Are ICO’s “Securities Offerings” and are Coins “Securities?”
The SEC is now saying that pretty much all ICO’s are securities offerings (and therefore all coins are securities), and subject to their rules and regulations. Are they right, or is that an over-reach? Most industry participants argue that while some ICO’s are indeed securities offerings, others are utility tokens and not a security.
What’s a “utility token”? If you give people money on, say, Kickstarter or GoFundMe (as I have done several times), you don’t expect stock in a company, you aren’t making a loan, and you don’t consider it an investment. You give money to someone, and in return they promise to give you a t-shirt, movie pass, potato salad, thank you letter or something else. Kickstarter sends you an email confirming this promise of a reward.
Now, imagine if instead of a contract or .pdf agreement they sent you a digital token (aka “Coin”). That doesn’t in itself make it a security. Nor does the fact that Kickstarter charged the “issuer” fees for marketing, sales and funds processing. And if you want to sell the right to that t-shirt to someone else who wants it, then there really isn’t anything prohibiting you from doing so.
Without question there are ICO’s, and the coins they issue, that don’t constitute “securities”. Though I think the SEC is arguably justified in over-reacting a bit as there has been a substantial amount of fraud and theft in this new, evolving market…but those problems don’t directly mean that any particular ICO or token does fall under their purview.
When does a token become a security? In 1946 the Supreme Court set forth some rules on this, which is referred to as the “Howey Test”. This essentially says that if the contract is being offered to a wide group of people, who are purchasing it as an investment, and the purchasers do so with the hope of financial returns or gains which are driven not by themselves but by the work of others (e.g. by the future work of the company raising funds and issuing the contract), then it’s a security and subject to the various Acts and the SEC. However, even if an investment contract doesn’t hit on all of the aspects of the Howey Test, the laws and regulations are very broad and the SEC has tremendous latitude in its ability to designate something as a security. Additionally, each state has its own securities “Blue Sky” laws, which have to be taken into consideration.
Here’s an example of how this gets dicey. Let’s say a company buys a Ferrari, and they offer people the ability to buy the right to drive it 1 hour per month. It’s offered to many people, who have no management control over the vehicle. It’s not any type of ownership in the car, nor is it a loan that has to be repaid. It is what it is, the right to drive the car an hour a month (“utility”). Let’s say that instead of giving you a paper contract for your hour, they put the contract on the blockchain and issue you a token. That doesn’t in itself, in my opinion, make it a security. And let’s say things change in your life, such as you moved somewhere that’s too far to make it practical to drive the car every month, so you want to sell that right to someone else. That doesn’t make it a security either. You, and others, are buying it for the utility it represents.
However, what if you weren’t really buying it for the utility? Instead, what if you and everyone else view this as an investment and hope the value of that hour appreciates considerably so you can sell it for a profit? And what if the issuer (or their sales & marketing representative) is promoting this not as “you get to drive my car for an hour a month” but as “you get a token/coin that is freely and easily tradable, is limited in quantity, and you have the chance to make a lot of money!“? And what if they further take steps to reinforce this by listing the token on an exchange, and/or by their sales and marketing tactics? I think the SEC is going to say that it’s now a security and not just a utility token.
Can Retail/Non-Accredited Investors Put Money in ICO’s?
In utility-token ICO’s? Sure, just as with Kickstarter or GoFundMe there is nothing preventing anyone from contributing money in exchange for some reward or promise of products or services.
In securities ICO’s? Only if the ICO is conducted pursuant to either Reg CF or Reg A (or via a registration statement such as an S-1). Of course, this presents a problem as Reg CF is limited to just over $1M and has very low per-investor caps, Reg A costs around $100,000 in upfront costs to get through legal, accounting and regulatory review and has a $50M cap, and a full registration statement can easily cost $500,000 or more.
Can People Buy Coins in an ICO and Then Sell Them on an Exchange for a Profit (Or Loss)?
Sure. There are no federal restrictions on anyone’s ability to resell their non-securities utility tokens. However, if the coin is a security, then its subject to securities rules on both the initial sale AND the secondary markets. For Reg D securities, investors must be accredited and are subject to Rule 144, so they can’t sell for at least a year. For Reg CF securities, non-accredited investors can’t sell for a year except to an accredited investor. For Reg A and other types of registered securities then yes, they can sell those whenever they want.
Keep in mind that if the coin represents equity in a company then the issuer is subject to restrictions on total number of shareholders they can have, which can represent an insurmountable problem given the anonymity of the blockchain (and no, the blockchain does not count as a single “shareholder of record” in my opinion, as its not a “person”, though I expect some people will passionately argue this point).
Are Exchanges Legal?
