This is not legal advice.

Cryptocurrency token sales or Initial Coin Offerings (ICOs) have occurred since 2013 but are really starting to gather steam in fundraising for startups. They are conducted via the trading of assets on the blockchain. Increasingly, investors are paying more attention to token sales for two reasons:

Startups are raising millions via token sales, overtaking the pace of VC funding thus far in 2017, according to research from Coindesk. The SEC and other regulatory bodies are investigating token sales to identify potential fraud and regulatory breaches.

We’ve seen the banning of ICOs in China, South Korea and Switzerland already to name a few. Far too often token sales are launched without proper due diligence or regulatory compliance. The financial securities regulators are correct to take a hard stance when it comes to cryptocurrency investments especially since they are extremely speculative and there’s a bit of a “gold rush “ moment happening. After all, securities regulatory bodies were set up to protect investors from financial harm. With so much attention on token sales, good and bad, we can only expect more scrutiny going forward.

Regulators ask a number of questions when examining token sales. The four main questions asked by regulators, and investors alike are:

1) is it a security?

2) the ambiguous use of the term “token”

3) the importance of the token to company operations

4) how the token will be used?

Those are at least four separate considerations on which startups and investors should seek legal and financial advice prior to launching or participating in a token sale — if they wish to avoid the potential consequences. Let’s dive in:

Is it a security?

Most token sales do not self-identify as securities or follow the regulatory framework for securities offerings. Just because they do not self-identify as securities does not mean that they are not securities.

In the USA, the test to determine whether a transaction is an ‘investment contract’ and therefore a security as defined in the Securities Act of 1933 and the Securities Exchange Act of 1934, was formulated in Securities and Exchange Commission v. W. J. Howey Co., 328 U.S. 293 (1946).

As Micha Benoleil states, the Howey test is as follows:

Is it an investment of money or assets?

In the case of token sales, this answer is certainly affirmative.

In the case of token sales, this answer is certainly affirmative. Is the investment of money or assets in a common enterprise?

Yes, every token sale involves the giving of money to a common enterprise.

Yes, every token sale involves the giving of money to a common enterprise. Is there an expectation of profits from the investment?

Token issuers need to be clear that the token gives right to use software. Similar to paying for a video game or for a golf course membership. Secondary trading should not be encouraged or facilitated by token issuers.

Token issuers need to be clear that the token gives right to use software. Similar to paying for a video game or for a golf course membership. Secondary trading should not be encouraged or facilitated by token issuers. Does any profit come from the efforts of a promoter or third party?

The token should be usable when it is sold. Similar to Netflix, the catalog may change, but the main functionalities of the token should be ready at the time the transaction takes place.

If the answer is Yes to all 4 of those questions, then your token is likely to be a security. The Howey test is the test in America. Other jurisdictions have similar tests to determine if an investment contract is a security. If your token sale is a security offering it will need to comply with local regulations as well as the regulations from all jurisdictions of its investors.

Ambiguous use of the term “token”

While they are generally referred to as token sales, the “token” could either be a protocol coin, utility token or tokenized security. A protocol coin like Bitcoin is considered an alternative to existing fiat currencies but does not represent ownership in any specific asset or company. It is a coin that secures the underlying blockchain network. Their value is speculative and highly variable depending on market activity. A utility token is an access key to participate within the a decentralized application or service on top of a blockchain network. A tokenized security represents shares or ownership in existing assets or equity in a business. Certainly tokenized securities must adhere to financial securities regulations, but protocol coins and utility tokens need to make sure their qualities don’t make them securities as well.

Token importance to the company operations

Many token sales are requiring the purchase of tokens, however based on the definitions outlined above, it may not be apparent why those tokens are important for the system to work. For instance, if the tokens are advertised as utility tokens (gaining access to the service when launched), but the purchasers have an expectation of profit based on the work of others, then it may in fact be a security. A clear outline of the functionalities and use case for the token will be companies from being deemed a security by regulators.

How will the tokens be used after purchase?

Will the tokens be utilized after purchase to access the software within the ecosystem or mainly as a means of exchanging value on secondary markets? Less of the former and more of the latter lends it to being more of a security.

Conclusion

The legal system is quickly catching up to token sales that have been operating in a ‘wild west’ environment for over three years now. Without taking these aspects into due consideration, the potential legal, corporate and personal risks are extremely high for exchanges, investors, startups and issuers. This doesn’t mean that this is the end of token sales or that the fundraising via token sales will become harder to conduct than with traditional VC fundraising. In fact, there are several solutions on their way most notably the Polymath solution.

Polymath is a one-stop shop for financial securities tokens which launches in Q4 2017. You can learn more about Polymath in a previous article and read their whitepaper here.

This is not legal advice.

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