Edit: Leios published this article when considering an ICO, which is no longer the case. This article still contains useful information for anyone looking to understand ICO in the light of compliance, so we will leave it on our blog.

Ah, token issuances. Nothing strikes fear into the heart of a CFO than the idea of raising money using a method that has been around fewer than ten years and is a regulatory minefield.

The good news is that the Blockchain CFO is on the case. He is currently the CFO of Leios International, Inc. (“Leios”) a revolutionary company that is streamlining international fund remittances using blockchain technology. Note that he is NOT a lawyer, so if you want real legal advice, pay a lawyer like we do.

Early Days

It was the early days of crypto-based fundraising, many, many, months ago (ok it was 2013). There was a lot of excitement about the potential of token sales, or “initial coin offerings”, as they were called, but little thought on regulation. Over the next few years, some well-known projects raised money through the ICO process, including Ethereum (2014), Augur (2015), and Waves (2016). In the U.S., the IRS issued guidance on the taxation of cryptocurrency transactions, but the Securities and Exchange Commission (SEC) stayed mum.

The SEC Starts to Clamp Down

However, in 2017 things began to change. The number of ICOs increased more than five-fold and the total amount raised increased by a factor of 40 (CoinDesk, coinschedule.com). This drew the attention of the SEC, who in July issued a report on The DAO, a 2016 ICO that had been hacked. The SEC concluded that tokens issued in the ICO were in fact securities. In concluding this the Commission cited the ruling from SEC v. W.J. Howey Co. (1946), a Supreme Court case that established the criteria for determining if an offering is an “investment contract” and thus subject to the Securities Act of 1933 and the Securities Exchange Act of 1934.

Guidance from the SEC didn’t stop other token issuers from testing the limits; in December 2017 the Commission issued a cease-and-desist order to Munchee Inc., claiming that its in-process ICO violated the 1933 Act. If that didn’t get the attention of projects looking to raise funds from U.S. investors, then SEC Chairman Jay Clayton’s February 2018 testimony to the U.S. Senate’s Committee on Banking, Housing, and Urban Affairs should have — in his prepared statement Clayton emphasised that the Commission was paying close attention to the ICO space and had many concerns.

Are There Ways Around?

SEC concerns did not slow the ICO movement — according to a report in June 2018 by PwC, funds raised through ICOs in the first five months of 2018 had already almost doubled that of all of 2017.

Token issuers are dealing with U.S. regulation in many ways. Some choose to ignore it, in particular issuers outside of the U.S. More commonly, foreign ICOs are limited to non-U.S. investors.

U.S. issuers and those seeking funds from U.S. investors, however, do not have the choice to ignore the SEC, and have to take into consideration existing guidance in structuring their token offerings. Some have chosen to adhere strictly to a “utility token” claim, which argues that a token’s sole purpose is to enable the issuer’s platform, and thereby it bypasses securities regulation. Others have taken the approach of utilizing existing exemptions from securities regulation when raising funds, using a promissory note-like vehicle called a “SAFT” that complies with SEC regulation. Once the project’s platform is launched, the SAFT expires and the SAFT holder is issued utility tokens that are arguably not subject to regulation.

A Regulatory Safe Path Forward

Leios has decided to take a more conservative approach. At the core of our approach is the assumption that all tokens are securities, and that any fundraising and subsequent sales of tokens need to be compliant with securities regulations. To be sure that we are pursuing a regulatory safe path, we began by engaging a reputable law firm, with experience in the token issuance process. While this is not inexpensive, some firms are willing to provide flexible payment arrangements that take into account the timing of the fundraise.

With a strong legal team to advise us, we needed to decide on the geographical location of the token issuance, and the type of investor to attract. For location, we settled on the British Virgin Islands (BVI), not for security regulation issues but for tax reasons. As far as investor type, we could limit our offering to non-U.S. investors, but this ignores the reality that at some point issued tokens will end up in the hands of U.S. investors, and thus be subject to SEC regulation.

What we have decided to do is to create a limited-functionality ERC20 token for use in the ICO process. We will then seek exemptions from security registration under the following:

Regulation D for U.S. investors. Under Regulation D, a security can be sold to an “accredited investor” (see definition) without registration with the SEC. Investors are subject to a one year “lockup” period before they can sell their tokens.

Regulation S for non-U.S. investors. Under Regulation S, securities can be sold to non-U.S. investors of any “size”. Investors are subject to a 90 day “lockup” period.

Note that we are also looking into raising a limited amount of funds using the exemptions under Regulation CF, which will allow us to sell to non-accredited U.S. investors.

Following the ICO, and using the funds generated, we will further develop the Leios platform and launch the Leios mainnet. The latter will include a fully-functional utility token, and an exchange for the ERC20 tokens issued during the ICO will take place.

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