To begin any good story you must start at the beginning to gain a full background understanding of the plot. Back in 1946 a group of ‘citrus’ farmers in Florida had a bright idea to sell plots of real-estate to wealthy folks in the north with mostly no agricultural background. They then offered a leaseback situation to the buyers, who most gladly accepted, to lease the land back to the growers, allow them to harvest the land and sell the fruit. The situation that was just described to you is the entire backing of the case (SEC v. Howey) and the creation of what is still the basis of securities law in the United States.
What does this have to do this the Blockchain and cryptocurrencies?
The last 6 months I have spent solid portions of my time masquerading as an attorney, a student, an activist of sorts, and discovering the power of politics and regulations within the US. I have had the opportunity to engage in dialogues with everyone from defense attorneys who have recently traded blows with the SEC, former SEC regulators and the Colorado Securities Exchange Commissioner Gerald Rome himself. From these conversations I have been exposed to both sides of the securities discussion and learned what a truly grey area that the Blockchain and cryptocurrencies live within in the United States. From my technology based perspective I will explain securities and the regulations surrounding them, from what I have learned.
The SEC’s thoughts
The definition of securities can be found throughout the web with ease and can span several pages in length. To test for a security however, the SEC only needs to rely back on their old friend the ‘Howey Test’ that we mentioned earlier. What are the Howey Test criteria? Let’s go over them:
Is it an investment of money?
Is there an expectation of profits from the investment?
Is the investment of money in a common enterprise?
Do any profit comes from the efforts of a promoter or third party?
If this list seems oddly vague, it is because it is, not just vague, but explicitly vague. As we discussed before it was written in 1946, in response to the citrus farm situation we explained. If this list does not already seem like a catch-all, I was able to hear a prominent member of the SEC explain that in his mind it only requires criteria number 2 to be a security “Is there an expectation of profits from the investment?”. This means that in the eyes of the SEC, if you are not an ‘accredited investor’ you are unable to invest in basically ANYTHING, including Initial Coin Offerings.
Utility Token?
Many of the blockchain companies and startups that I have spoken with seem to think that the token they are creating is a utility token. This is a very tricky idea to play with for a lot of different tokens and was finally explained to me fairly well with Chuck-E-Cheese as the analogy:
Scenario 1:
If you own a Chuck-E-Cheese and you sell tokens to people in order for the tokens to be used in the machines to play the games.
Likely Result 1:
This is NOT A SECURITY and resembles a utility token. The token’s value is the ability to use it within your Chuck-E-Cheese and does not introduce any expectation of profit to the token purchaser.
Scenario 2:
Now let’s say we are about to open a new Chuck-E-Cheese, because we are short on cash we decide to sell the same tokens to people in advance for a discounted price. Once the new location opens we will limit the availability of tokens and allow the token holders to resell them to patrons and collect a profit.
Likely Result 2:
The sale of the tokens before the location was opened in itself IS A SECURITY. Even though the tokens eventually will represent a utility token within the Chuck-E-Cheese, at the time of purchase the tokens were not ‘in use’. This is easy to see the ‘Howey Test’ failure for Initial Coin Offerings under rule #2 (Is there an expectation of profits from the investment?). The token purchasers bought the tokens in advance for a discounted price and reasonably could have expected to earn a nice profit on their purchase.
The main point to this example is that a token qualifying as a ‘Utility Token’ in itself is not a security, but the sale of these tokens at a discounted price before the token is ‘in use’ is a security. Makes sense right
So what options are we left with?
If you are interested in holding an ICO or participating in one, unfortunately there are not yet any black-and-white answers for you. As any good attorney would tell you ‘It Depends’, and from the full spectrum of feedback I have received, that is that absolute most correct answer.
OPTION 1: Do not register
In the current state of ICO’s within the US, the first option that I have heard is to not register your token as a security and proceed with an ICO. At the moment this might not seem like too bad of an option, the SEC has only once truly announced any position on ICO’s and haven’t taken any aggressive action towards companies that have held them. To me the question here is not ‘if’ it is a matter of ‘when’. As with any ‘stack’, the bottom of the stack cannot be reached until everything on top of it has been processed.
Many people think that if they have their company based outside of the US in a country such as Switzerland that the they will be beyond the reach of the SEC. Unfortunately the SEC is not so much concerned with where you are based, but who you are selling your tokens too. If just one US citizen purchases your tokens and files a complaint with the SEC you can be held liable, and they have a further reach than most could imagine.
OPTION 2: Reg D 506 C
Within the US Regulatory web this is probably the easiest option for most companies when holding an Initial Coin Offering.
Some of the benefits include:
You do not have to register this ‘offering’ with the SEC prior to your ICO, it can be done after the conclusion of the ICO, so you do not need to delay the start date and generally much less expensive
General solicitation is allowed including: television, newspapers, internet ads
Some of the drawbacks include:
Can only be sold to accredited investors white greatly reduces the number of potential investors
You as the issuer are responsible for taking “reasonable steps to verify” the status of the investor, this costs money and due diligence
OPTION 3: Reg A or Reg A+
This option is more restrictive for several reasons than a Reg D 506C filing, in terms of the amount of capital you can raise, but much less restrictive on who can participate in your ICO.
Some of the benefits of both include:
No restrictions on who can participate, your tokens can be sold to anyone within the United States.
With Reg A you can raise up to $20,000,000 within a one year period, with Reg A+ you can raise up to $50,000,000 within the same period.
Some of the drawbacks include:
Usually takes about 6 months to prepare and file either offering.
Generally costs upwards of $100,000 to have these offerings prepared.
Final Thoughts:
Obviously there are more options out there yet to be explored, one of my absolute favorite being the idea of ‘token cooperatives’. In my quest for knowledge I came across ‘cooperative law’ and think this might be an extremely viable option for certain tokens to take advantage of the cooperative model and the security exemptions that it offers (I encourage you to look into this some more and am open to talking to anyone interested in this application). We are still at the forefront of the Blockchain revolution and as with any young industry, the government and regulators have yet to give us much feedback on our situation.
Never fear, us entrepreneur are relentless in our pursuits and will find a way. Remember,
the SEC does not actively search for companies to prosecute, they only investigate companies that are reported to them by unhappy investors. So always try and stay within ‘the spirit of the law’ and follow as close to it as possible with whatever route you decide to pursue. Be transparent, keep open lines of communication between you and your investors, and take the time to learn as much as you can about your options. Call as many attorneys as you can, be open to critical feedback and be ready for a lot of skepticism.
Check out BUILD1x and BuildCoin, and read our White Paper for more information about BUILD1x, the BuildCoin ICO, and how you can become involved.
By: Mark Hoyt; BUILD1x CTO