RISE OF INITIAL COIN OFFERINGS (”ICOs”) IN AN UNREGULATED INDUSTRY
Sabeena Liconte, Deputy Chief Operating Officer and Chief Legal Officer/Chief Compliance Officer BOC International (USA) Holdings Inc.
1 A G E N D A
1. Rise of ICOs 1.1. Types of Digital Assets 1.2. ICOs Defined: What is an ICO? 1.3. ICO Purpose: Raising Investment 1.4. Benefits of ICOs 1.5. ICO Mechanics: How They are Structured 2. ICO Governance: How They are Governed 2.1. How ICOs are Governed in the US 2.2. Whether an ICO Constitutes the Sale of Security: the Howey Te s t & t h e AirFox Case 2.3. Legal and Compliance Considerations in Complying with Federal Securities Laws 3. Challenges with ICOs 3.1. An Era of Regulatory Uncertainty 3.2. A Bad Rep: ICO Failures and Initial “Con” Offerings 4. Trends in Enforcement & Regulation 4.1. Trends: SEC 4.2. Trends: FINRA 4.3. Trends: CFTC 4.4. Trends: FinCEN 4.5. Trends: OFAC 4.6. Trends: States 4.7. Trends: International
2 TOPIC 1
RISE OF ICOs: “ICOs 101”
3 1.1. TYPES OF DIGITAL ASSETS
There are three principal types of digital assets, each of which serves different functions:
A. Some serve principally as a medium of exchange and store of value, like Bitcoin; they operate as a virtual currency. B. Some are structured as utility tokens, giving preferential rights to use the output of a new project or a good or service within a business’ ecosystem. (Think a digitalized version of tokens used to play games at Chuckie Cheese.) These may be deemed securities. C. Others reflect an interest in an enterprise and are likely securities, like The DAO. They might be initially issued as part of initial coin offerings (“ICOs”); they may be associated with pre-sales (for example, via a Simple Agreement for Future Tokens (“SAFT”) from accredited investors pursuant to a Reg D offering; a Reg A offering provided it does not exceed $5M in any one-year period; or a Reg S offering for issuances outside the US). They are often referred to as digital tokens.
Note: Any digital asset may morph from one function to another during its life (e.g., the “secumodity”) or may have multiple purposes.
4 1.2. ICOs DEFINED: WHAT IS AN ICO?
The term “ICO” stands for initial coin offering. } The term is derived from the well-know stock market process “IPO” (or initial public offering), which is used to launch a company’s shares on the public stock markets for the first time.
A means to raise funding for a token offering/new cryptocurrency project. } The primary (but not necessarily sole) purpose is make an investment. A secondary purpose may be to build a network and operate as a medium of exchange. } ICO acts as fundraisers – a company looking to create a new coin, app or service launches the ICO. } Just as in Howey case, tokens/coins are cultivated in a way that causes them to grow in value to be sold later at a profit. The purchaser must on the efforts of a promoter/third party to build the network and make the enterprise a success. The philosophy is that purchase of a token/coin functions like a bet on the success of the enterprise – and not the purchase of something used to exchange for goods and services on the network.
It is the act of raising funding that causes the ICO to be considered a “security.” } Note: The digital asset itself is simply code. But the way it is sold (i.e., as part of an investment to non-users by promoters/third parties to develop the enterprise) makes it a security because it evidences an "investment contract. “
5 1.3. ICO PURPOSE: RAISING INVESTMENT
IPO ICO IPO investors acquire shares (equity) in a company, ICO investors acquire cryptographic tokens, but not along with associated voting rights. This equity gives actual shares. Tokens do not represent an equity stake in investors a claim on a real asset – the future earnings of the company or any kind of obligation of the issuer to the company. the token holders.
Since there is no clear link between the company’s earnings and the value of the cryptocurrency, investors may get no return even if the company becomes hugely profitable. At best, they may profit from a possible rise in the value of the company’s underlying cryptocurrency.
6 1.4. ICO BENEFITS
} Attractive because some ICO offerings have been incredibly successful and produced unbelievable returns – especially after tokens became listed on exchanges and publicly-tradable. } Per Coindesk ICO Tracker, since mid-2016, ICOs have raised nearly $4B in funding } Represents an efficient way to reach a global audience where initial purchasers have a stake in the success of the network by becoming a part of the network where their participation adds value beyond their investment contributions. From a marketing perspective, this simultaneously bring some marketing attention to the enterprise (especially where the coin/token is not yet operational). } Arguably enables cryptocurrency starts-ups and fintechs (and even established firms) to bypass the heavily-regulated and onerous capital-raising process required by venture capitalists, private equity firms, and banks. Instead of obtaining funding from such investors, these start-ups create new tokens and sell them publicly in exchange for funds (cash or cryptocurrency) to finance their daily operations.
