Compliant ICOs: U.S. Securities Law Notes
2017 has been a big year for ICOs. So much so, in fact, that it is difficult to keep up. With so many entrepreneurs entering into the fray, regulators are beginning to worry about investor safety. The SEC, which is the primary regulator of securities offerings, has expressed concern that most ICOs may be violating securities laws in one form or another. They have come out with formal actions against a few token sales and telegraphed to the community that they will be analyzing ICOs on a case-by-case basis using tried and true criteria that have been around for over 80 years. This has many people in the industry searching for the formula for a safe and compliant initial token offering. In this article, we’ll summarize a few of the most popular and promising proposals, as well as some helpful criticisms to see where we are on the road to a trouble-free token sale.
SAFT
The first attempt at a securities-law compliant framework to gain traction was the SAFT. Released in October, the Simple Agreement for Future Tokens, or SAFT, was created by Marco Santori of Cooley, NY, in connection with Protocol Labs. The SAFT uses a two-step approach that relies on two key assumptions about tokens and securities laws. First, it assumes that the level of functionality a token offers is one of, if not the, key factors that implicates whether a token is a security, and triggers securities laws filing or exemption requirements. The second assumption is that a token with little functionality is a security, but once sufficient functionality is built in, it ceases to be so.
Based on this assumption, in phase one, an entrepreneur using a SAFT will issue rights to acquire tokens at some future date. Because these rights have no current functionality, the authors of the SAFT assume that purchasers will be drawn to them for their speculative value, which means they are most likely securities. To comply with securities law requirements, this sale is made only to accredited investors in what is known as a Reg D offering, a common exemption under federal securities law. Once the token issuers have built out the token’s underlying functionality, presumably from the money raised in phase one, they enter phase two. At this point, the SAFTs sold in phase one convert into the proprietary tokens and can be freely traded. Presumably, at this point, consumers will be drawn to the token for its utility value, not its speculative value. Ergo, the SAFT framework assumes, the tokens are no longer securities and no longer need the protection of the Reg D exemption, so sales are opened up to the general public.
The advantage of the SAFT approach is that it offers issuers certainty in phase one because they are operating within the well-defined contours of the federal securities laws. There are, however, several drawbacks.
The assumption that a pre-functional token is per se a security is unsupported, and may prove overly-broad, thus unnecessarily deterring token issuers from accessing funds from non-accredited investors. Many pre-functional token sales closely resemble the pre-sale of goods are services that are not considered securities. For example, Kickstarter funding campaigns sell products in advance, then use the proceeds to develop and manufacture the pre-sold goods. These activities do not constitute securities.
The Cardozo Blockchain Project published a response to the SAFT proposal in November of this year. They identified several other potential drawbacks to the SAFT. First, they take issue with the way the SAFT addressed a prong in the securities law test focusing on the promoter’s efforts. In short, the SAFT says that a security must rely on the efforts of the promoter, and once the token is functional, the promoter’s efforts have been expended and are no longer needed. Thus, the token ceases to be a security at that point. The Cardozo response points out that in applying the test, courts have been persuaded by the importance of the seller’s efforts, not the timing.
The Cardozo response also worries that the SAFT draws dangerous attention to itself by emphasizing the investment-nature of the phase one sale. The argument goes that because the SAFT complies with federal law in phase one, it does not shy away from marketing itself as an investment opportunity. However, this might invite increased scrutiny from the SEC once the project moves to phase two, and it is by no means certain that a phase two token will survive this scrutiny.
Finally, the Cardozo response argues that SAFTs misalign issuers’ incentives and could harm consumers. They fear that SAFT issuers will seek only to profit from a short-term token sale and then “rush to market without sufficient technical development, business model ideation, or technical diligence.” This argument, however, seems overblown and unsupported. The results that the authors predict from the SAFT seem an accurate description of the concerns that currently beset the ICO model. It is unclear how a SAFT would be less safe than the status quo. Token sales that do not follow the SAFT model lack structural incentives to prevent short-term profiteering, and to ensure thorough functionality. It seems counterintuitive that issuers who are initially beholden exclusively to sophisticated and institutional investors will be incentivized to play fast and loose, while issuers selling to the general public will be compelled to act responsibly.
The SAFT model is clearly not without drawbacks or risk. Nevertheless, it is becoming increasingly more accepted as a path to a compliant ICO.
