Judging by the frequency of court cases in the United States involving the promoters of ICOs and STOs, there is either some confusion among token and coin promoters about the application of securities regulations, or there is a reluctance to comply with those regulations. In my earlier post for Publish0x, I reviewed the court judgment in the recent case involving Telegram Group and the SEC. In this post, I want to review some of the generic issues that seem to be causing problems for ICO and STO promoters.
The law that regulates securities varies from country to country, but there are similar elements in most of those laws. One important consideration for token and coin promoters is that the US claims extra-territorial jurisdiction for its securities regulations, meaning that if a token or coin is sold to a US resident, or is even offered for sale to a US resident, which is almost unavoidable given that ICOs and STOs happen online, then US securities laws will apply to the promoters and the offering. That being the case, it is wise for ICO and STO promoters, regardless of where in the world they are launching their offering, to consider the application of the US Securities Act 1933 and associated regulations, and, where appropriate, to register the offering with the SEC, to avoid problems later. Those problems being injunction applications and/or prosecutions by the SEC, and/or a private lawsuit or class action from unhappy token or coin purchasers.
Like any other bureaucratic procedure, from registering your moped to getting married to applying for a passport, there are processes that have to be followed, more or less helpful explanations provided by the governments, forms to be filled in, and fees to be paid. Whatever the toll in time, money and effort may be, however, it will probably be less costly, in the long run, to take the trouble to find out what the rules are and to comply with them rather than risk an important project being derailed by incorrect assumptions made in an effort to avoid red tape.
The Howey Test
The main legal test that is applied in the US to decide whether a token or coin issue constitutes a security, and therefore should registered with the SEC, is the Howey Test, which is named after a 1946 decision of the US Supreme Court. The test has three limbs or prongs for identifying a regulated investment contract, which we can cast in the form of questions:
- Is an investment of money proposed, or has it taken place?
- Is the investor involved in a common enterprise?
- Are the investor's profits based on the efforts of others?
There are many discussions of this test and its components available on the web, and it is unnecessary for me to go into those things in any great detail here. What I do want to point out is that, in recent court cases on the application of this test to ICOs or STOs, the arguments have revolved around the second and third elements of the test. In many of these cases, the defendants have conceded the first element, that is, that an investment of money occurs when a token or coin is purchased, even when the token or coin is not bought with fiat money but rather with another cryptocurrency. See for example Balestra v. ATBCOIN LLC, Ng and Hoover USDC SDNY, 17-CV-1001 (VSB).
As for the other two elements, establishing these has not proved to be a great obstacle to the SEC or the private plaintiffs in these court cases. In the Balestra case, for example, the court accepted that:
- The plaintiff investor was in a common enterprise with other investors because their funds were pooled together to facilitate the launch of a new blockchain, the success of which, in turn, would increase the value of their investments.
- Each investment's success, i.e. its profitability, depended on the promoter's "significant" and "essential" entrepreneurial and managerial efforts to commercialise the proposed blockchain and its coins, and the investors had no control over the technology, which was in the sole control of the promoter.
Looking at these case reports, you would have to conclude that most of the popular models that have been used for coin offerings or token offerings will trigger US securities regulations, and therefore any further offerings of those types should register with the SEC unless an exemption clearly applies. Clearly, a lot depends on the specific features of the offering structure. But, looking at the run of decided cases in the US courts in this area, you would have to conclude that the most common tokenisation scenarios will likely trigger the application of US securities regulations. These scenarios include:
- "Crowdfunding" funds to build brand new blockchain infrastructure: see e.g. the Telegram Group case and the Balestra v. ATBCOIN case.
- Attracting investments via a token issue to expand an existing business: see e.g. the Munchee case.
Assessing and Registering a Proposed ICO or STO
The SEC publishes an online framework for "investment contract" analysis to guide decision making for people contemplating launching an ICO or STO. There is no substitute for obtaining advice from a competent lawyer.
An ICO or STO, like every other security issue, is registered in the US by filing a registration statement with the SEC. This is a technical task that probably requires professional legal assistance.
[Photo credit: Dusk in Madrid, a public domain image of the Banco Hispano Americano, Madrid, by Matt Wilson, courtesy of Wikimedia Commons CC BY-2.0. This post is a a basic level, educational and informational discussion of legal concepts. It does not constitute legal advice for any person, nor does it create a lawyer/client relationship with any person. Although care has been taken to ensure that the law is described correctly at the time of publication, no guarantee of accuracy is provided.]