US REGULATION OF COIN OFFERINGS: REGISTERING YOUR TOKEN WITH THE SEC In our previous article, US Cryptoasset Regulation: Consumer Protections and Cursory Guidance1, we outlined the key messages emanating from the CFTC, SEC, and IRS on cryptoassets in the . Specifically, the Securities and Exchange Commission (SEC) has released regulatory guidelines2 that firms need to consider when pursuing an (ICO). Recently the SEC published it’s first ‘no action’ letter3 providing concrete guidance to firms seeking to avoid registration requirements with the Commission when conducting ICOs. This article will focus on common structures for digital asset offerings (ICOs, STOs, and IEOs), and the relevant regulations firms should consider when pursuing them.

ICOs, STOs and IEOs

Initial Coin Offering (ICO) Initial Coin Offerings (ICOs) were the original and most popular way for firms functionality only available to token holders. Utility tokens do not represent to raise funds to finance -based projects. At the time, people ownership or equity in a blockchain network that grows in value as the generally viewed an initial coin offering as the cryptoasset equivalent to business matures, but instead, they represent transferrable software an (IPO). Just as private companies raise funds from licenses. Because of this difference, companies launching non- via selling shares in an IPO, blockchain-based startups have based ICO’s generally face a much lower barrier to entry than those begun to fund their application and services development by offering their launching traditional IPOs. unique coins or tokens. The newly issued coins are bought with widely However, this distinction does not mean that all token offerings traded on such as and , characterized as ICOs are inherently unregulated by the SEC, nor does and in some cases can be purchased with traditional fiat currencies. it exempt companies from registration requirements if they characterize Unlike the shares sold in an IPO, initial coin offerings generally do not their tokens as utility tokens in name only. In fact, these specific give their purchasers any ownership in the issuing company. Their value is characterizations of ICOs have historically been enforced by the SEC. Two instead indirectly linked to the success or failure of the blockchain project. examples are CarrierEQ Inc. and Paragon Coin Inc., who conducted ICOs Among other considerations detailed below, depending on the structure in 2017, without registering them pursuant to federal securities law. In of the ICO and the underlying tokens, ICOs in some cases do not require November of last year, the SEC announced4 it had levied fines of $250,000 registration with the SEC that a (STO) necessitates. against both companies and mandated registration for their tokens as securities. Because of this distinction, various startups use ICOs to avoid the strict and cumbersome regulatory hurdles associated with traditional IPOs. In most ICO tokens can take the form of non-securities and avoid SEC registration, recent cases, firms preparing ICOs have structured their digital assets or if deemed to act as an investment contract and therefore, a security as utility providing instruments, to avoid classification of their tokens as they will need to register with the SEC. investment contracts and thus securities under applicable securities laws.

For companies such as TurnKey Jet, Inc., the tokens are classified as utility tokens, a decision we explain later in this article. Unlike securities tokens, utility tokens provide the holder of the tokens with access to the company’s decentralized applications, (DApps) or other privileged software

1 http://capco.com/Intelligence/Capco-Intelligence/US-Crypto-Assets 2 https://www.sec.gov/files/dlt-framework.pdf 3 https://www.sec.gov/divisions/corpfin/cf-noaction/2019/turnkey-jet-040219-2a1.htm 4 https://www.sec.gov/news/press-release/2018-264

