How to Execute an ICO in the United States
TL;DR: Only ICOs that offer tokens that power the use of a working product are likely safe from SEC regulation.
Two months ago, the Ethereum community was rocked by an unexpected report: the SEC had finally come calling. Months of unregulated ICOs, surging Ethereum prices, and ballooning profits for anyone who could put their name on a token had unsurprisingly gotten the government’s attention. Their verdict: digital assets can be securities, and are therefore subject to regulation.
Therein, however, lies an important distinction — securities law does not apply to all digital assets, nor does it outlaw ICOs out of hand. According to a “client alert” issued by the Reed Smith law firm, the SEC’s report is actually quite valuable for the blockchain community, as it “acknowledges the legality and validity of ICOs that comply with applicable federal laws and regulations…”
The SEC report in question referred to a specific token sale by the DAO, an erstwhile investor-directed VC fund that suffered the largest Ethereum heist to date, leading to a hard fork in the Ethereum blockchain to restore investor’s funds. Here are the two most relevant sections from the SEC’s press release regarding ICOs and securities:
“…the federal securities laws apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology.”
“Whether a particular investment transaction involves the offer or sale of a security […] will depend on the facts and circumstances, including the economic realities of the transaction.”
Importantly, the SEC noted that which token sales fall under securities regulation depends on the “facts and circumstances.” But what does that mean in practice?
Let’s Get Some Background
As the value of Ethereum skyrocketed in the last year, the blockchain community has witnessed the tremendous desire of network users to put their ether to work. It’s as if people had been playing Monopoly, and all of a sudden their pink and orange dollars were real — of course they want to start buying hotels.
This urge to spend ether and invest in the Ethereum network has led to an “ICO fever,” in which companies solicit contributions for tokens attached to prospective products with no obligation to deliver on their promises. Many people would buy tokens hoping that they would rise in value after the ICO, allowing them to cash out without ever using the proposed product. In these circumstances, there have been a number of high-profile instances of companies raising large amounts money without ever delivering a working product, more or less running away with investors’ money. Unsurprisingly, the SEC came calling.
What Constitutes a “Safe” ICO?
Earlier this year, before the SEC released its report on the DAO coin offering, BlockMason received expert legal advice and began to pave a path forward for an ICO that complied with U.S. securities law. The SEC’s report confirmed everything about the advice we had received and the path we were following. That is why we are ready to do a U.S. securities law-compliant ICO immediately after the SEC report. Based on the wording of the report, and our own extensive legal research, we believe there are only two secure types of ICOs that can operate without fear of exchanges shutting down token trading:
An ICO that goes through a traditional registration process with the SEC.
An ICO that offers product-use tokens, NOT investment tokens.
Differentiating Investment Tokens and Product-Use Tokens
The most significant question when considering whether an ICO falls under SEC regulation is whether or not the company has a working product at the time of the ICO.
In our opinion, ANY ICO THAT IS NOT BASED ON AN EXISTING PRODUCT IS IN DANGER OF BEING A SECURITY.
This is because token sales based only on theoretical or promised products usually fail what is known as the Howey Test for whether an arrangement constitutes an investment contract. For blockchain token offerings, three separate elements of Howey test must all be met for the token to be a security.
An investment of money
In a common enterprise
With an expectation of profits predominantly from the efforts of others.
If an ICO is not attached to a working, or at least beta-version, product, then the company is inevitably offering inducements for investment by marketing its team and its vision for the product’s future, implying the value of the token will rise based on the efforts of the team. If people purchase the token with an expectation of profit based on the actions of a team, its management, and its ability to make their purchase more valuable, then that will achieve automatic scrutiny from the SEC. Such investment tokens generally require little to no action on the part of the purchaser to achieve profit. This could describe any tokens associated with revenue sharing, equity, or tokens that don’t have an actual use — hence, their only value comes from trading.
The same Supreme Court case that established the Howey test notably exempted sales that offer the use or consumption of a product.
According to “Securities Law Analysis of Blockchain Tokens,” a report issued by the law offices of Debevoise & Plimpton, when considering the Howey Test, one must examine how token holders may profit from owning tokens:
“While non-security Blockchain Token holders may receive money or other forms of financial incentives by virtue of holding the token, we believe that any such incentives are derived through their own efforts, rather than through a passive investment (as would be the case with a Blockchain Token security).”
Therefore, a customer may purchase an ICO token with the expectation of profit, as long as that profit is not passively obtained. In considering this proposition, one can examine what rights, licenses, or actions are enabled by owning a token. The brief continues:
“Essentially, each of the rights allows the non-security Blockchain Token holder to utilize, contribute to or license the use of the system in various ways, none of which would be considered a passive investment. Rather, we see the non-security Blockchain Token holders as active participants, like franchisees or licensees.”
Such tokens describe what Coindesk founder Daniel Masters calls a “protocol coin,” or tokens that allow holders to somehow use or access a product that previously did not exist. So, what are some good examples of product-use tokens that would likely pass SEC scrutiny? Apropos recent ICOs, Filecoin provides a pretty decent model for a product-use token, as token holders gain access to a system facilitating distributed data storage. Where Filecoin may have gotten into hot water is their lack of a working product at the time of their ICO, though they avoided any sticky issues with the SEC by executing their ICO through CoinList and only selling to accredited investors.