Introduction 7 1.5. ICO MECHANICS: HOW THEY ARE STRUCTURED
} The starting point for an ICO is a “white paper” - a document which functions like a offering document/prospectus and explains the technical and business dimensions of a start-up’s project, such as how the technology works, a roadmap for the project, the mechanism for issuing tokens, and the potential use of the funds raised. } While some ICOs price tokens in fiat currencies, many prefer to receive cryptocurrencies (such as bitcoin or Ethereum) from investors, as avoiding fiat currency means they may be able to avoid regulatory restrictions. In such ICOs, investors typically send bitcoins/ethers to a smart contract which, upon verifying the payment, sends the newly created tokens back to the investors with an amount proportional to their investment.
8 TOPIC 2
ICO GOVERNANCE: HOW ARE THEY GOVERNED?
9 2.1. ICO GOVERNANCE: HOW ARE SECURITY TOKENS REGULATED IN US?
} Product Level Registration – the Security Token: } Subject to federal and state regulation. Security must be registered with SEC (and potentially states) or qualify under an exemption from registration.
} Offers and exchanges: } Exchanges for digital tokens that qualify as securities must register as national securities exchanges (e.g., BDs operating alternative trading systems) or be exempt from such registration requirement Under SEC and state law, participants should be aware of potential BD registration requirements.
} Advice: } Participants in the business of giving advice about securities to clients are investment advisers and may be required to register with the SEC. } An investment company is a vehicle that issues securities and is predominantly involved in the business of investing in securities. Under the Investment Company Act, investment companies must register with the SEC or qualify for an exemption from registration.
10 2.2. WHETHER AN ICO CONSTITUTES THE SALE OF A SECURITY: THE HOWEY TEST
} Key issue: whether an ICO constitutes the sale of a security
} With its July 25, 2017 Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The Dao (“The Dao Report”), the SEC broke its silence on whether an ICO is a securities offering. } The litmus test of whether the sale of an asset – such a digital token – constitutes a “securities offering” is based on the Howey Test (which originates from a 1946 legal case involving the offering of units of an orange grove development, coupled with a contract for cultivating, marketing and remitting the proceeds to the investor). } This test states that a transaction is considered to be a security/investment contract if: } It is an investment of money; } There is an expectation of profits from the investment; } The investment of money is in a common enterprise; and } Any profit comes from or is derived from the efforts of others (i.e., a promoter or third party)
See Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Release No. 81297 (SEC July 25, 2017), available at: 11 https://www.sec.gov/litigation/investreport/34-81207.pdf and See SEC v. Howey Co., 328 U.S. 293 (1946), available at https://supreme.justia.com/cases/federal/us/328/293/. 2.2. WHETHER AN ICO CONSTITUTES THE SALE OF A SECURITY: THE AIRFOX CASE (cont’d)
In the AirFox case (Nov. 16, 2018), AirFox’s digital coins, AirTokens, had some hallmarks of a virtual currency. For instance, AirFox claimed that AirTokens would be used as means to establish a network to “allow prepaid mobile phone users to earn free or discounted airtime or data by interacting with ads” and AirFox required that potential purchasers acknowledge that they were purchasing the coins to use as a utility not as an investment. Moreover, AirFox apparently intended to build a functioning network by building an ecosystem, adding an AirFox app, and entering into agreements with telecommunication firms.
However, the SEC found, that despite these statements, AirFox was really selling a profit making venture, not a medium to exchange services on mobile phones, including: - by marketing to US persons when the network could only be used by non-US persons; - reducing digital coin supply to increase value of the coins.
See SEC Press Release, available at https://www.sec.gov/news/press-release/2018-264 and in Carriereq, Inc.,, D/B/A Airfox Cease and Desist Order, available at 12 https://www.sec.gov/litigation/admin/2018/33-10575.pdf 2.3. LEGAL AND COMPLIANCE CONSIDERATIONS IN COMPLYING WITH FEDERAL SECURITIES LAWS
} ICOs can be securities offerings: ICOs, based on specific facts, may be securities offerings, and fall under SEC’s jurisdiction of enforcing federal securities laws.
} ICOs may need to be registered: ICOs that are securities most likely will need to be registered with the SEC or fall under an exemption to registration
} Tokens sold in ICOs can be called many things : ICOs, or more specifically tokens, can be called a variety of names, but merely calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security.