US REGULATION OF COIN OFFERINGS: REGISTERING YOUR TOKEN WITH THE SEC / 2 Security Token Offering (STO) Initial Exchange Offering (IEO) Simply put, an STO is a regulated coin offering, used to raise finance for Projects which issue tokens through a crypto exchange to raise funds a blockchain project or release equity/cash in a physical asset. There are are generally referred to as Initial Exchange Offerings or IEOs. IEOs are many potentialities for STOs and new use cases are still emerging. Just relatively new and will likely replace ICOs where tokens are not regulated as digital certificates are offered to equity investors in an IPO, ownership security tokens. The key differential between IEOs and ICOs is that an information for an STO is recorded on the associated blockchain and existing crypto exchange issues and administers the newly released coins. issued to the owner as a security token. The same regulations that govern For an ICO, the to the recipient of the newly released tokens traditional IPO’s would apply to tokens offered within STOs. Conversely, is the token developer, whereas in an IEO the exchange functions as an an ICO like that of TurnKey Jet can structure their digital assets as utility intermediary. tokens to avoid having to register their token offering with the SEC. For IEOs, token issuers will typically pay a fee to have their tokens listed on the exchange or provide to the exchange a percentage of all tokens issued. Exchanges sponsoring the IEO’s will conduct due diligence on the new projects to protect the interests of their customers and will generally assist the issuers with marketing and security services. Verifying the validity of a new coin or project is one of the main benefits of an IEO, fostering greater trust in the token by the potential customer base against fraudulent or riskier investments. As an example, in March of 2019, Bittrex canceled5 the RAID Project’s IEO after learning RAID’s strategic partnership with the gaming data analytics company OP.GG had been terminated.

ICO STO IEO

KEY ATTRIBUTE Utility Token Security Token (regulated) Either a Utility Token or Security Token

TOKEN SALE Blockchain project Blockchain project Crypto Exchange

Regulation depends on token and IRegulated pursuant to Securities and REGULATION Limited regulatory presence by SEC/CFTC offering key attributes Exchange Act 1934

MARKETING Blockchain project Blockchain project Crypto Exchange

TRUST Low High (Tokens registered with the SEC) Medium

SECURITY Low High Medium

FEES Low issuing cost Low issuing cost Exchange listing cost

5 https://twitter.com/BittrexIntl/status/1106249536547237889

US REGULATION OF COIN OFFERINGS: REGISTERING YOUR TOKEN WITH THE SEC / 3 REGISTRATION WITH THE SEC

Multiple factors are involved when determining whether a new token • Are efforts by the active participant ‘undeniably significant ones’ which offering needs to be registered with the SEC. How a digital asset is ‘affect the failure or success of the enterprise’ as opposed to efforts structured, marketed, offered, and sold will influence whether or not the that are more ministerial in nature? SEC considers it a security. Many of these considerations are solidified • Can the digital asset be transferred or traded via secondary markets or within the Howey Test which we detail below. platforms, or will it be in the future? • Is the digital asset offered and purchased in quantities indicative To understand how the Test is applied to different types of token offerings of investment intent instead of quantities indicative of a user of the we also analyze SEC rulings within three use cases: network? 1. The DAO, • Are prospects for the appreciation in the value of the digital asset 2. Munchee Inc., and limited? For example, the design of the digital asset provides that its 3. TurnKey Jet. value will remain constant or even degrade over time. Keeping in mind the guiding principles of the Howey test, we look first to INTRODUCTION TO HOWEY the DAO company and how its ICO met the above criteria. Section 2(a)(1)6 of the Securities Act of 1933 and section 3(a)(10)7 of the Securities Exchange Act of 1934, layout definitions for what can be CASE 1: DAO TOKENS AND HOWEY considered a security. Both acts list ‘investment contracts’ as one of the Some of the first SEC guidance regarding securities registration for many financial vehicles that can be considered securities. One way to digital assets came in July of 2017 when the Commission issued its determine whether digital assets constitute investment contracts and thus investigative report11 concluding DAO tokens released in 2016 by The DAO securities under the above legal groundings is via the Howey test. We (Decentralized Autonomous Organization) were in fact securities. briefly touched on the Howey test, and it’s four main criteria in our previous article8. Slock.it created The DAO, a blockchain infrastructure platform provider, and made headlines in 2016 with its ICO upwards of The SEC has released new guidance regarding the Howey test and its $150 million equivalent of Ether12. Vulnerabilities in the blockchain were applicability to digital assets in April 2019. Valerie Szczepanik, the senior subsequently targeted in June and attackers made off with around $50 SEC advisor for digital assets and innovation (widely referred to as the million worth of Ether committed to The DAO. DAO tokens were then de- SEC’s Crypto Czar), and director Bill Hinman, released staff guidance listed from various crypto exchanges including Kraken13 and Poloniex14 on when digital assets may be considered investment contracts under later that year. applicable securities law. In a statement for the release of the guidance framework, the two clarified that the framework is simply the SEC staff The SEC found that investors in The DAO invested money, (although not views and “not a rule, regulation, or statement of the Commission.”9 in the form of fiat currency but Ether) with the reasonable expectation However, the guidance is still an important step in providing additional of profits, as The DAO informed investors that it was, in fact, a for-profit clarity to a regulatory environment that market participants have been company whose objective “was to fund projects in exchange for a return looking for maturity. on investment.15” The profits were also to be derived from the managerial efforts of others (not the purchasers of The DAO tokens) namely DAO The focus of the framework10 is centered upon what the SEC staff founders and Slock.it, who actively oversaw DAO business and operational characterizes as “usually the main issue in analyzing a digital asset management. In short, from the perspective of the SEC, the sale of DAO under the Howey test.” That is, whether the purchaser has a reasonable tokens met the necessary criteria within the Howey test for consideration expectation of profits derived from the efforts of others. Key questions as transactions that represent investment contracts. potential ICO issuers should ask themselves include:

