To describe several key legal and regulatory considerations for initial coin offering (ICO) issuers and investors seeking to navigate some of the regulatory waters in the rapidly developing space of Bitcoin, Ether, and other cryptocurrencies.
Explains securities law, commodities law, tax and anti-money laundering considerations. Introduces the SAFT (Simple Agreement for Future Tokens) and provides a future outlook.
The dramatic rise in value of Bitcoin, Ether, and other cryptocurrencies in 2017 generated great interest in initial coin offerings as a new form of financing on the part of both investors and companies seeking to raise funds. At the same time, ICOs raise a myriad of complex legal issues in a rapidly evolving regulatory environment in the United States and around the world. Recent regulatory actions make it more likely that most ICOs will be considered to be securities offerings.
Practical guidance from experienced finance, investment management, consumer financial service, tax, and payment systems lawyers.
Nolan, A., Dartley, E., Baker, M., ReVeal, J. and Rinearson, J. (2018), "Initial coin offerings: key US legal considerations for ICO investors and sponsors", Journal of Investment Compliance, Vol. 19 No. 1, pp. 1-9. https://doi.org/10.1108/JOIC-02-2018-0016Download as .RIS
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Copyright © 2018 K&L Gates LLP.
Initial Coin Offerings (ICOs) suddenly emerged in 2017 as a hot trend in FinTech, as ICO issuance volume for the first three quarters of the year reached $2 billion, compared to $350 million of traditional venture capital funding for blockchain companies during the same period. The dramatic rise in value of Bitcoin, Ether, and other cryptocurrencies in 2017 has generated great interest in this new form of financing on the part of both companies seeking to raise funds in very short offering times and on the part of investors. At the same time, ICOs raise a myriad of complex legal issues in a rapidly evolving regulatory environment in the USA and around the world.
In an ICO investors use primary cryptocurrencies such as Bitcoin or Ether to buy customized cryptocurrencies (commonly known as coins or tokens) issued via a smart contract on an application blockchain protocol – typically Ethereum. The proceeds of an ICO can provide kick-start funding to develop the technology and platforms for the token holder’s access. The ICO issuer is typically organized outside the USA, often using foundation structures in Switzerland, Singapore, Gibraltar or other jurisdictions. The digital tokens issued in an ICO can be easily offered and sold to pseudonymous investors in peer-to-peer transactions over the internet and can just as easily and just as pseudonymously be resold. ICOs have some similarities with crowdfunding campaigns, but the active secondary market sets ICOs apart from crowdfunding.
US regulators and enforcement agencies have recently sharpened their focus on this burgeoning market and are trying to determine whether and under what circumstances offerings of and transactions in cryptocurrency are subject to their rules and regulations. The regulatory posture of the market for cryptocurrencies has developed quickly and is likely to continue to evolve as regulators grapple with the important questions about how to properly categorize the features implicit in each particular token offering. How US and foreign regulators will eventually come to terms with these issues is difficult to predict. Among the regulators that have staked claims over the regulation of one or more facets of token offerings are the Securities and Exchange Commission (SEC), the Commodity Futures and Exchange Commission (CFTC), the Internal Revenue Service (IRS), and the Financial Crimes Enforcement Network (FinCEN).
In this article, we describe several key considerations for ICO investors seeking to navigate some of the regulatory waters in this rapidly developing space.
1. Securities laws considerations
1.1 Is a token a security?
An important threshold question is whether an ICO is an offering of securities within the meaning of the USA securities laws (specifically, the Securities Act of 1933 (the “Securities Act”) and the Securities Exchange Act of 1934 (the “Exchange Act”). Until recently the question was generally whether the tokens constitute investment contracts under standards established by the USA Supreme Court in SEC v. W.J. Howey Co. Under the Howey test, a token is an investment contract – and accordingly constitutes a security – where there is an investment of money in a common enterprise with a reasonable expectation of profits to be derived primarily from the entrepreneurial or managerial efforts of others. Under the consumptive use doctrine developed by courts and the SEC applying the Howey test, an instrument that can be used solely to purchase existing goods and services from the platform is not a security even if it might incidentally have a trading value.
