Blockchain companies have raised billions of dollars through Initial Coin Offerings (ICOs) this past year. Has it all been legal? Have all the correct taxes been paid? Are all the companies issuing the coins operating legally?
The answer may likely be “no” to at least one, or perhaps all three, of these questions. If you are considering a blockchain enterprise and an ICO and want to abide by the law, or want to assure that any company in which you are participating is abiding by the law, here’s a five-part primer on the issues to consider.
Parts 1 and 2 of this series address the basic securities law questions. Part 3 will discuss the tax issues. Parts 4 and 5 will address some of the many operating issues.
Part 1: The Securities Quagmire
The U.S. securities laws regulate the offer and sale of “securities,” and those laws in most circumstances impose expensive registration and reporting requirements on securities transactions. Securities transactions which don’t comply with these laws expose the sellers to significant fines, potentially prison sentences, and expose the buyers to potential financial losses.
Under a seemingly ancient standard from the mid-1940s known as the “Howey test,” the United States Securities and Exchange Commission (SEC) defines a transaction to involve a securities contract, when:
- It is an investment of money;
- There is an expectation of profits from the investment;
- The investment is in a common enterprise;
- Any profit from the enterprise comes from the efforts of a promoter or third party.
If a company is raising funds to develop a token to be distributed later to investors, then the company is likely selling securities under U.S. law. This type of transaction is technically not an ICO, but rather is more akin to a token presale, and it is virtually certain that the SEC would assert jurisdiction over it if the marketing is aimed at or the investors include US citizens. It is for this reason – because a failure to register the sales or offers to US citizens could constitute a violation of the law – that many token pre-sellers explicitly bar U.S. investors. Of course, in the virtual and crypto world, policing a U.S. citizen ban is problematic, to be charitable.
For real ICOs, there are exceptions to the registration requirements under the securities laws, such as sales which are limited to wealthy accredited investors, sales to no more than 35 sophisticated investors, or sales under the SEC’s Regulation Crowdfunding. Some token offerings take advantage of these exceptions – it is do-able. But many do not because, realistically, the blockchain enterprises need to raise relatively small amounts of money from many sources and not large amounts from a few sources, or they simply won’t have the funds to comply even with the far less burdensome requirements of these types of sales.
If a company has completed development of a token and is distributing the token in a public ICO, the experts can begin their debate. The SEC’s position is relatively firm: registration is required, but the law and the SEC leave some small amount of daylight.
Twice in the past two months, the SEC or its Chairman, Jay Clayton, has issued public statements on cryptocurrencies and ICOs, telling blockchain startups and their promoters that they may be violating the securities laws, and warning ICO investors that they may be risking their investments.
The next segment of this series will analyze these recent statements.
For more information about blockchain and cryptocurrency law, please contact Edward Tolchin at firstname.lastname@example.org.
ABOUT EDWARD TOLCHIN
Edward Tolchin is a Principal and Chair in the firm’s Government Contracting practice group. Mr. Tolchin’s practice is focused on government contracting, business litigation, and technology matters. In the technology arena, Mr. Tolchin has assisted in disputes, licensing, and business development matters for clients ranging from startups to Fortune 500 companies. Mr. Tolchin’s interest in and knowledge of technology issues also has enabled him to assist clients involved in security and privacy disputes and business issues in the cyber arena. Mr. Tolchin has an active blockchain practice and has written and spoken regarding the legal perspectives of blockchain enterprise development and cryptocurrencies.
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