An Initial Coin Offering (ICO) is a new method of raising  capital to finance a project by selling crypto tokens. The tokens are typically tied to a smart contract on the Ethereum blockchain or similar platform, and represent the right to utilize the technology that is being financed by the ICO. In many ways, an ICO is a lot like an Initial Public Offering (IPO), where and investors purchase stock the company. This is especially so when the token is treated as a security for legal purposes.  Some tokens are even designed to be convertible into stock or have other equity aspects (“equity tokens”).

While the concept is fairly new, ICO’s have become somewhat controversial within the blockchain community. Some think that ICOs are an unregulated way for founders to generate unjustified cash resources while sidestepping the law. Others think that this is an important innovation that should be allowed its place in traditional fundraising practices.

Technologies like the ERC20 Token Standard make it easy to organize and structure the ICO, which relies on abstracts of the development process in the creation of new cryptographic assets. Most often this works with investments sent as Bitcoin or Eether to be managed by a smart contract. Funds can be kept here and their equivalent value distributed at a later point in time.

As discussed below, in mid-2017, the U.S. Securities and Exchange Commission (SEC) began to bring administrative actions against some ICOs that were being offered without complying with the U.S. securities laws.  Triggered in part by the collapse of The DAO securities token and other market failures, the SEC has also been making public statements that it treats its jurisdiction broadly in this area and will be closely monitoring the ICO market.

Some companies have reacted by limiting their public token sales to non-U.S. persons. Others are attempting to structure their ICOs as “utility tokens” that do not constitute securities under U.S. law. However, one of the most fundamental risks of this type of fundraising is that the cash is collected before the project is completed. This is a major risk, which can make people doubtful of the ICO as a valid fundraising technique. Furthermore, because there are few restrictions on who may participate in an ICO that is not a security, the chances are real that small and unsophisticated investors will, in some cases, loose most or all of their investment. For these reasons, it seems that greater regulation by the SEC and Congress is inevitable.

History of ICOs

Back in 2013, there were several crowdsourcing projects attempting to fund their development through virtual currencies. For example, Ripple pre-mined 1 billion XRP tokens then marketed them to investors in return for Bitcoins or hard currencies, with the funds being used for the mining project. In early 2104, Ethereum conducted the largest ICO that had been achieved up until that time at over $18 Million.

The DAO was one of the next companies to attempt an ICO, in this case through the Ethereum blockchain. The goal was to create a decentralized system that could be used for the foundation of future blockchains. The factor that set The DAO apart from other similar projects was that all governance decisions would be made those holding tokens.  The sponsors thought that this would make the token holders active participants in the business and thus not passive investors, believing that this made their tokens into non-securities “utility tokens.”

In spite of raising $150 million, due to technical vulnerabilities The DAO was sapped of much of its capital by an unknown attack. This is when the Ethereum Foundation moved forward with the “stiff fork” and was able to gain back some of the lost resources. However, it also attracted the attention of the SEC, which eventually issued a Report that stated that The DAO tokens were securities.

While many believe the first attempt by to fund a token on the Ethereum platform was not successful, there was an important lesson to be learned. It was still easier to build a token on the Ethereum platform rather than attempt to pursue a course of action through the usual venture capitalist methods. For one, the ERC20 standard made building tokens off the Ethereum blockchain a relatively easy task for developers.  Many ICOs have subsequently been conducted using the Ethereum platform, and its popularity remains undeniable.

Are ICOs Securities?

Whether a given ICO token or other type of cryptocurrency are securities under the Federal securities laws depends on the features of each particular transaction structure. If they are securities, they are subject to regulation by the SEC. In this case, a sale of tokens in an ICO would either have to be registered with the SEC, an expensive and time-consuming process, or else qualify for an exemption from registration, such as the one for a private placement to accredited investors.

In July 2017 the SEC made a press release that stated: “Whether a particular investment transaction involves the offer or sale of a security – regardless of the terminology or technology used – will depend on the facts and circumstances, including the economic realities of the transaction.”  In a related Report issued at the same time, which summarized its investigation into the token sale by The Dao, the SEC concluded that The Dao tokens were securities.

The definition of security under the Securities Act includes “investment contracts.” The seminal Supreme Court case for determining whether an instrument meets the definition of security is SEC v. Howey, 328 U.S. 293 (1946), which involved the sale of orange groves coupled with a management agreement to operate the groves. According to Howey, an investment instrument is an investment contract, and thus a security, if there is:

  • an investment of money;
  • in a common enterprise;
  • with an expectation of profits; and
  • solely from the efforts of others (e.g., a promoter or third party).

