Author: Joshua Kushner

If you’re thinking about raising money for your startup by selling tokens, you should first be familiar with the regulatory requirements. Depending on the circumstances, your token offering may be considered a security.

If that’s the case, the offering will be subject to federal securities laws. In this article, we’ll explain the laws that are relevant to token offerings and how the SEC decides whether they apply to an initial coin offering (ICO).

When is a Token a Security?

There is some confusion about what sorts of tokens constitute securities. For example, some cryptocurrency websites claim that a token designed to provide a functional benefit places the offering outside the Securities and Exchange Commission’s jurisdiction. But the SEC states that even tokens of this sort, known as “utility tokens,” may be securities

Some sites claim that through an ICO, in contrast to a security token offering, companies can sell tokens without registering with the SEC. But tokens sold through ICOs may be considered securities. The SEC made this clear in its 2017 DAO Report of Investigation. In 2018, the agency filed enforcement actions against two companies for non-compliant ICOs.

The Consequences of Failing to Register With the SEC

Airfox raised $15 million to develop an app through which users could earn tokens and redeem them for mobile data. Paragon raised $12 million to fund the development of a “decentralized solution for the cannabis industry.”

The SEC imposed $250,000 penalties on each company. It also required them to register their tokens as securities and compensate harmed investors. After filing for bankruptcy, Paragon and its founders and executives were found liable for over $12 million in a civil suit.

Since 2014, the SEC has brought 41 enforcement actions against other companies and individuals for offering unregistered securities in the form of digital assets or ICOs. 

What is a Security?

The Securities Act of 1933 defines a security as:

“The term ‘‘security’’ means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, … or, in general, any interest or instrument commonly known as a ‘‘security’’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”

The applies the Howey test to determine whether a token meets that definition. The test comes from the 1946 Supreme Court decision in SEC v. W.J. Howey Co. According to the test, a token is an investment contract if it is “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”

What Kind of Token Offerings Need to Be Registered?

The SEC offers a framework to give companies guidance on whether U.S. federal securities laws apply to their token offering. There are three elements to consider:

  1. Was there an investment of money?
  2. Were the parties engaged in a common enterprise?
  3. Did the purchaser have a reasonable expectation of profits derived from the efforts of others?

Token offerings generally meet the first and second elements. In the DAO report, the SEC said, “[i]n determining whether an investment contract exists, the investment of “money” need not take the form of cash.” There is an investment because something of value is exchanged for the digital asset. 

The parties will likely be found to be engaged in a common enterprise as well because “the fortunes of digital asset purchasers have been linked to each other or to the success of the promoter’s efforts.

Since the first two elements are typically met, the SEC’s primary consideration is whether the purchaser have a reasonable expectation of profits derived from the efforts of others. Two of the key factors are whether the expectation is reasonable and the efforts significant. 

While that’s the basic framework, there are many other considerations based on a large body of case law that will continue to evolve as the courts hear new cases against companies that raise money through token offerings.

For that reason, it’s important to seek legal counsel before holding a token offering. New pitfalls will arise as blockchain technology advances and courts interpret the laws in new situations. An attorney who is familiar with the relevant federal laws and how the courts have interpreted them can help you avoid an enforcement action.

How to Hold a Compliant Token Offering

When a token is a security, the offering must be registered with the SEC or the offering company must file for an exemption with the SEC. SEC regulations contain ten capital-raising exemptions with different requirements and restrictions.

Three common exemptions are:

  1. Rule 506(b) of Regulation D. Under this exemption, a company can raise money from an unlimited number of accredited investors and up to 35 “sophisticated but non-accredited investors in a 90 day period.” The company cannot advertise the offering.
  2. Rule 506(c) of Regulation D. Under this exemption, a company can raise money from an unlimited number of accredited investors and must take “reasonable steps” to ensure that all investors are accredited. The company can advertise the offering.
  3. Regulation A: Tier 1. Under this exemption, a company can raise up to $20 million from any investors. “Testing-the-waters” through advertising and general solicitation is permitted.
  4. Regulation A: Tier 2. Under this exemption, a company can raise up to $75 million from any investors, but non-accredited investors are subject to investment limits. “Testing-the-waters” through advertising and general solicitation is permitted.

Each exemption has different rules and required filings, so we recommend getting professional advice from an attorney to determine which exemption you should seek, if any.

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