August 18, 2017
“Token Sales” & ICOs: Food for Thought
In response to my recent blog about “initial coin offerings” (also known as “token sales”), Margaret Rosenfeld of Smith Anderson sent me this interesting note:
1. It’s Real – The crypto-economy is a reality and this is not fringe anymore – but frontier. I can remember when I practiced outside the U.S. before Regulation S was adopted. As practitioners, we had to grapple with how to fit into the SEC regulation regime. There were many cowboys, there were many conservatives and there were many of us right down the middle, which is where Regulation S ended up being.
2. Bankers Are “In” – There are many people taking advantage of the crypto-economy. Bankers that will do an accredited investor ICO for you in exchange for 50% of the raise are using the SEC’s Section 21(a) Report to tell people that the SEC is coming down hard on ICO’s and everything done will be considered a “security.” Why are they promoting this so strongly? Very obvious.
3. Millennials Love It – The driver of the crypto-economy is the millennial generation, which now has purchasing power. They want disruptive, socially conscious ways that differ from their elders.
4. SEC’s Position Is Howey Test Applies – Most of the law firm memos written about the SEC’s Section 21(a) Report note that it didn’t state that every ICO is a securities offering. The Howey test applies. Many digital assets are being sold primarily for non-economic purposes. Note that many of us active in the crypto-economy are working to use consistent nomenclature and call these “Tokens” and “Token Sales” rather than “Coins” and “Initial Coin Offerings.”
By the way, here’s an example of a Token Sale that is trying to do it the right way after the SEC’s Section 21(a) Report.
5. Game Theory Involved – There is a lot of “game theory” involved in this economy. Millennials grew up on gaming.
6. The Securities Law Question – This is the most important question facing the cryptoeconomy right now on the regulator front: If the primary purpose for someone’s purchase of a Token is for a non-investment reason – but the Token’s value can increase or decrease, does that make it a security?
Think of Chuckie Cheese, a millennial breeding ground. Kids put money into machines to play the games. They got tickets. They compete with their friends to get tickets and to see who is the best at the game and has the most tickets at the end. The tickets end up having a value because they can be traded in for cheap trinkets. Are the kids putting the money into the machines to play the games, to compete and be the big winner or for the trinkets (which shows value)? My kids often went home with tickets in their pockets. My son actually stockpiled his tickets.
In the case of tokens, the Buyer is primarily buying for something other than a potential investment. For example, the Buyer may get a right to participate in a future event to vet and approve projects of the company (I purposefully use those words rather than voting). As a company builds a community of tokenholders and grows more successful, those tokens can increase in value. If there is a limited supply of tokens and a demand builds to have those tokens to join the community, a market develops to trade those tokens. So, will the SEC take the view that those tokens, which a buyer bought for a non-investment purpose, is a security because their value can increase?
Think of it this way. I buy a house in a nice community. It has a HOA and I have a vote to decide where HOA money is being spent and other HOA matters. If it is a good HOA, arguably the right I have to vote (my Token) and participate in community activities may be increasing the value of that community and my token. If my house goes up in value, is that a security?
7. Moving Outside the US Probably Doesn’t Solve – Does incorporating your company in the Caymans and stating that “US citizens cannot participate” work? Law firms out there are advising this and allowing securities to be offered. Really? These websites are not blocking ISP addresses in the US. Putting your company offshore and allowing offering materials flow into the US does not mean you are not subject to the US securities laws (uh, Regulation S anyone?).
Individuals may think they are protecting themselves – but if you are physically on the ground in Florida and doing this, I expect the SEC Staff will be calling you.
Six Possible Approaches
AND, the people participating in this economy from the beginning are trying to be disruptive. They want to make changes to the world and create a global currency that helps all. They don’t want to limit things to “accredited investors.” So here are six approaches that I see:
– Structure it as a true utility sale – a Token Sale. It must be a product that has real rights and not a primary purpose for investment. And you must say that clearly and often in your disclosure.
– When you launch your pre-sale, you must already know clearly what those rights are and state them. You can add to those rights, but you must analyze before the pre-sale (which is a right to be converted into the eventual token sold at a discount) whether it is a utility or a security. Pretty obvious but many out there are diving in without doing this and being advised that it is okay.
– Anti-fraud applies. Duh. Don’t lie. Disclose risks.
– Don’t fuss around with the offshore and limits. Pillar did this and found that the limits killed its raise. It restructured. Folks are smart and wonder why are you putting this in the Caymans.
– If it is not a utility, structure is as a security. Do it right. And let’s as a community try to find bankers who will not gouge the companies with crazy fees.
– Right now, 506(c) approach is what is being done for the private placements. This is good. BUT I would like to work with the SEC to see if we can use Form 1-A to come up with a standard ICO approach. I think it could work but the SEC has to be willing to be nimble about review on this.
I have been around a bit – practicing securities law since 1997 – and seen many trends. This is a paradigm shift in the economy. I was in Jakarta a month ago and watched a waiter pull out his phone so that he could buy into an ICO. I got to talking with him and learned that the stability of cyber-currency was a huge attraction for Indonesians.
I am usually a debunker of trends – but I predict in 10 years there will be a global crypto-currency that dominates. Remember how we grew up and there were just three channels on TV! Could you imagine sitting in front of a TV with 300 when you were 10? The future is now. Believe it or not, there are already 10 token/coin offerings that are targeted to be announced at Burning Man at the end of the month…
– Broc Romanek