Other blockchain companies, like REX, have recently blustered about how their product is “regulation-ready.” However, they still have opted out of allowing U.S. customers to participate in their forthcoming ICO — likely because REX’s tokens would almost certainly be considered a security, if for no other reason than that their marketing emphasizes the ability to convert their token into fiat currency, inducing investors with their belief that the REX coin will rise in value. It is worth noting, though, that the presence of a secondary market for tokens does not necessarily make the token a security. Once more, from Debevoise & Plimpton:
“We note that appreciation in the value of a non- security Blockchain Token after issuance, due to secondary trading, does not change our view that it is not an investment contract. For example, the value of license or franchise right can increase over time due to the secondary market. Such increases in value derive both of the efforts of the holder and from the system itself, so we do not view such changes as decisive.”
In this case, secondary trading is not the primary use or purpose of the token. The Debevoise & Plimpton report expounds on a number of token “rights” that would likely disqualify a token from meeting the definition of a security:
Rights to program, develop or create features for the system or to “mine” things that are embedded in the system;
Rights to access or license the system;
Rights to charge a toll for such access or license;
Rights to contribute labor or effort to the system;
Rights to use the system and its outputs;
Rights to sell the products of the system; and
Rights to vote on additions to or deletions from the system in terms of features and functionality.”
Any token that grants these rights would in all probability constitute a product-use token. Such considerations would likely apply even if the rights of the token could be granted by the token holder to another party, akin to software sublicensing or the selling of franchise rights.
The Credit Protocol ICO and our Product-Use Tokens
Recently, BlockMason published a legal opinion from Stephen Galebach analyzing the SEC report on the DAO token offering, examining court precedent, and explaining how the upcoming Credit Protocol ICO passes the Howey Test, making it legal to sell tokens to customers in the United States. Galebach has broad lawyering experience in the tech world; he was IPO manager for the largest Internet IPO in US history (Genuity Inc., June 2000, record broken 12 years later by Facebook), in addition to serving as an editor of the Harvard Law Review, a senior aide to the U.S. Attorney General, and a legal policy advisor in the White House. In drafting his legal opinion, Galebach also consulted with a former SEC official. We invite you to read Galebach’s 30-page legal opinion; its in-depth analysis speaks for itself.
Based on Galebach’s legal opinion, we believe BlockMason’s Credit Protocol (CP) token is firmly a product-use token, and therefore not subject to SEC regulation. Unlike virtually every other major ICO, BlockMason offers a product that is already functional, and has even deployed a working application atop the protocol, Friend in Debt. This draws a clear and severe distinction between our forthcoming CP ICO and the DAO token sale. According to Galebach:
“The DAO had only concepts and future hopes to sell to purchasers, not market-ready products and services. Enterprises that have developed products and services, on the other hand, are able to motivate purchasers by a desire to use or consume the products and services that are offered for purchase, licensing or token-based usage.”
Based on this understanding, Credit Protocol Tokens (CPT) are clearly product-use tokens. CPT enables purchasers to use the Credit Protocol itself, to power applications they build atop the CP, or to use in other CP-based applications, like Friend in Debt. In this way, CPT are akin to a perpetual software license, with each token allowing the holder a certain number of transactions on the Credit Protocol, that may then be “sublicensed” to other users, either for free or for profit. Once more, from Galebach:
“This element becomes all the more significant when the product or service can be further developed and enhanced, marketed or sold or sublicensed, by the purchasers of rights to use it, whether those rights are sold in the form of tokens or any other manner.”
Because the CP is open source, CPT holders who sell the rights to their CP transactions have the opportunity to act as value-added resellers. Any token holder may build applications atop the CP, to which they can apply the transactions granted by their CPT, increasing the value of the network without the efforts of the BlockMason management team. This possibility means that the Credit Protocol ICO likely fails the definition of common enterprise, because token holders may build applications that are only usable by the developers themselves, and not the entire cohort of token holders. To satisfy this condition, Galebach describes “a system that does not rely on concerted effort to create, update or enhance such as where independent actors use the base code for a variety of unrelated activities (for example, IBM’s Watson can be used for many different purposes by independently operating groups).” This is the CP in a nutshell.
So What’s the Big Deal?
Considering these factors, BlockMason is confident that CPT does not constitute a security. And, unlike other blockchain companies, we are willing to stand behind our belief by OFFERING OUR TOKENS FOR SALE IN THE U.S.
Any company that opens an ICO, but does not offer their token for sale in the U.S. confirms their fear that their token is at risk of SEC regulation. CPT is demonstrably a product-use token that can be immediately used on the CP or in applications like Friend in Debt. Token holders may employ their CPT in applications of their own development, or applications developed by BlockMason or other companies.
We understand that it is possible that secondary markets for CPT will arise, or that CPT will be listed on crypto exchanges. This is not the primary purpose of CPT, and BlockMason neither encourages nor discourages such secondary markets. Furthermore, users who buy CP Tokens are pioneers in a new technology, and it may be difficult for purchasers to know how many tokens they need for their intended use, development, and marketing purposes. Some will need to buy more, some will have excess to sell. Thus the exchanges fill an operational need for these initial customers, especially given that the total number of CP tokens is capped.
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