I think the problem here is the word “exchange”. When regulators hear that, they feel it’s subject to regulation. But Craigs List, eBay, Amazon, StubHub and other “marketplaces” exist to make it easy for people to sell stuff that isn’t subject to SEC regulations. I think some crypto exchanges, if they exist only to make it easy for holders of utility tokens to list and buy/sell, and they aren’t fostering market-making, are doing themselves a disservice to use the word “exchange”; not that it’s illegal or wrong to use that word, but because it raises regulatory red flags and puts the marketplace/exchange directly in the crosshairs.
Now, if the coins are securities then exchanges located or operating in this country are required to be registered with the SEC. Period. To my knowledge, only tZero and Templum are on top of this, and I’ve read that some other exchanges are also working on filing or have filed as either an ATS or a securities exchange (e.g. Bittrex, Coinbase). Non-registered securities exchanges are conducting business illegally. Check out Howard Mark’s (StartEngine CEO) article about this by clicking here.
State Blue Sky: If the exchange is operating as an ATS, the securities listed on it are not exempt from state blue sky regulations. This means that issuers have to apply and get approval in order for a states residents to buy their securities on the ATS. Mergent is recommended extensively by OTC Markets to help clear state blue sky in 39 states, but doesn’t include many big ones such as NY or CA. Thus issuers will need to have their lawyers file for Mergent as well as all the other states; that is, providing Mergent supports crypto (I have no idea). On the other hand, if the exchange is just that, a full-fledged registered US securities exchange and not just an ATS (like NASDAQ or NYSE vs OTC), then the securities listed on it are exempt from state blue sky restrictions. For more detail, though a little dated at 5 years old, see the SecondMarket Blue Sky Report on the SEC’s website.
So, Then What’s the Difference Between a Securities ICO and a Stock or Bond Offering?
Nothing. A company (“issuer”) wants to raise money. They create an offering pursuant to securities regulations (A, D, CF, S, etc) and carefully prepare required & compliant disclosures. They convince investors, who hope for financial gain, to sign subscription agreements and send money via ACH, wire, check, credit-card, or crypto (e.g. Bitcoin). As soon as the offering meets the minimum (if it has one), then the issuer takes the cash and gives investors a coin (aka “token”) just like they would a stock certificate or bond note.
What Does This Mean?
It means that securities ICO’s are no different than any other securities offering. No different than selling shares of stock or selling debt/bonds. They have the exact same regulations, the exact same processes, the exact same limitations on who can buy (and how much), and the exact same secondary trading restrictions. Welcome to the securities industry everyone.
Investor Bonus – SAR’s and the IRS!
Anyone buying securities using coins (Bitcoin, Ethereum, etc) instead of sending $, unless those coins are coming from an account at a regulated financial institution, gets named in a “Suspicious Activity Alert” (SAR), which is sent to the US Treasury. Guess who the Treasury has tasked with reviewing SAR’s? Yep, the IRS.
Why is this? Imagine if you walked in with a bag full of cash. The person receiving it has no idea where you got it, it’s untraceable. For all they know, you might have gotten it from a terrorist, from a money-launderer, or from unreported income streams. So, government regulations require a SAR to be filed on the person who brought the cash. It doesn’t mean it’s illegal, it’s just a flag to the IRS that they may want to investigate or audit that person. Currently, every type of crypto-coin is, like cash, untraceable. Thus, a SAR has to be filed on everyone using it in investing or in commerce. Except and unless the coins come from an account at a regulated financial institution, then just as with cash sent via wire, check, ACH or credit card, the receiving party can rely on the fact that the sending financial institution has met its KYC and AML obligations and thus a SAR doesn’t need to be filed. So this is fairly easy to avoid by holding your crypto in an account/wallet at a financial institution (which includes brokerage firms and trust company’s) where they are responsible for all regulatory and other aspects of custody.
Naturally, Prime Trust, just like all financial institutions, has to file SAR’s on people who send crypto into escrow or custody, unless it’s sent to us from another financial institution. And guess what, so should issuers. If a company takes the stance of “screw that, I’ll just have crypto sent to us directly instead of through the escrow agent, bank custodian, money transmitter or (now-regulated) exchange” and it turns out that some of the funds were from the aforementioned bad persons, the fallout (and penalties) from regulators will be significant and certainly not worth the effort to avoid (or evade) the issue.
I remain optimistic about the future for the next generation of crypto, as well as for businesses doing innovative things with blockchain technology. Prime Trust and FundAmerica will continue to take cautious steps to support this industry. But we must all proceed with a heightened awareness of regulatory obligations, both for investor protection and for the very survival of this nascent industry.