13 2.3. LEGAL AND COMPLIANCE CONSIDERATIONS (cont’d)
FACTORS FOR ASSESSING WHETHER A DIGITAL ASSET IS OFFERED AS AN INVESTMENT CONTRACT/SECURITY:
} Does a person (individual, entity or coordinated group of actors) play a significant role in the development or maintenance of the digital asset?
} What is the primary purpose? Are purchasers “investing” (i.e., seeking a return)? Or is the primary motivation for purchasing the digital asset for personal use or consumption, as compared to investment?
} Is the digital asset marketed and sold to the general public (instead of potential users of the network for a price that reasonably correlates with the market value of the good/service in the network)?
} Is the application/digital coin fully functioning (already on network) or in early stages of development (pre-network)?
} Do informational asymmetries exist between the promoters and prospective investors in the digital asset?
See Digital Asset Transactions: When Howey Met Gary (Plastic), speech by William Hinman, Director, Division of Corporation Finance, Securities & Exchange Commission (June 14, 2018) 14 TOPIC 3
ICO CHALLENGES
15 3.1. ICO CHALLENGES: AN ERA OF REGULATORY UNCERTAINTY
} Which regulators have jurisdiction? } SEC? } CFTC? } FinCEN, the state money transmission rules or OCC? } Which players are regulated/need to be registered? } Infrastructure developers, such as apps and app developers? Or platform and platform builder? } Users? } Service Providers? } What instrument/service is being offered? } Raising capital? } Operation of an exchange? } Advising? } Money transmission? } Facilitating purchases and sales? } E-wallet? } Who can I offer to? } Retail investors? } Accredited investors? } Blurry line between "commodities” and “securities” and rise of “secumodities” } Blurry line between a virtual currency (commodity) and an investment (security) } The rise of the “secumodity”: digital assets morphing between being defined as a “security” and a “commodity” and moving back and forth between SEC and CFTC jurisdiction
16 3.1. ICO CHALLENGES: TYPE OF OFFERING?
REGISTRATION EXEMPTIONS DESCRIPTION
Regulation D (“Reg D”) One of the most popular exemption offerings. It allows for exemption from filing registration statement with the SEC. Under Rule 506 of Reg D, issuers (without advertising and engaging in general solicitation) can sell to an unlimited number of “accredited investors” (i.e., individuals that make over $200,000 yearly or for couples $300,000 yearly or assets over $1,000,000 excluding main residence) and up to 35 other purchasers (i.e., non-accredited investors) provided they are sophisticated (i.e., having sufficient knowledge/experience in the financial markets). All purchasers receive “restricted securities,” which means that the securities cannot be sold for at least six months or a year without registering them. In 2017, the trend was to use Reg D with the Simple Agreement for Future Tokens (“SAFT”). Under Rule 504 of Reg D, an issuer can offer and sell up to $5,000,000 of their securities in any 12-month period. Like with Rule 506 offerings, except in limited circumstances, the purchasers receive restricted securities, which cannot be sold for at least six months or a year without being registered.
Regulation S (“Reg S”) A securities offering by either a U.S. or foreign issuer limited to overseas investors and must be offered outside the U.S. There can be no “directed selling efforts” made by the issuer in the U.S.
Regulation CF (“Reg CF”) To implement the provisions of Jumpstart Our Business Startups Act (“JOBS Act”), Regulation CrowdFund was adopted by SEC and permits offerings up to $1,070,000 in the first round from non-accredited investors more widely and accessibly. This is viewed as an easier way to raise money from a wider range of income demographics and investors.