In its report on The Dao, the SEC stated that the tokens in question met all four of the Howey elements and thus were securities:

  • The investors in The Dao tokens paid for them with ether (ETH), a cryptocurrency. The SEC stated that this constituted an investment of money, noting that the courts have long held that “cash is not the only form of contribution or investment that will create an investment contract.” [Quoting Uselton v. Comm. Lovelace Motor Freight, Inc., 940 F.2d 564, 574 (10th Cir. 1991).]
  • The SEC found a common enterprise with an expectation of profits because the investors’ funds, in the form of ether, were pooled and made available to the Dao to fund projects: “The projects (or ‘contracts’) would be proposed by Contractors. If the proposed contracts were whitelisted by Curators, DAO Token holders could vote on whether The DAO should fund the proposed contracts. Depending on the terms of each particular contract, DAO Token holders stood to share in potential profits from the contracts. Thus, a reasonable investor would have been motivated, at least in part, by the prospect of profits on their investment of ETH in The DAO.”
  • The SEC found that The Dao was marketed as a passive investment and that investors were depending on the promoters’ efforts and skill in finding and managing projects to generate profits for the investors.

The Munchee Order

In September 2017, the SEC issued an Administrative order, In re Munchee, Inc., which conducted an ICO to fund the development of its smartphone app for reviewing restaurants.  The company raised $15 million in an ICO.  The tokens that it sold represented the right to buy future, undeveloped goods and services after the company had developed an “ecosystem” for its app with the proceeds of the offering.  Despite the company’s claims that it had conducted a Howey test and determined that the tokens were not securities, the SEC had no problem finding otherwise, emphasizing the many statements made by the company highlighting the skills and abilities of its management team and other factors that indicated an expectation of profits from the efforts of the company and its management and technical team:

“Munchee said in the MUN White Paper that the value of MUN tokens would depend on the company’s ability to change the Munchee App and create a valuable ‘ecosystem’ that would inspire users to create new reviews, inspire restaurants to obtain MUN tokens to reward diners and pay Munchee for advertising, and inspire users to obtain MUN tokens to buy meals and to attain higher status within the Munchee App. Munchee said that it and its agents would undertake that work during 2018 and 2019.”

Some law firms have undertaken elaborate analyses that distinguish a “utility token” from a “securities token.”  They believe that a “utility token” representing the right to use the systems and products being financed through the token sale are not securities, analogizing them to licenses or franchise rights where the token represents the right to use the underlying systems and products in the active conduct of their business.  For example, a token that represented the right to use blockchain technology for the secure cloud storage of data, where the technology was being developed with the proceeds of the token sale, would not be a passive investment and thus not a security under the Howey test.

Given the aggressive approach of the SEC in The Dao and In re Munchee, we recommend that clients forming cryptocurrency funds assume that the cryptocurrencies and tokens in which they will be investing will be treated as securities by the SEC, and that the fund manager will subject to the Advisers Act unless an exemption is available.

The Risk Capital Test

Token issuers must also consider securities regulations at the state level. Companies that distribute their tokens in the United States must comply with the state securities (“Blue Sky”) laws of each state in which an offer or sale takes place. Thus, tokens that are beyond the jurisdiction of the SEC because they do not satisfy the Howey test might still be subjected to regulation by the securities laws of one or more states.

There are different frameworks for determining whether a token is a security under state law. Courts in the state of California, Washington, Arkansas, Michigan, and Oregon use what is known as the “Risk Capital” test, which looks at  whether there was an attempt by the issuer to raise funds for a business venture or enterprise. The test will deem a token to be a security if the investor is in a passive position to affect the success of the venture and  if the investor’s money is at a substantial risk due to inadequate security.

Using this test, the Supreme Court of California found that country club memberships were securities in landmark cases like Silver Hills Country Club vs. Sobieski, which involved the sale of country club memberships to finance improvements of the country club. The memberships didn’t allow the holders to share in profits and only allowed the holders to use the facility. According to the court, the substance to protect should come from risk capital and these schemes would create too much risk. Thus, the purchaser would be risking their capital and gaining none of the benefits of the profits.

States that utilize the risk capital test may use it in accordance with Howey. This transaction will be considered to be a security if it satisfies the tests. Since so many token issuers are using general public funding for their business ventures, they will have passive investors that are contributing a risky product. Such risk capital testing may be more applicable to a variety of circumstances.

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Lawyers for ICO's, ICO funds and BDC's, and Cryptocurrency Exchanges