The SEC first applied the Howey test to digital tokens in an investigative report that focused on the characterization of digital token issued by a virtual organization known as “the DAO”. In that instance the SEC concluded that digital tokens issued by the DAO were indeed securities and that the DAO was essentially a collective investment scheme. Moreover, in recent enforcement actions involving alleged fraudulent ICO offerings, the SEC alleged that the underlying tokens constituted illegal offerings of securities for which no registration statement was filed and as to which no exemption from registration was available.
Following the DAO report, participants in the ICO market focused on the consumptive use doctrine developed by courts and the SEC applying the Howey test. Whether a token is a security depends on the facts and circumstances underlying the ICO, and in particular the function the token performs. For instance, if the tokens issued in the ICO can be used solely to purchase existing goods and services from the platform (“utility tokens”), they may not be an “investment contract” under the consumptive use doctrine developed by courts and the SEC applying the Howey test. On the other hand, a token that represents an interest in an enterprise or to-be-formed enterprise will likely be considered to be a security.
Subsequent to the DAO report the SEC has signaled – with increasing emphasis – that it will consider a token to be a security even if it is a utility token where prospective purchasers are being sold on the potential for the tokens to increase in value – with the ability to lock in those increases by reselling the tokens on a secondary market – or to otherwise profit from the tokens based on the efforts of others. In the SEC’s settled cease and desist order in In Re Munchee (the “Munchee Order”) the SEC noted that even if tokens had a practical use at the time of an ICO, that utility would not preclude the token from being a security if it were marketed and designed in such a way as to give investors an expectation of profits in secondary market trading. It further noted that determining whether a transaction involves a security does not turn on labelling – such as characterizing an ICO as involving a “utility token” – but instead requires an assessment of “the economic realities underlying a transaction”. SEC Chairman Jay Clayton has noted that promoters’ emphasis on potential secondary market trading may be a material indicator of whether an ICO is a securities offering. Chairman Clayton also noted that the sale of tokens based on the potential for purchasers to profit by reselling tokens on a secondary market “are key hallmarks of a security and a securities offering”.
1.2 Exempt offerings of digital tokens
Tokens that are securities may only be offered to USA investors in a registered offering or in a transaction that is exempt from registration, such as through a private placement to accredited investors pursuant to Regulation D under the Securities Act or an unregistered offering under Securities Act Regulation A+ or in reliance on the safe harbor provided by Regulation S. An important issue for the issuer and investors in a Regulation D offering or a Regulation S offering is how the issuer or others engaged in a sale can effectively police compliance with the transfer restrictions imposed by applicable law.
Where an ICO is conducted as a private offering under Regulation D or an offshore transaction under Regulation S an important consideration is how the ICO is structured to comply with offering and transfer restrictions imposed by securities law in order to be exempt from registration and in order to avoid a reseller of a token from being an underwriter. In light of the easy transferability of cryptocurrency tokens and the pseudonymous nature of cryptocurrency holders, an important consideration will be the manner in which the ICO sponsor can police transfer restrictions under Regulation D, Rule 4(a)((7) or other exemptions applicable to offers or resales to US persons as well as those applicable to Category 3 issuers for distributions in offshore transactions under Regulation S. In the case of offerings under Regulation D these include accredited investor qualification under Rule 506(c), investment intent and non-integration. In the case of offerings under Regulation S these include offering restrictions, offshore transaction requirements and limits on sales to US persons during the distribution compliance period.
Although an ICO could fall within the SEC’s crowdfunding regulation (Regulation Crowdfunding) if issued by a US person, the ICO would be limited in other significant respects, including limitations on the offering amount per 12-month period, the size of the investment per individual investor, and restrictions on the resale of tokens. As a practical matter, Regulation Crowdfunding may be unavailable because most ICO issuers are organized outside the USA and because securities offered under Regulation Crowdfunding must be offered and sold through funding portals and broker-dealers that are registered under the Exchange Act.