Regulation A (“Reg A”) Nicknamed “IPO light” or “Regulation A+,” Reg A was overhauled by the JOBS Act in 2015 to offer an exemption from registration of public offerings Reg A has two offering tiers: Tier 1, for offerings of up to $20 million in a 12-month period; and Tier 2, for offerings of up to $50 million in a 12-month period. Additional requirements apply to Tier 2 offerings, including limitations on the amount of money a non-accredited investor may invest in a Tier 2 offering, requirements for audited financial statements and the filing of ongoing reports. Issuers in Tier 2 offerings are not required to register or qualify their offerings with state securities regulators. 17 3.2. A BAD “REP”: ICO FAILURES AND THE PROBLEM OF THE INITIAL “CON” OFFERING
} Largescale ICO failures } In 2017, there were 902 crowdsales which took place. Of these, 142 failed at the funding stage and 276 failed in later stages. Therefore, 46% of the 2017 ICOs experienced failure according to tokendata.io (an ICO tracker). } The DAO (2016): The first token crowdsale in mid-2016. Raised $152m in a matter of weeks. Tokens included voting rights to select collective investment projects. Shut down after a hacker used a flaw in The Dao’s code to steal approximately 1/3 of its assets. } Te z o s (2017): Raised approximately $232m for “self-amending” better blockchain. Founders currently in dispute with the Swiss foundation established to administer ICO proceeds. } Lack of uniformity in disclosures in white papers making it hard for investors to understand the nature and risks of the investment
} ICOs as Initial “Con” Offerings } Fraud in the ICO space – e.g., My Big Coin Pay (Sept. 26, 2018) touted as being a partnership with Mastercard and backed by gold, but was really operating as a Ponzi scheme, as promoters arbitrarily changed the listed value of the coin to mimic actual activity when there was none } Misstatements and misrepresentations, including in disclosures in white papers } Often launched from offshore locations to avoid US regulatory scrutiny and which makes any regulatory enforcement action difficult
18 TOPIC 4
TRENDS IN ENFORCEMENT & REGULATION
19 4.1. TRENDS: SEC
} SEC enforcement: SEC focus on whether a virtual organization might be required to register as an investment company and a securities exchange. } In the SEC’s Report of Investigation regarding The DAO, the SEC found that digital tokens issued by an entity for the purpose of raising funds for a project may be considered securities under federal law based on its conclusion that THE DAO tokens were securities under the Howey test. In footnote 1 of this report, the SEC did not analyze whether The DAO was an investment company. However, today, potential investment companies investing in digital assets are starting to become more of an SEC focus. } For the first time in September 2018, SEC charged a hedge fund for failing to register as an investment company for creating a hedge fund based on investments in digital assets. Crypto Asset Fund, LLC allegedly invested more than 40 percent of its value in digital asset securities without complying with applicable law. The hedge fund was also charged with making false or misleading statements to investors. The hedge fund was ultimately fined $200,000, among other sanctions.
20 4.2. TRENDS: FINRA
} FINRA enforcement: Focus on material misstatements and disclosure of PSTs } In September 2018, the Financial Industry Regulatory Authority (“FINRA”) commenced a disciplinary proceeding for violation of its rules in connection with the offer and sale of digital cryptocurrencies. } First issue: FINRA alleged that Timothy Ayre made material misstatements in public filings and unlawfully offered to the public HempCoin, tokens that he claimed were backed by marketable securities of a company of which he was a principal owner. } Second issue: FINRA also charged Mr. Ayre with engaging in private securities transactions (“PSTs”) without notifying the broker-dealer he worked for at the time. Note: This is the second time FINRA has charged an entity for violating this rule. Earlier in 2018, Arthur Meunier, a.k.a Arthur Breitman, agreed to be suspended for two years from association with any FINRA-regulated broker-dealer to settle FINRA charges that, from February 2014 to April 2016, he participated in the development of Te z o s , a blockchain technology project, without notifying the broker-dealer he was then employed by of such activity, as required by FINRA rules.
21 4.3. TRENDS: CFTC
} CFTC has jurisdiction over commodities, and virtual currencies have been deemed to be a commodity. } Commodities are generally defined as any goods, articles, services, rights and interests “in which contracts for future delivery are presently or in the future dealt in.” } Bitcoin and other virtual currencies first became defined as commodities in 2015 when CFTC filed and settled charges against Coinflip, Inc. and Francisco Riordan for operating a trading facility for Bitcoin options without being registered as an swap execution facility (“SEF”) or designated contract market (’DCM”). } On August 23, 2018, a federal court in New York confirmed that virtual currencies are commodities and that the CFTC had jurisdiction to bring an enforcement action against CabbageTech, Corp. and Patrick McDonnell, its owner and controller, for unlawfully soliciting customers to send money and virtual currencies for virtual currency trading advice and for the discretionary trading of virtual currencies by Mr. McDonnell. (This was based on the fraud-based manipulation prohibition in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and a corresponding CFTC rule, CFTC Rule 180.1.) } On September 26, 2018, a federal court in Massachusetts determined that virtual currencies are commodities on the basis that Bitcoin was already the basis of futures contracts approved by the CFTC.
