Lindsay Lin is a counsel and program manager at Lightyear.io, a company that leverages the open-source Stellar protocol to build digital payments infrastructure and services.

In this opinion piece, Lin argues that issuers of ICOs should not only accept but embrace regulators’ classification of their tokens as securities.

In the past year, most organizations conducting initial coin offerings (ICO) have desperately sought to avoid having their tokens categorized as securities.

These organizations tend to emphasize that their tokens are “utility tokens,” more akin to a tradable gift card or software license than a security. Others frame their ICOs as donation initiatives, whereby those who contribute bitcoin or ether in exchange for tokens are deemed to have charitably contributed to a foundation or non-profit entity.

However, the SEC’s philosophy is “substance over form.” It is still unclear what token characteristics will suffice to avoid categorization as a security, and the analysis may differ by state.

Contrary to popular sentiment, there are multiple reasons why organizations planning ICOs may actually want to consider issuing security tokens rather than try to avoid the label. When sold in a compliant manner, security tokens have the potential to provide legal certainty (ergo lower risk), strengthen buyer protection and deliver better returns.

Given the uncertain regulatory landscape, there are even benefits to presuming that a token would be categorized as a security.

Issuing security tokens under regulatory frameworks such as Regulation D, Regulation S, Regulation A+, and Regulation Crowdfunding is significantly cheaper and faster than conducting an initial public offering, and it can significantly reduce legal risk.

As the SEC ramps up investigations and enforcement actions, organizations that issue tokens in a compliant manner will have certainty that they will not suffer significant business interruptions from SEC enforcement actions and private litigation arising from unregistered securities offerings.

Gambling on ‘utility’

If an organizer freely issues tokens that are later deemed to be securities, this could open up a Pandora’s box of potential liability.

Issuing unregistered securities is a violation of Section 5 of the Securities Act of 1933, and, beyond significant monetary penalties, issuers could face a maximum of five years of federal prison. Secondary trading markets that facilitate transactions in the tokens could themselves be liable for penalties for failing to register as a broker-dealer, exchange or alternative trading system (ATS).

Arguably, given that the SEC has limited resources to initiate enforcement actions, private plaintiffs may be the most pervasive nightmare for those who issue unregistered, non-exempt security tokens.

For example, token buyers could instigate private litigation under Section 12(a)(1) of the Securities Act, in which they could obtain monetary damages or rescission of the sale. If the price of the token nosedives below the original ICO price, token buyers may find this option quite attractive. Moreover, token buyers who feel misled or defrauded could leverage the private cause of action in Rule 10b-5 of the Securities Act.

An organization that claims that its tokens are non-security utility tokens, and does not register or use a registration exemption, also must evaluate the “Blue Sky” securities laws of all states in which token buyers reside.

By contrast, if you rely on an SEC exemption like Rule 506(c), 506(b), and Regulation Crowdfunding, federal preemption obviates concerns with any particular state’s “Blue Sky” securities laws.

Clarity and recourse

The ultimate goal of the SEC is to protect ordinary investors and prevent them from being taken advantage of by fraudulent entities.

Many compliance requirements, such as disclosures and filings, help to clarify token buyers’ expectations and rights. Limiting certain sales to accredited investors and setting investment limits for non-accredited investors help to protect those who cannot afford to lose money on high risk investments.

Rules against unfair or fraudulent behaviors, such as Rule 10b-5, provide a private right of action for fraudulent activities, affirmative misrepresentation and material omissions, market manipulation, insider trading, and more.

Securities laws have been developed and continuously refined for decades. Security tokens would inherit a wealth of legal precedents that would illuminate token buyer rights, protections and expectations.

Additionally, they would clarify duties and obligations of the issuer.

Flexibility in token structure

What percentage of token buyers purchase ICO tokens for the utility, instead of solely as an investment?

The truth may be that most token buyers are HODLing tokens as an investment, not because they intend to use them personally. While there are utility tokens that are structured to have no investment characteristics, they are few and far between.

If an organization acknowledges that its token is a security, then it can acknowledge it as an investment. The organization could provide token buyers with benefits like dividends, profit shares and voting rights which it would normally avoid if it wanted to avoid the security label. Its security token could still feature significant “utility” attributes; it could still be used in native transactions in an organization’s service or product.

Moreover, the organization can be more transparent with buyers about token economics and how they intend to increase token value.

Bottom Line

If you were to dedicate years of your life to building a revolutionary product and business, wouldn’t you want certainty that your ICO is not a ticking litigation time bomb?

If you are a token investor seeking high monetary returns from your tokens, wouldn’t you want to have defined protections against market manipulation and organizational wrongdoings?

The cryptocurrency community must reevaluate its attitude towards security tokens. Instead of something to fear and avoid, security token ICOs may actually be the path forward.

Special thanks to Terrence Yang for providing insight into the content of this post.

Blue skies image via Shutterstock