1.3 Is the ICO sponsor an investment adviser?
Sponsors of ICOs also need to consider whether they are offering investment advice such that they would be subject to SEC registration requirements applicable to investment advisers. The Investment Advisers Act of 1940, as amended (the “Advisers Act”), applies to any person who, for compensation, engages in the business of advising others as to the value of securities or the advisability of investing in, selling, or purchasing them. Depending on the structure of a token offering, Advisers Act considerations may be applicable if a token is a security. The Advisers Act may apply to the sponsor of an ICO if the tokens are a security and if the platform’s business involves the acquisition of securities, including digital tokens that are investment contracts. A particularly important consideration for an investment adviser relates to how such an adviser can comply with the SEC’s custody rule. For instance, how can a password for a token be stored for purposes of the custody rule? Notably, a sponsor may be an investment adviser but could be exempt from registration as an Exempt Reporting Adviser (ERA). An ERA will still remain subject to certain regulations under the Advisers Act.
1.4 Inadvertent investment company considerations
Depending on facts and circumstances, an issuance of tokens that are considered securities may implicate the Investment Company Act of 1940, which, generally speaking, applies to issuers of securities that invest in securities. A platform that invests proceeds of an ICO in investment securities pending build-out may inadvertently be an investment company.
2. Tradability and intermediaries
Often, one of the features desired by ICO sponsors and their potential investors is the ability to trade the offered tokens after they have been acquired in the ICO. At bottom, there is a regulatory trade-off in seeking tradability of tokens, and sponsors that want to offer this feature need to address the added regulatory requirements that arise under USA securities laws and commodity futures laws.
2.1 Commodity Exchange Act considerations
Providing for secondary market trading and liquidity for tokens issued in an ICO requires a consideration of whether the token is a “commodity” under the USA commodity laws. A commodity is typically defined as a reasonably interchangeable good or material, bought and sold freely as an article of commerce, which includes all services, rights, and interests in which contracts for future delivery are traded presently or in the future. The CFTC has taken the view that Bitcoin and other primary digital currencies are “exempt commodities.” As such, they are subject to regulation by the CFTC under the Commodity Exchange Act.
Pursuant to Section 2(c)(2)(D) of the Commodity Exchange Act, if a platform or exchange offers or sells cryptocurrencies that are considered to be commodities to persons that are neither an eligible contract participant nor an eligible commercial entity and the transaction is margined, leveraged, or financed, it must “deliver” the relevant cryptocurrency to the buyer on spot, i.e. within 28 days or it must register with the CFTC as a futures commission merchant.
In December 2017 the Commodity Futures Trading Commission issued a proposed interpretation of the term “actual delivery” within the specific context of retail commodity transactions in cryptocurrency. The proposed interpretation is based on the CFTC’s final interpretation of the term “actual delivery” in the context of Section 2(c)(2)(D) of the Commodity Exchange Act (the “2013 Guidance”). The 2013 Guidance explained that the Commission will consider evidence ‘beyond the four corners of contract documents’ to assess whether actual delivery of the commodity occurred. It establishes that actual delivery must involve the transfer of title and possession of the commodity to the purchaser or a depository acting on the purchaser’s behalf.
The CFTC’s view of when actual delivery has occurred within the context of cryptocurrency requires the following:
A customer having the ability to take possession and control of the entire quantity of the commodity, whether it was purchased on margin, or using leverage, or any other financing arrangement; and use it freely in commerce (both within and away from any particular platform) no later than 28 days from the date of the transaction; and
The offeror and counterparty seller (including any of their respective affiliates or other persons acting in concert with the offeror or counterparty seller on a similar basis) not retaining any interest in or control over any of the commodity purchased on margin, leverage, or other financing arrangement at the expiration of 28 days from the date of the transaction.
Consistent with the 2013 Guidance, a sham delivery does not constitute actual delivery for purposes of the proposed interpretation, and in the context of an ‘actual delivery’ determination in cryptocurrency, physical settlement of the commodity must occur.
2.2 Are intermediaries securities exchanges, investment advisers or broker-dealers?
The Exchange Act regulates securities exchanges and broker-dealers. If a token is a security, exchanges on which it is traded would have to be registered under the Exchange Act and intermediaries would have to be registered as broker-dealers under the Exchange Act or as registered investment advisers under the Advisers Act. Because most – if not all – cryptocurrency exchanges are not so registered, the exchanges will accept tokens for unrestricted trading only if they believe the tokens are not securities. As discussed above, the Exchange Act would also apply to intermediaries and funding portals used in primary offerings under Regulation Crowdfunding. Owing to the prevalence of securities tokens and the policing issues discussed above, it is likely that a market infrastructure will emerge of virtual currency exchanges that are registered as alternative trading systems with the SEC and that police transfer restrictions using a form of permissioned blockchain.
