased by the retail investor”. Amongst other requirements, where such products are being offered to retail investors, issuers are required to produce a “key information document” (KID) which provides detailed information about such products in accordance with certain prescribed criteria.
To the extent that a token is deemed to be a security for US regulatory purposes, the registration provisions of the US securities laws require that the offer or sale of securities to the public must be accompanied by the “full and fair disclosure” afforded by registration with the SEC and delivery of a statutory prospectus containing information necessary to enable prospective purchasers to make an informed investment decision. Registration entails disclosure of detailed information about the issuer’s financial condition, the identity and background of management, and the price and amount of securities to be offered. These same laws also provide that, unless a registration statement is in effect as to a security, it is unlawful for any person, directly or indirectly, to engage in the offer or sale of securities. If an exemption to registration under the US Securities Act is relied upon, US securities laws impose a standard to which the disclosure must be prepared by the issuer and provides a private right of action by an investor to enforce that standard. The disclosure must not make any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.
5. If the tokens are not regulated investments, do other potential regulatory issues arise?
While important, laws relating to the regulation of investment products and services are not the only potentially relevant regulatory issues. Some important examples are set out below.
Money services regulations. US federal law makes it illegal to knowingly conduct, control, manage, supervise, direct, or own all or part of a money transmitting business which is not licensed under state and federal law. FinCEN, a bureau within the US Department of the Treasury, has published guidance to clarify whether a person dealing in cryptocurrency would fall under the definition of a “money transmitter”. In its guidance, FinCEN has stated that those who issue and redeem cryptocurrency, and those who accept and exchange cryptocurrency for either fiat or other cryptocurrency as a business, would be deemed money transmitters. Consequently, it is possible that a token sponsor (or the entity which handles the exchange of cryptocurrency) would be deemed to be engaging in an unlicensed money transmission business in violation of US law. Regulation of exchanges. The SEC has made it clear that any entity or person engaging in the activities of an exchange, such as bringing together orders for securities and entering such orders pursuant to agreed terms of the trade, must register as a national securities exchange or operate pursuant to an exemption, such as an ATS. To the extent tokens are deemed securities, a qualified venue must be registered with the SEC in order to facilitate trading in the secondary market.
6. Can tokens be offered into the People’s Republic of China (PRC)?
A circular was issued jointly by seven regulatory authorities in the PRC on 4 September 2017, which, amongst other things, demanded that all token offerings cease immediately and any completed offerings be unwound (i.e. any proceeds raised should be returned to investors). In addition, cryptocurrency exchanges could no longer provide any trading services (between fiat and cryptocurrencies, or between cryptocurrencies) or pricing/quote services. The circular does not specifically address whether it is only targeted at domestic token offerings although, insofar as it relates to cryptocurrency exchanges, the penalties stated suggest that it is focusing only on exchanges operating in China. In January 2018, the National Internet Finance Association of China stated that most onshore token offerings have been “cleaned up”, but it was aware that tokens have continued to be marketed to PRC residents on a cross-border basis and warned investors of the risks involved.
It is difficult to gauge at this stage whether and how the Chinese regulators would, in practice, seek to enforce against cross-border token offerings. It is expected that new regulations will be introduced to prohibit illegal fundraising activities (which may include token offerings) in the near future.
7. What are some of the most significant practical issues currently faced in relation to token offerings?
Bankability. Token issuers have faced difficulties in banking fiat currencies converted from cryptocurrency proceeds received from token offerings. Banks typically view token offerings as presenting a high risk for money laundering, which means that banks would be obliged to undertake enhanced customer due diligence and enhanced monitoring of business relations to comply with their “know-your-client” (KYC) and anti-money laundering (AML) obligations. A key practical issue is that banks generally require the source of funds to be established, which necessarily involves identifying:
- the institution or investor from which the funds originate; and
- the activity that generated the funds.
It may be difficult to ascertain the source of funds in relation to token offerings, given the generally anonymous nature of cryptocurrency proceeds, particularly where conversion takes place on a cryptocurrency exchange. Globally, a number of banks are reported to have closed bank accounts of companies offering cryptocurrency services. At present, there does not appear to be a clearly identified practical solution to the “bankability” problem. Accounting and taxation. The classification of a token as a “security” or a “utility” may also have implications on its accounting and tax treatment. Such treatment will depend on the applicable accounting standards and tax laws in each relevant jurisdiction and will also depend on the specific features of the tokens and the token offering in question. Some issues to consider include:
- the corporate and personal tax implications relating to an issue of tokens;
- relevant sales, stamp duty and other ad valorem taxes; and
- how the token is accounted for in the financial statements of the issuer.
Issuers and other participants in token offerings should consult a professional accountant and/or tax adviser on these issues.
Security and token holdings. A significant issue in the context of token offerings has been whether and how tokens can be held in a secure way. In particular, it is generally unclear, both as a practical and legal matter, whether or how a claim to tokens that have been lost (for example, because the relevant wallet provider was hacked, or due to fraud) can be enforced. Transfers, clearing and settlement. The legal basis of transfers, clearing and settlement of transactions in tokens and other cryptocurrencies or assets is unclear. For example, in certain jurisdictions, it is unclear whether, and if so how, the holder of a token could successfully enforce a “proprietary” claim to the token against a third party (for example, in the case of theft or misappropriation). Mechanics applicable to other types of investments such as bonds or shares are not applicable or easily adaptable to tokens. Ability to exchange for fiat currency. Many tokens are not directly exchangeable for fiat currency or, even if they are, are not exchangeable easily. The ease with which a new token will be able to be transferred and exchanged will depend on whether they are accepted for trading by a cryptocurrency exchange platform. While more popular tokens and existing cryptocurrencies will be traded across multiple platforms, new tokens may not be accepted by exchange operators and therefore liquidity will be negatively impacted. Without easy access to a market price for any new token, it could be difficult to exchange the token for fiat currency. Regulatory status. As noted above, in many jurisdictions tokens and token offerings can be subject to multiple classifications, each with their own regulatory requirements. One recent example of this was highlighted by the U.S. Commodity Futures and Trading Commission (CFTC) in its recently published Primer on Virtual Currencies. In its primer, the CFTC stated that tokens issued in connection with token offering may be both a “commodity” for purposes of the U.S. Commodity Exchange Act and a security for purposes of the securities laws, while emphasising that it will look beyond the form to the actual substance and purpose of an activity when applying CFTC regulations. To the extent that a token is a CFTC commodity, it could become subject to a host of regulatory requirements which are substantially different to those imposed on securities (e.g. trading and clearing requirements, transaction reporting and position limits). Therefore, as the regulators in each of the discussed jurisdictions develop their views on the status of tokens and token offerings, any issuer, adviser or purchaser should be aware that the terms of the transaction will determine the financial regulations to which they are subject and that the securities analysis, while critical, is not the end of the discussion.