Whether they are referred to as “initial coin offerings,” “virtual currencies” or “token sales,” blockchain-based tokens are raising eyebrows as well as significant funds. It seems like the dot-com boom of the 1990s is returning with a new twist – or perhaps it is the next natural step after the rise of crowdfunding platforms. However, just as there are many stories of dot-com failures and kickstarters that turned out to be non-starters, investing in virtual tokens involves significant risk. And for creators of virtual tokens, there is also significant risk – not only from disgruntled investors in the event a product does not succeed, but also from regulators who now have virtual tokens squarely in their sights.
A number of US regulators have affirmed their jurisdiction over cryptocurrency transactions, depending on the nature of the token. The Securities Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC), the Treasury Department’s Financial Crimes Enforcement Network (FinCEN) and the Internal Revenue Service (IRS) have all made various pronouncements regarding the application of their rules to crypto transactions. All of these agencies have affirmed that if cryptocurrency transactions take place in the US or with US persons, their jurisdiction applies. This note describes where those regulators’ interests lie and attempts to demystify the patchwork of rules that govern token sales.
The SEC and the CFTC have made a number of public announcements recently and have begun filing cases (sometimes criminal cases) where they view token sales to have breached the rules over which they have jurisdiction. As the SEC noted in its July 2017 report on the now-infamous DAO, the SEC’s jurisdictional reach is broader than just traditional equity and debt securities. The Securities Act gives the SEC jurisdiction over “investment contracts” – “investments of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.” The SEC’s view is that investors in most ICOs are purchasing tokens not for their utility (which may be undeveloped at the time of the ICO) but in the hopes that the tokens will increase in value due to the ICO team’s technology development and promotional efforts. While it is possible that a token offering can be deemed to fall outside this definition if it is already fully functional, since most ICOs are done prior to development, many of them will in fact be considered securities.
The Securities Act requires that all issuances of securities (including investment contracts) either be registered with the SEC (a relatively complex and expensive process) or be subject to an exemption from registration. One of the most commonly used exemptions allows for issuances to an unlimited number of US persons, as long as those persons meet the criteria to be “accredited investors” (that is, they must meet certain wealth and/or sophistication standards). Many companies are taking a new approach of issuing “SAFTs” (Simple Agreement for Future Token), which allow them to take in funds from accredited investors while their actual tokens are still under development. But even with the accredited investor exemption, the Securities Act still requires that a SAFT issuer disclose all information that an investor would consider material in making an investment, and not make any material misleading statements or material omissions. Thus, SAFT offering documents can (and should) include all of the same information that any private placement memorandum would include.
Even if a token is not considered a security, the CFTC has stated that cryptocurrencies are commodities, and the CFTC has jurisdiction over commodities (with a few odd exceptions, such as onions). The CFTC does not have the authority to require unleveraged sales of cryptocurrency on the “spot” market (as opposed to futures or derivatives contracts) to be registered – however, it does have the authority to prevent fraud and manipulation even in the spot markets, and like the SEC, it has not hesitated to use this authority.
Note that a security is not a commodity – if an instrument is a security, it is specifically excluded from the CFTC’s jurisdiction. So at least as far as the SEC and the CFTC are concerned, there will not be conflicting jurisdiction. However, other federal regulators have also asserted jurisdiction over the cryptocurrency markets.
FinCEN has released guidance addressing “convertible” virtual currency – that is, virtual currency that has an equivalent value in real currency or can act as a substitute for real currency. If a cryptocurrency is not a “convertible virtual currency” under FinCEN’s definition, FinCEN is unlikely to consider activities related to that cryptocurrency as within its jurisdiction. However, this does leave most tokens as subject to FinCEN’s jurisdiction, as most tokens are designed to be traded on liquid markets and thus will have an equivalent value in real currency.
If a party undertakes specific activities in connection with convertible virtual currency, FinCEN’s rules require that entity to register with FinCEN as a money transmitter, and it will be subject to FinCEN’s regulatory regime. There are two types of entities that may be money transmitters in connection with their virtual currency activity. First, token “administrators” issue tokens and have the authority to redeem or withdraw them from circulation. This category includes issuers of tokens that are used as payments for services from the issuer (such as tokens that allow access to an issuer’s software), since the issuer has the ability to determine whether or not to put the tokens back into circulation. Second, token “exchangers” engage as a business in the exchange of cryptocurrencies for real currency or other cryptocurrencies. In a demonstration of its authority over non-US businesses that provide services to US persons, FinCEN fined crypto exchange BTC-e over $100 million for facilitating money laundering, ransomware and drug trafficking (and even caused the arrest of its Russian founder).
There is no escaping taxes. The IRS has confirmed that cryptocurrencies are indeed property and thus subject to tax laws like all other property. This means that gains on the sale of cryptocurrency are indeed subject to tax, that salaries received in cryptocurrency are subject to income tax, and that information reporting is required. The IRS took crypto-exchange provider Coinbase to court to compel it to provide information on significant transactions in Bitcoin, but this may be only the opening salvo as the ruling was limited to transactions over a limited period of time and for Bitcoin transactions only.
And the States too?
US States are in the process of developing their own regulations for virtual currency, with New York the first to announce a comprehensive framework. Further articles in this series will explore state regulation, as well as delving deeper into the federal framework.