If a token is a security, an exchange or other entity that for compensations advises on the value of tokens or the advisability of investing in tokens would be subject to the Investment Advisers Act considerations discussed above.
3. Tax considerations
The IRS characterizes cryptocurrencies as property rather than currency for federal tax purposes. Other than stating that “general tax principles applicable to property transactions apply to transactions using virtual currency,” the IRS has provided little guidance on the application of that characterization to specific facts and circumstances, resulting in considerable uncertainty for cryptocurrency issuers, investors and users. In general, when a cryptocurrency is exchanged for another cryptocurrency, or a good or service of greater value than the buyer’s basis in the cryptocurrency being exchanged, the transaction will trigger a taxable gain to the buyer in the amount of the difference between fair market value and basis. For issuers and investors, the tax treatment of transactions involving ICOs will vary depending on the facts of each ICO, including whether the tokens being issued are equity, security or utility tokens. An issuer must determine whether the sale is inventory or equity. An investor will need to determine whether the value of the inventory or equity received exceeds the investor’s basis in the cryptocurrency being exchanged.
These effects might be mitigated to some extent if the Cryptocurrency Tax Fairness Act of 2017 (the “Act”) becomes law. This bill, which is currently pending in the USA House of Representatives, would exclude from gross income up to $600 in gains on certain cryptocurrency sale and exchange transactions while creating a reporting regime for cryptocurrency transactions. However, sales or exchanges of cryptocurrency for cash or cash equivalents would not qualify for the exclusion, so the form of the ICO would affect the Act’s applicability. Further, since the Act is intended to facilitate common usage of cryptocurrency, it is unclear if ICO transactions would be within its purview.
Tokens may be considered interests in partnerships or unincorporated associations, giving rise to various tax considerations. P.L. 115-97, known as the Tax Cuts and Jobs Act, extends the holding period for certain partnership interests from one to three years in order to qualify for long-term capital gain treatment, and could apply to ICOs.
Tax reporting obligations intended to make non-US financial investments more transparent to USA government authorities may be applicable, although this aspect of tax compliance has not kept pace with the evolution of cryptocurrency and is not well developed. Pursuant to the USA Bank Secrecy Act and its related regulations (collectively, the BSA), the IRS administers foreign bank account reporting (FBAR) on behalf of the Financial Crimes Enforcement Network. FBAR reporting is required when a US person holds an interest in, or signature authority over, one or more financial accounts located in a foreign country with an aggregate value exceeding $10,000. The penalty for failure to comply with FBAR requirements can be as large as fifty percent of the aggregate balance of all foreign accounts. To date, the IRS has not ruled on whether an ICO or other cryptocurrency arrangement constitutes a financial account. The Foreign Account Tax Compliance Act (FATCA) requires individual taxpayers and specified entities with an interest in certain foreign financial assets over certain threshold amounts, e.g. joint filers with assets valued greater than $100,000 at the end of the taxable year, to disclose such interest on Form 8938 with the annual tax return. Penalties apply for failure to comply. Like FBAR reporting, the IRS has not ruled whether an ICO or other cryptocurrency arrangement is subject to reporting on Form 8938. FATCA reporting also could apply to ICO issuers located outside the USA. FATCA requires non-US foreign financial institutions (FFIs) to identify US account holders and annually report those accounts to the USA Department of the Treasury (Treasury). For purposes of FATCA, ICO issuers might meet the definition of an FFI. Failure to comply results in a thirty percent withholding tax on many types of US-source income paid to the FFI. Country-by-country reporting, an outcome of the Organization for Economic Cooperation and Development’s Base Erosion and Profit Shifting initiative, also could apply to cryptocurrency exchanges, depending on their size.
In response to a recommendation in 2016 by the Treasury Inspector General for Tax Administration, the IRS agreed to establish a virtual currency strategy, including whether information reporting requirements should be updated. The burden and uncertain status of US tax laws and regulations could be one reason why token issuers tend to be established in jurisdictions outside the USA. However, to the extent that USA investors are subject to tax on their worldwide income, a non-US issuer will not insulate US investors from US tax implications.
