So you want to launch an initial coin offering? Better buckle up and lawyer up.
At the FinTank CryptoCon event in Chicago on Thursday, two attorneys addressed the complexity and pitfalls that come with launching an ICO. Barbara Jones, an attorney with GreenbergTrauig, said there continues to be some ambiguity over regulation of ICOs. SEC Chairman Jay Clayton has said numerous times that he has not seen a token from an ICO that is not a security. Meanwhile, Commodity Futures Trading Commission Chairman Chris Giancarlo is considering tokens as commodities, and has said the commission will pursue any cases involving token fraud. Interestingly, the CFTC issued a Customer Protection Advisory on Thursday warning customers about pump-and-dump schemes in less liquid and new “alternative” virtual currencies, digital coins or tokens. Both chairmen have said they are working together to address this new instrument. In short, there isn’t a lot of regulatory certainty yet, but it is evolving.
One of the problems is that all tokens produced by ICOs are not equal. Some fall under the category of equity token, security token or utility token, which may or may not make them a security. Equity tokens allow firms to essentially issue stock in a company, bypassing Wall Street through the use of smart contracts based on blockchain technology like Ethereum. But there is little regulatory guidance on this so far. Security tokens broadly refers to any kind of tradable asset and fall under SEC regulation. Utility tokens may fall outside of the realm of security tokens and may provide a good or service. For example, they could provide cloud storage for token holders or some other service.
To understand which one of these categories a token falls into, firms must consider the so-called Howey test, a 1940s guideline that uses three factors to determine whether or not something is subject to securities regulation. Generally speaking, the Howey test states something is a security if: it involves an investment of money, is an enterprise and has an expectation of profit. And that may be where Clayton is applying his assertion that tokens are indeed securities.
Richard Levin, an attorney with Polsinelli, told the audience in another regulation panel that Clayton is sending a serious and loud message to the market on tokens.
“If you are trading what they now call digital assets, you need to be ready to justify what you sold is not a security. Because if you try to argue it’s just a utility token, it’s a bit of a BS euphemism, to be candid,” Levin said. “It’s something they can see right through and they will go after you.”
Meanwhile, ICO issuers should also consider state securities laws. Given how new this space is, states vary on what is required in terms of registration and how best to regulate them. Jones pointed out, for example, that New York residents are prohibited from participating in ICOs and cryptocurrency exchanges unless those companies obtain a so-called BitLicense. And any crypto-based platform that converts fiat currency into digital currencies may fall under state licensing regulations.
On top of that, firms may also be subject to the “know your customer” rules, which adds an additional layer to investors.
Jones’ advice is simple, “Take a step back. Don’t jump in headfirst. Be thoughtful, be considerate and ask a lot of questions. Think through the issues and make sure you have great advisers, great service groups, good auditing groups, good tax advisory groups to work through the issues and good law firms to help you get that structure.”
All of that might make someone consider doing an ICO outside the U.S., and Jonathan Turnham, an attorney with Travers Thorp Alberga, said his firm is advising clients to consider setting up the entity in the Cayman Islands. Many hedge funds have done so for years and a firm setting up an ICO may also find similar tax and regulatory benefits. To date, he said, Cayman law does not consider ICO tokens as a security.
How this will also shake out in the US and elsewhere is ongoing. But in the meantime, the ICO fever is still quite high. The firms that are taking early precautions may be the ones who survive the regulation that is surely on its way.