Many technology companies have raised substantial amounts of capital through initial coin offerings, or ICOs, and have done so in an unprecedented manner that has generated a great amount of intrigue and attention within the business world, among investors, and amidst state and federal regulators. The potential benefits of an ICO are awesome and obvious. Given the largely uncharted territory into which ICOs have ushered entrepreneurs, investors, and regulators, however, so are the potential risks.
The crystal ball industry needs a successful ICO, as no one is entirely sure when, how, where, and by whom the vast array of legal issues underlying ICOs will be settled. What we do know at present are the general questions companies partaking in ICOs are likely to confront in the event securities regulators come knocking. The most notable of those questions, at least from our perspective, are briefly discussed below.
Does it Quack Like a Duck?
The United States Supreme Court posed that question long ago, in a galaxy far, far away from the internet, blockchain, and cryptocurrency: “[T]he reach of the [Securities] Act does not stop with the obvious and commonplace. Novel, uncommon, or irregular devices, whatever they appear to be, are also reached if it be proved as matter of fact that they were widely offered or dealt in under terms or courses of dealing which established their character in commerce as ‘investment contracts,’ or as ‘any interest or instrument commonly known as a ‘security’.” SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344, 351 (1943).
In July 2017, the SEC cited that passage in its DAO Investigation Report, explaining that it was still checking to see whether the transactions before it quacked like a duck. The SEC specifically announced that it would apply the classic Howey investment contract test to companies partaking in ICOs, and, as has always been the case in every other setting, that the Howey test would be applied to ICOs on a case-by-case basis. Like the Howey court did long ago, the SEC declined to establish a one-size-fits all rule that applies to ICOs, instead reiterating that the facts and circumstances continue to matter in the brave new world of cryptocurrency.
That isn’t to say the SEC has remained quiet about its general feelings. SEC Chairman Jay Clayton recently stated, for example, that he “[has] yet to see an ICO that doesn’t have a sufficient number of hallmarks of a security,” and the SEC concluded the DAO Report itself with a finding that the tokens under consideration there were, in fact, securities. Those observations should serve as a word of caution to technology companies contemplating an unregistered and non-exempt ICO, as should the enforcement action the SEC recently undertook against Munchee, Inc. in connection with its ICO. In that case, the SEC successfully argued that Munchee violated Section 5 of the Securities Act because the tokens it issued to investors constituted a sale of unregistered and non-exempt securities. With that being said, Munchee is just one early case in what is certain to be many years of litigation spawned by the growing popularity and vastly differing applications of cryptocurrency. Going forward, the facts and circumstances will continue to be diverse, and, as they always have been, will be front-and-center in the “securities” analysis.
In addition to federal laws and regulations, each state has its own securities regulatory agency that may apply its own test for violation of state blue sky laws – many of which are more stringent than the Howey test. For example, in addition to the factors set forth in Howey, a minority of states (including WA and CA) may apply a “Risk Capital” analysis under certain circumstances – a test that is generally broader and more inclusive than the Howey test, and which could potentially cover a broader range of transactions than Howey. Bottom line: The state (or states) that have jurisdiction over your ICO could have a significant impact upon whether the tokens or other digital assets you are offering may be deemed a security.
Many have argued that “utility” tokens issued through an ICO – i.e., tokens issued for consumptive use, rather than an asset like stocks or bonds held primarily with the expectation of profit derived from the activity of others – do not constitute securities under Howey or applicable SEC guidance, and therefore need not be registered or qualify for an exemption. While the legal landscape regarding such “utility” tokens is almost entirely uncharted, the SEC certainly seems to have suggested that, under appropriate circumstances that have yet to be clearly or fully defined, it would consider utility tokens to be outside the definition of securities. Again, and as a bottom line to any company contemplating an ICO, the facts and circumstances of each individual ICO will be centrally important to determining whether it quacks like a duck.
Are You Unwittingly Operating an Unregistered Securities Exchange?
In a lesser discussed section of the DAO Report, the SEC made clear that any platform facilitating the exchange of tokens would risk being deemed a “Securities Exchange” under the Exchange Act of 1934. While the facts and circumstances will certainly matter in this realm as well, designation as an unregistered exchange could have potentially significant consequences for ICO issuers. At best, such a designation would trigger the significant and costly registration and compliance burdens of becoming a registered exchange, and more likely would result in enforcement action by the SEC. If your venture is operating a platform that facilitates the exchange of tokens, or if your intended blockchain protocol contemplates such transactions as part of the services offered, you face heightened risk if the tokens traded on your platform are deemed securities.
Is it a Commodity?
The CFTC regulates the commodity futures and option markets in the Unites States. How do CFTC regulations apply to ICOs? Good question. While the law in this realm is also continuing to develop in real time, the CFTC has taken the position that “virtual currencies” fall under the definition of a commodity. Against that backdrop, the safest assumption issuers can make is that tokens issued in an ICO might be deemed a commodity. The CFTC’s purview covers derivative instruments such as futures, options, and swap contracts covering commodities, as well as clearinghouses, traders, and other market infrastructure. The CFTC doesn’t regulate the primary market for token issuances, but financial instruments covering them, including potentially SAFTs, depending on how they are structured, could be a target for regulatory investigation.
Thanks to my colleague, Jordan Rood, for the valuable insight on these important issues.