4. Bank secrecy act and anti-money laundering considerations
The ICO market has recently come under criticism from prominent figures within the financial services industry because of its potential to facilitate money laundering, terrorist financing, and other criminal activities. Participants in an ICO in the USA or targeted at USA persons should be sensitive to the BSA.
The BSA generally requires entities meeting the definition of “financial institution” to maintain and develop appropriate programs to assist the USA government in detecting and preventing criminal activities. A “financial institution” under the BSA includes not only banking institutions, SEC-registered broker-dealers, and CFTC-registered futures commission merchants, but also includes money services business (MSBs) such as money transmitters. In March 2013, the Financial Crimes Enforcement Network (FinCEN) issued guidance (the Guidance) clarifying that certain cryptocurrency administrators and exchangers are considered to be “money transmitters” under the BSA, requiring registration as an MSB with FinCEN and the implementation of an effective anti-money laundering (AML) compliance program. In certain cases, ICO sponsors and other companies engaged in activities relating to cryptocurrencies could be subject to BSA regulation as money transmitters.
Each financial institution subject to the BSA, including money transmitters, must maintain a written AML program that is reasonably designed to prevent the business from being used to facilitate money laundering and the financing of terrorist activities. The AML program must be commensurate with the risks posed by the location and size of the business and the nature and volume of its financial services. The program must include policies, procedures, and internal controls designed to achieve ongoing compliance with applicable BSA requirements, designation of one or more compliance officers, ongoing training of appropriate personnel, and independent monitoring. MSBs also are required to collect and retain certain specified customer information.
FinCEN’s Guidance distinguished among “users,” “exchangers” and “administrators” of virtual currencies. While users are not subject to BSA regulation as money transmitters, exchangers and administrators generally will be. Under the Guidance, an “exchanger” is a person engaged in the business of exchanging virtual currency for real currency or other virtual currency; an “administrator” is engaged in the business of issuing (putting into circulation) a virtual currency and that has authority to redeem that virtual currency. Whether an ICO sponsor is subject to the BSA would therefore depend on whether its activities cause it to be an exchanger or administrator.
5. State money transmitter licensing
States have also focused on whether sellers, issuers, transmitters and/or exchangers of cryptocurrency must be licensed as “money transmitters” under state laws. Currently over ten states have indicated an intention to license certain activities involving cryptocurrencies. And last year the Uniform Law Commission issued a proposed “Regulation of Virtual Currency Business Act,” which “provides a statutory framework for the regulation of companies engaging in “virtual-currency business activity”. The proposed framework defines this activity as “exchanging, transferring, or storing virtual currency; holding electronic precious metals or certificates of electronic precious metals; or exchanging digital representations of value within online games for virtual currency or legal tender.” The extent to which these state regulatory efforts may impact entities issuing tokens or sponsoring ICOs is still unclear and is beyond the scope of this article.
6. The Simple Agreement for Future Tokens
During the first wave of ICOs based on the Howey test there emerged a device, known as the SAFT (Simple Agreement for Future Tokens), to help address some of the regulatory uncertainties in ICOs of utility tokens where the utility does not exist on the date of the ICO.
With respect to securities law compliance, the SAFT framework was designed to permit an issuer to comply with the federal securities laws in an exempt offering while having those requirements (and any concern about underwriter liability) fall away when the SAFT is redeemed for a utility token (i.e. a token that is not a security). From the perspective of money transmitter laws, the SAFT is arguably one step removed from a “convertible cryptocurrency” and may also reduce the possibility that the issuer or the investors will be considered to be an exchanger or that the issuer may be considered an administrator. From a tax perspective, the SAFT is generally intended to be taxed as a forward contract, which may mitigate — but does not eliminate — tax inefficiencies in token transactions. If that characterization is upheld, the first taxable event in the ICO would occur only when the tokens are delivered to the investors upon redemption of the SAFT.
The utility of the SAFT has been much reduced to the extent that tokens issued in an ICO are considered securities irrespective of utility. Furthermore, it is important to be mindful that the SAFT has not been endorsed by the SEC, the IRS, or FinCEN and has not been the subject of any judicial decisions. However, it may be regarded as representing an emerging consensus on a responsible approach to addressing certain regulatory issues posed by ICOs.