6 https://www.law.cornell.edu/uscode/text/15/77b 7 https://www.law.cornell.edu/uscode/text/15/78c 8 http://capco.com/Intelligence/Capco-Intelligence/US-Crypto-Assets 9 https://www.sec.gov/news/public-statement/statement-framework-investment-contract-analysis-digital-assets 10 https://www.sec.gov/files/dlt-framework.pdf 11 https://www.sec.gov/news/press-release/2017-131 12 https://www.sec.gov/litigation/investreport/34-81207.pdf 13 https://support.kraken.com/hc/en-us/articles/115000313088-DAO-Delisting 14 http://www.econotimes.com/Poloniex-to-delist-27-altcoins-including-DSH-and-DAO-265860 US REGULATION OF COIN OFFERINGS: REGISTERING YOUR TOKEN WITH THE SEC / 4 15 https://www.sec.gov/litigation/investreport/34-81207.pdf CASE 2: MUNCHEE INC AND THE COMPLEXITIES OF HOWEY I would like to emphasize that the analysis of whether The Howey test, while encompassing, is not always straight-forward in something is a security is not static and does not strictly its application to specific digital assets. Bill Hinman, the director of the Division of Corporate Finance at the SEC, said as much in a July 2018 inhere“ to the instrument10. Even digital assets with utility that speech: function solely as a means of exchange in a decentralized “I would like to emphasize that the analysis of whether something is a security is not static and does not strictly inhere to the instrument10. Even network could be packaged and sold as an investment digital assets with utility that function solely as a means of exchange in strategy that can be a security16. a decentralized network could be packaged and sold as an investment strategy that can be a security16.”

The importance of this distinction becomes apparent when looking to the SECs case against Munchee Inc., a California-based app development In Munchee’s whitepaper17 released in October 2017, the company detailed company which offered and sold MUN tokens in late 2017. their mobile app-based restaurant review platform and the planned” distribution of MUN tokens. The tokens were to be offered as a reward by restaurants to their customers, to incentivize submitting reviews, pictures, and posts on social media about each restaurant. The document stated, “the MUN token holds utility for the consumer as a payment method at participating restaurants, for use in the Munchee app for rewards and interactions.” Regarding legal considerations, the white paper referenced the DAO report discussed above and explicitly stated: “a Howey analysis has been conducted to determine that, as currently designed, the sale of MUN utility tokens does not pose a significant risk of implicating federal securities laws.”