22 4.4. TRENDS: FinCEN
} FinCEN Regulation } A person who provides money transmission services or any other person engaged in the transfer of funds must be registered as a money service business (“MSB”). Financial Crimes Enforcement Network (“FinCEN”), which oversees the financial institutions’ compliance with the Bank Secrecy Act (“BSA”) and USA PATRIOT Act, has issued rulings suggesting that virtual currency payment systems and virtual currency exchange platforms are money transmitters. } On March 18, 2013, FinCEN issued guidance regarding the applicability of the regulations implementing the BSA “to persons creating, obtaining, distributing, exchanging, accepting, or transmitting virtual currencies.” The guidance provided that simple users of virtual currencies were “not subject to the FinCEN registration, reporting, and recordkeeping regulations for [MSBs].” FinCEN further clarified that a “user” is defined as “a person that obtains virtual currency to purchase goods or services” (and includes miners) and, therefore, not subject to money service business (“MSB”) reporting and recordkeeping obligations. } On March 6, 2018, the US Treasury Department publicly released a letter stating that developers or exchanges that exchange ICO-issued coins or tokens for fiat or virtual currency would typically be required to be licensed as an MSB by FinCEN unless an exception applies, such as they are otherwise registered with the SEC or CFTC.
23 4.5. TRENDS: OFAC
} The Office of Foreign Assets Control (“OFAC”) updated its FAQs to include that persons subject to its jurisdiction are prohibited from doing business with persons named on the Specially Designated Nationals (“SDN”) and Blocked Persons list, whether utilizing fiat or virtual currency. } OFAC indicated that it may add digital currency addresses to its SDN list to alert the public of specific digital currency identifiers associated with blocked persons. } Persons that identify digital currency identifiers or addresses associated with prohibited persons should take the steps to block the relevant digital currency and file a report with OFAC. } On May 3, 2018, the National Futures Association (“NFA”), the self-regulatory organization of the futures industry, issued a notice reminding futures commission merchants and introducing brokers to comply with the recent OFAC guidance for virtual currency transactions.
24 4.6. TRENDS: STATE REGULATION
} Tokenization of traditional securities being recognized at the state level: } Delaware enacted new provisions authorizing corporations to maintain certain required records, including stock ledgers, on electronic networks or databases, including distributed electronic networks. } Arizona became the second state to allow corporations to maintain data on a blockchain.
} Most states regard transactions in virtual currencies as part of a business as being subject to money transmitter requirements. } In New York, such transactions are also subject to NY BitLicense requirements, and in other states, requirements under the Uniform Regulation of Virtual Currency Businesses Act as may soon be adopted. } On March 15, 2017, the Office of the Comptroller of the Currency (“OCC”) issued a draft licensing manual supplement for evaluating bank charter applications from financial technology companies for the purposes of creating a new “special purpose national bank” category for FinTechs. } In May 2018, the North American Securities Administrators Association (‘NASAA”), comprised of over 40 state and provincial regulators in the US and Canada, announced that its “Operation Cryptosweep”- a coordinated effort to protect Main Street investors from ICO and cryptocurrency-related investment product fraud, resulting in nearly 70 investigations and 35 enforcement actions.
25 4.7. TRENDS: INTERNATIONAL REGULATION
} Foreign regulators have taken different approaches to the regulation of ICOs: } Bermuda: Under a proposed bill, ICOs will be treated as a restricted business activity that will require consent from the Minister of Finance. } Canada: The Canadian Securities Administrators (“CSA”) recently issued guidance regarding when digital tokens are subject to securities laws. CSA provided 14 fact patterns and conclusions as to whether the relevant digital token had characteristics of a security or not. } Switzerland: FINMA published a notice that it was investigating a number of ICOs to determine if regulatory provisions have been breached, and noted ICOs may come under existing regulatory legislation } Hong Kong: The Securities and Futures Commission (“SFC”) issued a notice stating that digital tokens offered or sold as part of ICOs may constitute securities and be subject to Hong Kong securities laws. } United Kingdom: The Financial Conduct Authority (“FCA”) issued a warning about ICOs being high risk and that some involve regulated activities and regulated financial investments (while not being regulated separately). Whether an ICO falls within the FCA’s regulatory purview is decided on a case-by-case basis. Depending on how they are structured, some ICOs may involve regulated investments and firms involved in an ICO may be conducting regulated activities. } China and South Korea: Seven government regulators in China banned the use of initial digital coin offerings as a fundraising device. South Korea has also banned ICOs.
26 4.7. TRENDS: INTERNATIONAL REGULATION (cont’d)
} Legal status of cryptocurrencies also varies from country to country (and is constantly changing!). } Japan granted its first licenses for cryptocurrency exchanges. Binance, a cryptocurrency exchange originally founded in China, was forced to move its offices to Japan after regulatory measures from the Chinese government; however, Japan recently suspended Binance, claiming that it was violating Japanese rules and was not properly registered. } A number of national governments are exploring the issuance of cryptocurrency tokens which represent fiat currency (e.g., Singapore, Kazakhstan, China, Russia, Australia and Sweden).
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