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.
Part 1 of this series, which introduces the securities law questions, appears here. Part 2, below, continues to address the securities issue. Part 3 will discuss the tax issues. Parts 4 and 5 will address some of the many operating issues.
Part 2: The Securities Quagmire Continued
On November 1, 2017, the SEC cautioned against illegal ICOs and their “unlawful promotion” by “celebrities and others.” You can read about one such scheme here, promoted by boxer Floyd Mayweather.
The SEC’s November 1, 2017, statement repeated its prior warnings that “virtual tokens or coins sold in ICOs may be securities, and those who offer and sell securities in the United States must comply with the federal securities laws. Any celebrity or other individual who promotes a virtual token or coin that is a security must disclose the nature, scope, and amount of compensation received in exchange for the promotion. … Persons making these endorsements may also be liable for potential violations of the anti-fraud provisions of the federal securities laws, for participating in an unregistered offer and sale of securities, and for acting as unregistered brokers.”
On December 11, 2017, Chairman Clayton explained that “to date no initial coin offerings have been registered with the SEC.” Given this circumstance, Chairman Clayton warned investors of the risks of these ICOs, and told those in the industry, once again, that token offerings often represent an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others, and therefore securities law registration is required.
Professionals in the industry, in the past, have differentiated securities type tokens and “utility tokens,” the former which require registration and the latter which don’t require registration according to the professionals. A securities type token has no utility other than representing the value of the issuing source. Utility tokens are coins whose value derives from their usefulness on the blockchain program with which they are associated, and not from their speculative value as a share in the blockchain enterprise that issued them. For instance, a token that allows access to or use of a blockchain transaction could grow in value based on the transaction value, but it would not grow in value based solely on the value of a blockchain enterprise.
In his December 11, 2017, statement, Chairman Clayton warned that “certain market professionals have attempted to highlight utility characteristics of their proposed initial coin offerings in an effort to claim that their proposed tokens or coins are not securities. Many of these assertions appear to elevate form over substance. Merely calling a token a ‘utility’ token or structuring it to provide some utility does not prevent the token from being a security. Tokens and offerings that incorporate features and marketing efforts that emphasize the potential for profits based on the entrepreneurial or managerial efforts of others continue to contain the hallmarks of a security under U.S. law.” Mr. Clayton explained that: “… a token that represents a participation interest in a book-of-the-month club may not implicate our securities laws, and may well be an efficient way for the club’s operators to fund the future acquisition of books and facilitate the distribution of those books to token holders. In contrast, many token offerings appear to have gone beyond this construct … Prospective purchasers are being sold on the potential for tokens to increase in value – with the ability to lock in those increases by reselling the tokens on a secondary market – or to otherwise profit from the tokens based on the efforts of others. These are key hallmarks of a security and a securities offering.”
The SEC’s statement lacks clarity, to be sure. But, it is important to those in the industry to understand that Mr. Clayton did not say that every token issuance is a securities offering. So, there is a class of token issuances out there that may pass a non-securities muster. But, Mr. Clayton left little doubt that the SEC would take an expansive view of what is an improper, unregistered ICO. In fact, the SEC recently filed a fraud suit against the organizers of the PlexCoin ICO, which has been called one of the more slap dash, comical offerings in recent history. The SEC also halted the Munchee ICO, which touted its token sale as a way to raise cash for operations, using some interesting over-the-top marketing claims which could rubify even a snake oil salesman’s cheeks.
Given the SEC’s aggressive positions, the industry has moved in two different directions. Some blockchain entrepreneurs are planning to register, a process which is expensive but not impossible. Others are seeking to demonstrate “utility” and run the risk of the ever-expanding SEC definition of a security.
So can a token be a utility token that can avoid registration? The SEC is still developing a definition, and when it does, it likely will be limited by the SEC to tokens that represent consumption of actual assets or services, or an entrance key to access the assets or services. If the value of the token is its value as a marker of consumption or an access device, the SEC could bless it. If a token is viewed or hyped as an investment – something that will increase in value as the blockchain enterprise with which it is associated increases in value, it can be expected that the SEC would contest any attempt to classify the token as a utility coin.
Time will tell, but the definition may be hashed out in court filings rather than regulatory announcements, as the SEC continues to wrestle the ICO bear.
For more information about blockchain and cryptocurrency law, please contact Edward Tolchin at email@example.com.
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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