The SEC review of the token and Munchee’s ICO came to a different conclusion. The committee found18 that even if the MUN tokens acted as utility tokens to be used on the mobile app at the time, this did not rule out their classification as securities. “Determining whether a transaction involves a security does not turn on labeling – such as characterizing an ICO as involving a ‘utility token’ – but instead requires an assessment of ‘the economic realities underlying a transaction’”. The SEC then goes on to lay out why the MUN tokens would be considered securities under applicable securities law, much like it had done six months prior within its DAO report.

16 https://www.sec.gov/news/speech/speech-hinman-061418 17 https://www.theventurealley.com/wp-content/uploads/sites/5/2017/12/Munchee-White-Paper.pdf 18 https://www.sec.gov/litigation/admin/2017/33-10445.pdf

US REGULATION OF COIN OFFERINGS: REGISTERING YOUR TOKEN WITH THE SEC / 5 CASE 3: TURNKEY JET AND NEW 2019 SEC GUIDANCE On the same day in April 2019 that the SEC staff released its framework for According to the SEC, TKJ’s tokens were not utility tokens in name only. The investment contract analysis of digital assets, the SEC Division of Corporation economic realities underlying the transactions of TKJ tokens – including Finance made public a no-action letter19 responding to TurnKey Jet Inc.’s their pricing and distribution – were sufficient to exempt TurnKey Jet. from token sale. In response to a submission by TurnKey Jet Inc., an air charter registering the tokens as securities with the SEC. services company, the SEC agreed with the company’s legal opinion that their One of the widely levied criticisms of ICOs and their susceptibility to fraud ICO and resulting TKJ tokens do not have to register with the commission is that millions of dollars in funding can be raised in relatively short time under the securities and exchange acts. Among other considerations, the periods with the issuing company having little more than a white paper to key facts surrounding the TurnKey Jet. ICO and why its coins do not require back up their development claims. Companies like TurnKey Jet appear to registration under the Security and Exchange Acts include: be preempting these concerns20 by promising to have fully functioning and • No funds from the sale of the TKJ coins will be used to develop the TKJ operational networks by the date of the token release. platform • TKJ tokens are restricted to the TKJ platform only, and cannot be sold via external platforms • TKJ tokens will be sold for $1 USD and each TKJ token represents a TKJ obligation to supply air charter services at the value of $1 USD per token

LOOKING FORWARD

The world of digital assets is constantly evolving, with new 2019, the bills were sent to the subcommittee on commodity taxonomies and coin classifications emerging every few months. exchanges, energy, and credit for review. While these new The recent appearance of IEO’s as an alternative to ICO’s regulations are still pending, both the SEC’s no-action letter and clearly demonstrates this. STO’s as a regulated replacement to newly released framework guidance show that the commission traditional ICOs have already led to the tokenization of illiquid is willing to engage market participants and provide clarity when assets such as real estate and art. As we discussed in our earlier possible. Chief legal advisor of the SECs FinHub, Jonathan paper, Congress has introduced two bills21 to solidify digital Ingram, said as much in an interview with Forbes stating, “We asset classification in new SEC regulation and prevent price are open for business. And we want people to engage with us.22” manipulation within wider markets. In February

19 https://www.sec.gov/divisions/corpfin/cf-noaction/2019/turnkey-jet-040219-2a1.htm 20 https://www.sec.gov/divisions/corpfin/cf-noaction/2019/turnkey-jet-040219-2a1-incoming.pdf 21 https://www.congress.gov/bill/116th-congress/house-bill/923/ 22 https://www.forbes.com/sites/michaeldelcastillo/2019/04/03/sec-issues-historic-first-letter-saying-it-will-not-take-action-against-a-cryptocurrency-business/#5cf6a9ac53f1

US REGULATION OF COIN OFFERINGS: REGISTERING YOUR TOKEN WITH THE SEC / 6 AUTHOR Tyler Salathe [email protected]

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