Angel List and Republic
Another framework to a compliant ICO takes a dual-track approach as proposed by Angel List and Republic. This approach involves bifurcating token offerings into two separate exemptions under the federal securities laws. Like the SAFT, the Angel List approach tailors a token sale to fit within the Reg D exemption, meaning that securities are only sold t accredited investors. Unlike the SAFT, this approach sells actual, pre-functional tokens instead of rights to acquire tokens at a future date. The second track, proposed by Republic, a subsidiary of Angel List, allows issuers to sell tokens to the general public under the crowdfunding exemption found in Section 3 of the JOBS Act. Section 3 permits the sale of unregistered securities to the general public through crowdfunding portals. Issuers must comply with several restrictions, such as only selling through a designated and registered funding portal. Additionally, they are limited to raining $1 million per year, and individual investors are limited in how much they can invest.
The Angel List/Republic approach offers several advantages over the SAFT. First, the question of whether the tokens are functional or pre-functional, or whether or not they are securities is moot, because all sale are made in compliance with regulatory exemptions. Second, while the SAFT reaches accredited and non-accredited investors, it does so sequentially, limiting participation in phase one to accredited investors only. The Angel List/Republic dual-track approach can operate simultaneously, allowing general investors to participate at the earliest stages.
On the other hand, this approach is limited by the stringent restrictions placed on crowdsale securities offerings. Issuers may have limited use for $1 million dollars per year and the cost of ensuring that their offering complies with Section 3 may outweigh the benefit.
tZERO
Unlike the SAFT and Angel List/Republic solutions which propose a framework for issuing tokens under exemptions to federal securities laws, tZERO offers an exchange where tokenized securities can trade. tZERO is registered with the SEC as an Alternative Trading System. This allows it to operate as an exchange for registered securities. This is the key difference between tZERO and the SAFT or Angel List/Republic. While the others try to create exempt securities offerings, tZERO offers issuers a blockchain-based exchange or registered equity tokens. This offers a blockchain-based alternative to issuers who would ordinarily access the capital markets through the sale of traditional registered stock certificates. These issuers can now issue digital equity as tokens, rather than shares of stock, and can do it on tZERO’s decentralized exchange. tZERO has stated its ultimate goal is to attract enough capital to make for a highly liquid tokenized equity exchange. In fact, a tZERO spokesman has stated that he hopes it will become the largest exchange in the world.
The one clear drawback to the tZERO approach is that issuers must comply with federal securities law requirements for registered securities. This means, among other things, corporate governance and regular financial reporting requirements that are both time consuming and expensive. For issuers prepared to shoulder this burden, a tZERO equity token sale, because it is registered like traditional equity securities, should be a known quantity that offers regulatory certainty. Perhaps the biggest advantage to the tZERO approach over the other frameworks is the liquidity that the exchange would offer if it reaches its stated potential. At present, liquidity in all but the largest cryptocurrencies is relatively thin across all exchanges. So while tZERO is still in its very early stages and appears to cater towards later-stage companies, it provides a potential path to a compliant ICO.
What We’ve Learned So Far.
The fact that there are multiple frameworks for safe and compliant ICOs is good news. As regulation begins to crystallize and market participants move to operate within the law, investor safety and confidence is bound to improve. The SAFT is a novel approach that gives accredited investors access to instruments that convert to tokens at a time when they become available for sale to the general public. Angel List and Republic offer a two-pronged approach to access both accredited and non-accredited investors, but significantly restricts participation from the latter group. Finally, tZERO eschews regulatory exemptions by registering tokens with the SEC and opening issuers up to the requirements that this entails.
Each of these frameworks takes a different approach to the same problem: how to sell tokens within the requirements of the federal securities laws. It is important to note that none of these approaches has been embraced by the SEC. In fact, in a recent statement from SEC Chairman Clayton, he made veiled criticism of both SAFT-like products, and token trading platforms like tZERO.
What we have learned definitively is that the SEC is going to rely on fundamental principles of securities law as it approaches digital tokens. Here are a few key takeaways:
Promises matter: The more an issuer touts a return on investment, such as through a profit sharing model, the more likely the token is a security
Functionality matters: While the SEC has not embraced the SAFT’s black and white distinction of non-functional = security and functional = not a security, they have indicated that a token with no functionality is likely to be a security.
Marketing matters: In a cease and desist order to the issuers if the Munchee token, the SEC placed serious weight on the claims that the issuers made in marketing the token, namely that investors could expect the value of the token to rise. They also highlighted the plan of distribution, pointing out that tokens were only marketed to investors, not to people who would be interested in actually using the token.
2017 is just about in the rear-view mirror, and what a wild ride it was. While there is still much uncertainty, we have learned a great deal so far about what makes an ICO safe and compliant from a federal securities law perspective. 2018 will undoubtedly prove to be a banner year for the coming together of a cogent regulatory framework and innovations from participants on maximizing value while complying with legal requirements. To keep abreast of how events unfold, be sure to follow along with Uinta Blockchain Research.