7. The Weiji forward 危机
We are spectators in a race between technological innovation that outstrips existing financial markets regulation and adaptation of regulation to ensure that the new technology does not harm financial markets or investors. The Etherium blockchain ERC20 protocol has rapidly accelerated the potential of distributed ledger technology by making possible the practical use of smart contracts to convert Bitcoin (as well as Ether and other cryptocurrencies) into a wide range of tokens that can represent an astonishing array of decentralized applications providing real and virtual goods and services. This creates a fascinating tension between the way in which markets are evolving through new technology and the requirements of regulatory schemes that were created in a vastly different technological world. The rapid evolution of technology that has made ICOs possible is matched by a rapid evolution of the views of regulators and of how to regulate this new market. This will create opportunities for entrepreneurs but also creates a unique regulatory risk profile for market participants considering participating in ICOs or other cryptocurrency transactions. 2018 will likely see rapid advances in the development of market infrastracture and further technological innovations that will help facilitate regulatory compliance in token offerings.
Cryptocurrency refers to decentralized digital assets that use cryptography as a means of securing transactions independent of clearinghouses while preserving anonymity in the traditional sense. Cryptocurrency typically takes the form of digital coins or tokens that exist on the Ethereum blockchain or distributed ledger, whereby owners receive a key that serves as the password to ownership of the coin or token.
328 US 293, 301 (1946); see also United Housing Found., Inc. v. Forman, 421 US 837, 852-853 (1975). Other standards may apply to the characterization of a token under the Securities Act depending on the characteristics of the token. See, e.g., Reves v. Ernst & Young, 494 US 56 (1990).
Report of Investigation Pursuant to Section 21 of the Securities Act. See www.sec.gov/litigation/investreport/34-81207.pdf
In the Matter of Munchee Inc., Securities Act Rel. No. 10455 (December 11, 2017), available at: www.sec.gov/litigation/admin/2017/33-10445.pdf. On the same date, the Chairman of the SEC released a statement on ICOs and cryptocurrencies that provides important guidance on (i) the SEC’s position with respect to whether tokens offered in ICOs are securities; (ii) the need for adequate disclosure; and (iii) the vital role of lawyers, accountants, consultants, and other professionals as “gatekeepers” of investor protection.
Analogous concepts under the securities laws of other countries may also be applicable depending on the location of the purchaser.
In re BFXNA INC. d/b/a BITFINEX, CFTC Docket No. 16-19 (June 2, 2016) (consent order). See also CFTC vs McDonald et al., Memorandum and Order 18-CV-361 (E.D.N.Y. March 6, 2018).
The Treasury Department has convened the SEC, CFTC, Federal Reserve Board and FinCEN to coordinate on how to appropriately regulate crypto/virtual currencies. This may conceivably recommend that Congress amend the Commodity Exchange Act to shorten the spot delivery period from 28 days, which would give the CFTC broader jurisdictional authority over retail transactions in virtual currencies that are not securities.
Retail Commodity Transactions Under Commodity Exchange Act, 78 FR 52426 (Aug. 23, 2013).
For a further discussion of this proposed interpretation, see www.klgates.com/virtual-currency–-nfa-reporting-requirements-and-cftc-proposed-interpretation-of-actual-delivery-01-08-2018/
IRS Notice 2014-21.
These include Alabama, Connecticut, Georgia, Hawaii, Idaho, Illinois, Kansas, New York, North Carolina, Texas and Washington.
The SAFT is an investment contract modeled on Y Combinator SAFE notes, which are widely used to finance early-stage venture companies, with the difference being that the holder is entitled to receive tokens instead of equity. For more information about the SAFT, see the white paper developed by the SAFT Project, http://saftproject.com/static/SAFT-Project-Whitepaper.pdf.
About the authors
Anthony R.G. Nolan (firstname.lastname@example.org) is partner at K&L Gates LLP, New York, New York, USA
Edward T. Dartley (email@example.com) is partner at K&L Gates LLP, New York, New York, USA
Mary Burke Baker (firstname.lastname@example.org) is a government affairs counselor at K&L Gates LLP, Washington DC, USA
John ReVeal (email@example.com) is a partner at K&L Gates LLP, Washington DC, USA
Judith E. Rinearson (firstname.lastname@example.org) is a partner at K&L Gates LLP, London, UK and New York, New York, USA