3 Simple Rules to ICO the SEC Way

[johba]

3 Simple Rules to ICO the SEC Way

Of the 1,500+ ICOs announced to date, a big majority has been selling tokens long before the application represented by the token had genuine functionality. “As such, the sellers have (un)intentionally be selling securities, and have failed to comply with several U.S. laws.” (SAFT whitepaper)

Yet, cryptocurrency and token-based networks hold the potential to create value on an order of magnitude similar to that of the internet. How can entrepreneurs tap into this potential and run token sales without excluding US investors or risking their reputation?

We have compiled an easy checklist for you to run a compliant ICO:

• Structure your sale according to SAFT framework
• Check that token is not a security under Howey
• Ask the SEC

Let’s dive into the different points:

SAFT framework

The Simple Agreement for Future Tokens is a compliant token sale framework. It is the best tool currently available for navigating U.S. law and seeks to respect the policy goals that drive the law. The framework builds on the assumption that pre-function tokens always represent a security, and sets forth 4 steps to structure an enterprise until a public sale of tokens can be held legally:

Step 1: Founders work out a whitepaper for an intended business idea and incorporate a company. They can start pitching to investors and start securing commitments.

Step 2: When conventional startups issue notes or certificates to close seed investment they rely on the exemption set forth in Rule 506(c)69 of Regulation D of the Securities Act, which permits to raise from accredited investors in private sales. The SAFT framework provides a contract template that allows to execute a similar agreement, but not promising shares but future tokens. The SAFT also offers investors a discount on the final token sale and is a security, so the founders file a Form D with the SEC disclosing the sale.

Step 3: The company now uses the provided investment to develop its application which is powered by a closed loop token economy, providing genuine utility to its users.

Step 4: The company launches its application and delivers the promised, now functional tokens to the investors. The company and investors can conduct a public sale without violating U.S. law.

Consequently, the SAFT framework offers an independent growth strategy leveraging public token sale after the seed stage. Check out the whitepaper and contract templates provided on the project page: saftproject.com

Howey Test

The next step on our checklist is to evaluate the token that you are building in the Howey Test. This test is designed to classify if a financial instrument represents a security, such as notes, stocks, bonds, and investment contracts.

It is illegal in most countries to sell securities to the public unless they are registered with the national stock market supervision. In the U.S. the Securities and Exchange Commission (SEC) takes that role. Registering securities is usually expensive and time-consuming.

Under the Howey Test, a transaction is a security if it passes all of these 3 conditions:

• It is an investment of money.
• The investment of money is in a common enterprise.
• There is an expectation of profits from the efforts of a promoter or third party.

Contrary to common perception, you want to fail the Howey Test, not pass it. This can be done by avoiding just one of the prongs above.

Investment of Money

Although the Howey Test originally refers to "money", later cases have stated that any transfer of value will satisfy this condition. This prong can hardly be avoided.

Common Enterprise

Courts use different interpretation of the term “common enterprise”. Some define a horizontal structure, whereby investors pool their money to realize a goal, others are looking for a vertical commonality, where buyers and sellers sit in one boat. Due to the many possible interpretations of this term, it will be practically impossible to avoid a classification of a token sale as common enterprise across all jurisdictions.

Expectation of Profits Predominantly from the Efforts of Others

This is the condition that most app-tokens will fail in the test. Courts look at the economic realities behind an investment scheme to see if any profit that comes from an investment is largely or wholly outside of the investor's control.

While an investment can appreciate in value merely through market fluctuations, this is not enough to classify it as a security. The increase of value has to be caused by work of others, while the investor sits and waits and can not consume his token in any other way but selling it.

Make a token consumable in the application to satisfy this prong.

Ask the SEC

Because this post is not written by lawyers and does not constitute legal advice, you should consult a professional first. When you have done that, be proactive and make sure to validate your results with the SEC. They offer a handy contact form here: www.sec.gov/forms/corp_fin_interpretive

(Header image source: pixabay.com)

[jhanson]

Some great points made here. If any ICO wan't global reach, they will have to be compliant.

I read a recent article about an ICO that got a license for legal esports betting in Europe. https://www.coindesk.com/regulated-cryptocurrency-betting-just-got-big-boost-europe/

[Dasani7867]

Is the SAFT always the way to go?

The SAFT wants to eliminate the utility token argument. Many tokens are NOT securitites and are more like metrocards and software licenses, however the SAFT doesn't care and essentially creates a securities where there is not. As Cooley admits, the token is often not the security while the SAFT always is. So then why add such a regulatory burden and why limit the amount you can raise and who you can offer to (only Accredited Investors (i.e. high net worth)? (rhetorical question)

Furthermore, what protections do the SAFT provide once the tokens are delivered? Are the tokens now treated as restricted securities, meaning that you must hold your tokens for a year or more before selling them? That seems like a major drawback for anyone buying tokens for short to medium term investing.

SAFT may also create more problems than it solves. Such as...

Can SAFTs be swaps? A swap is an agreement in which (among other variations) one party pays cash and the other party delivers cash, securities, or other consideration in an amount based on the economic performance of a specific security or other asset. Although the CFTC has not yet issued official guidance, we currently believe that most SAFTs should properly be treated as forward purchase agreements rather than as swaps. If SAFTs are swaps, they generally could be purchased only by investors with $10 million in assets, which is considerably higher than the $1 million net-worth test for "accredited investors" under the federal securities laws.

The SAFT is not always going to be a good fit for ICOs, crypto and blockchain technology startups.

[kris_wolf]

The most serious implication is your day of reckoning will come if you didn't issue/sell your coins in a legal, compliant and ethical way as deemed by the SEC. Roughly these past and present issuers will be scrutinized and face serious consequences if they didn't. Best for ICO issuers to stick to regulatory practices in line with accredited investor raises. Currently ICOs shouldn't be issued to unaccredited investors but I have a feeling the legality of that will change soon enough .

[DestiNeedCoin]

International laws play a big part in how ICO's are regulated. In essence, launching an ICO in a jurisdiction that is less than satisfactory can result in the biggest difficulty when carrying out the process. I suggest looking at a framework of each country and their current ICO regulations, before deciding where to launch from.