The Initial Exchange Offering (“IEO”) offers a return to the heady days of ICO-driven 2017

Photo by Melinda Gimpel on Unsplash

The legal tail should not wag the business dog . . . and this is not to be construed as legal advice. [2]

The Initial Exchange Offering (“IEO”) offers a return to the heady days of ICO-driven 2017 — millions of dollars in seconds that is free from the tyranny of regulatory uncertainty. Money that comes without the need to push a project all over Sand Hill Road (and shill til’ you can’t no more).

In an IEO, a cryptocurrency exchange manages the token offering and sale process. The process solves many of the offering’s logistical issues:

The exchange already performed the required Know Your Customer (“KYC”) procedures on their account holders (to whom they will sell the tokens);

The exchange is also in a position to receive payment for the newly issued tokens from its purchasing account holders without the need for a separate escrow or custodian;

The exchange may act as a sophisticated party conducting diligence on the issuer’s management team and the viability of the project.

Moreover, the IEO brings the added advantage of instant investor liquidity on a major cryptocurrency exchange. [3] Further, unlike the ICO, the IEO is not tainted by the discounted token presale process, effectively a systematic pump-and-dump whereby crypto-whales bought very low and flipped tokens for massive profits shortly thereafter. [4] Truly, we live in marvelous times . . . or do we?

Legal Fact [5]

Conducting an IEO in the United States, or selling to “U.S. Persons” [6] by way of an IEO,is almost certainly a violation of the Securities Act of 1933. Punishable by a host of draconian penalties. [7]

Business Fact #1

Attempting to do a legal private placement of securities in the United States (tokens or otherwise) is an expensive,time-consuming process fraught with angst and potential rejection.

Business Fact #2

Given a choice between (a) selling millions of dollars of tokens in seconds on one hand; and (b) undertaking the private placement process, there is only one reasonable choice- sell the tokens, fund the project, and do your best to not run afoul of regulatory requirements.

Irrefutable Conclusion — My clients are going to opt to engage in an IEO no matter what I tell them to do. So would I.

Photo Taken by George Pagan III for Unsplash

That being the case, the clear action plan is to take all measures to comply with Regulation S. That means one thing, more or less: ensure your newly issued tokens do not flow back to U.S. Persons until at least a year from the date of the initial sale. [8] Prior to the advent of digitized assets and international cryptocurrency exchanges, compliance with that simple directive was relatively easy. Before tokenization, access to international markets was largely unthought-of by most retail investors. You had little to worry about beyond putting a few legends on the paper representing the securities, and avoiding “directed selling efforts.” [9] This is no longer the case. The tokens will move and you have to deal with it.

Crypto-Exchange Compliance with Regulation S is Spotty [10]

Several categories of crypto-exchanges exist:

Crypto-exchanges that do not willingly allow US Persons to participate;

Crypto-exchanges where US Persons can participate;

Crypto-exchanges that are decentralized and allow almost anyone to participate.

Of course, for traders who work with a relatively small amount of value, the only diligence by the exchange is self-reporting and geo-fencing [11] of IP addresses. A motivated U.S. person can evade these screens in under ten minutes through the use of a VPN or other devices.

Crypto-exchanges are not operating out of some munificent compulsion to foster a decentralized world. Quite the opposite. By conducting IEOs, crypto exchanges are generating traffic to their exchange platforms. To that effect, once the tokens are listed, the exchange has little incentive to keep track, much less prohibit a secondary sale to a US Person. [12]

Stop Trusting Your Purchasers to Not Transfer Tokens in Violation of Regulation S

Of course, once out in the world, tokens do not have to stay on crypto-exchanges. The whole point of the consumptive token is that the tokens serve a purpose beyond speculative trading. Unfortunately, until that one-year holding period ends, that purpose should not involve a transfer to a US Person. It seems likely that a secondary seller would not even think that selling a token to a US Person would violate the law. As is often the case, reasonable protection requires planning for the blissfully uninformed.

When the Practice of Law Becomes Software Consulting

It is incumbent upon a US token issuer selling tokens via an IEO to take all reasonable steps to avoid secondary sales to US Persons prior to the end of the one-year hold period. The question of what is reasonable is one of “facts and circumstances”. [13] An issuer’s reliance on purchaser self-reporting and geo-fencing may not be enough, especially when there are technical solutions that a token issuer can bake into their token.

A growing list of service providers offer both on-chain and off-chain solutions [14] for the screening of token transactions. [15] A sufficiently capable project team can also design their own screening mechanism. Current providers or projects that are on the path to building a screening mechanism include: [16] Vertalo, Securitize, Polymath, Securrency, PrefLogic, and TokenSoft.

A Bittersweet End.

Mission accomplished. My client can go and get the funding they need to develop their project. If I work with enough issuing clients, maybe I can help facilitate the next (first) killer app on the blockchain. It is too bad that most US Persons won’t have a chance to get in on the ground floor.