Note: This post does not provide legal advice. In any token sale, there are a host of legal requirements to consider. Please consult your own securities lawyer.
“I believe every ICO I’ve seen is a security… ICOs that are securities offerings, we should regulateq them like we regulate securities offerings. End of story.”
This is a statement made by Jay Clayton, the Chairman of the U.S. Securities and Exchange Commission, before the United States Senate on February 6, 2018. He makes it clear that the US securities laws apply to almost every ICOs and that the entrepreneurs who raise funds with an ICO are required to comply with regulations set by the SEC. In his speech, Clayton revealed that he instructed the SEC staff to be on high alert for ICOs that may be contrary to the nation’s Securities Law.
SEC has now made it crystal clear that virtually all ICOs are securities and they want to define a path forward for the industry through rigorous enforcement. Simply put, the commission wants all ICOs conducted for fundraising in the U.S. to be brought into immediate compliance with securities laws. SEC proposes a way to do that with a Reg D-compliant private sale, combined with a new token permissioning technology (the “R-Token”) that makes it possible for issuers and investors to abide by existing rules and regulations. This approach shall be called as Private Placement ICO or “PICO”. Before exploring the PICO, let’s take a deeper look at the journey ICO founders have traveled to reach the PICO policy.
A brief history of ICO and compliances
Initially, no one thought of applying compliances to the ICOs. Especially since those ICOs were small and launched with little public awareness. However, by March 2017, ICOs had raised a total of $330 million, and six months later in September 2017, the total raised funds were over $2 billion. This explosive growth of ICOs resulted in SEC publishing a report (DAO report) in June 2017, which mentions that digital assets could be securities, applying traditional securities law doctrine (the Howey test). After this report, Protocol Labs and the law firm of Cooley LLP introduced a conceptual framework for how securities laws might apply to token sales in a white paper entitled “The SAFT Project” (October 2017). The paper argued that tokens designed for use as payment in blockchain protocols were likely not securities when the protocol was functional and the token had true utility. At the same time, the white paper expressed concern over ICOs of utility tokens before they were functional, warning that most such tokens would likely be deemed securities subject to the federal securities regime.
SAFT project outline a model in which, instead of issuing pre-functional utility tokens, the company would enter into a forward contract with accredited investors. The accredited investors would provide the company with immediate capital, and in exchange, would be promised rights to receive functional utility tokens once the protocol was working. While the SAFT itself was security, the tokens themselves would not be securities because they were functional. Thus there would be no restrictions on the further sale of these utility tokens. Since October 2017, many companies have followed this process. However, the recent series of escalating comments from the SEC shows that the simple binary functionality distinction in the SAFT white paper is not sufficient to exclude ICOs from the SEC compliances.
Origin of Reg D compliant “Private ICOs”
ICO fundraising hasn’t slowed even with SEC’s enforcement but has accelerated with a record of around $2Billion raised in 2018 already. However, the Commission’s action has resulted in public crowd sales being replaced by private ICOs that limit token sales to accredited retail investors and institutions. Nearly 84% of the ICO fundraising in 2018 was from private ICOs. The Private ICO uses the Reg D, specifically Rule 506(c) to comply with the securities laws. A significant restriction in the Form D security issuance is that only authorized investors with more than 1 million USD in net worth may buy it. Reg D securities can be issued more easily than public securities through their trading is restricted in the first year. Many private ICOs have the drawback of not enforcing restrictions in secondary trading. The problem of secondary trading during the restricted period can be solved by selling tokens to an authorized investor subject to a one-year lock-up so that investors don’t receive their tokens for at least one year.
Even though Reg D securities are easier to issue than public securities, their trading is restricted in the first year after issuance. To comply with this, ICOs started selling tokens to accredited investors with a token lockup of one year so that the investors don’t receive their tokens for at least one year. This solved the problem of secondary trading during the restricted period, but it created a practical issue where the protocol could not function in the first year due to the unavailability of tokens.
To address this problem, ICOs started giving away free tokens in name of “airdrops” to the investors under the assumption that securities laws do not apply for tokens that are given away rather than sold. However, this practice also turned out to be not acceptable for the SEC since the company has already received or will receive “any value” from the recipients of the airdrop in exchange for the tokens. This makes the securities laws apply to the airdrop as well. In light of the recent comments and actions of SEC, we can expect stronger policies from them against the approach of “lockup + airdrop” for token distribution.
How to Make PICOs Compliant?
The objective of a Reg D-compliant private sale needs to
- enforce restrictions on secondary trading
- enforce restrictions on initial issuance of tokens
- tokens need to be sufficiently available to enable use of the protocol.
Solution: A combination of Reg D, Section 4(a)(7), and Rule 144 can achieve the objective of a private ICO as pointed above. Under Section 4(a)(7), the private resale exemption accredited investors may generally resell to other accredited investors after a 90-day post-issuance lockup period. One year after the initial issuance, the public may generally buy and trade the tokens under Rule 144.
In this scenario, the company raises initial funds on a SAFT from accredited investors, then issues the tokens to those accredited investors. After a relatively short 90-day lockup, those initial accredited investors are free to trade with any other accredited investors. This allows the protocol to begin functioning. Nine months after that, all investors, not just accredited, are free to own the token.
How to enforce secondary trading?
A new technology called R-Token enforces the secondary trading requirements under Section 4(a)(7) and Rule 144. An R-Token is a permissioned token based on the Regulated Token Standard. The Regulated Token Standard is based on the ERC-20 standard but contains additional code to check an on-chain Regulator Service before it trades. The Regulator Service can be configured to meet relevant securities regulations, Know Your Customer (KYC) policies, Anti-Money Laundering (AML) requirements, tax laws, and more.
When a trade is requested, the R-Token checks with the Regulator Service to make sure that the investor and the trade are compliant; otherwise the token throws off an error message and will not transfer. In the case of Section 4(a)(7), for example, R-token will ensure that a token is being transferred to an accredited investor after the initial 90-day period. The R-Token can also be implemented to ensure that the tokens trade only on approved trading platforms.
The PICO’s protocol allows for multiple jurisdictions for true international compliant use. For example, Reg S provides an exemption under U.S. securities laws for international offerings sold to non-U.S. persons. Issuers wanting to do a Reg S token sale could permission R-Token to exclude U.S. persons altogether. Alternately, R-Token could facilitate the combination of a Reg D offering to accredited U.S. investors and a Reg S offering to non-U.S. persons to achieve the widest possible compliant token distribution.
The SEC has a 3-part mission: (i) protect investors, (ii) maintain fair, orderly, and efficient markets, and (iii) facilitate capital formation. The Reg D-compliant PICO serves all three interests, providing a common, reliable, and efficient way to raise funds with slowly expanding liquidity as the risks to investors lessen and become better known:
- Compliance with Reg D protects investors by limiting the initial issuance to accredited investors who have the sophistication and financial resources to deal with the risks of a nascent industry with young companies.
- The 90-day lockup period of Section 4(a)(7) dampens the initial speculative fever that has accompanied prior ICOs. The continued limitation of trades after 90 days to accredited investors protects the broader investor community when the protocol and company are still very young and risky.
- The opening up of secondary trades to any investor after a year allows for essentially public distribution of the tokens.
In the first year after the token issuance, the company will have a limited pool of engaged, and fault-tolerant users which can add value to the company, and after a year from the token issuance, there should be much more information for all investors on whether the protocol is working, the use and valuation of the token, etc., Moreover, after a year the functionality of the protocol may have advanced sufficiently such that the tokens have truly become utility tokens. R-Token ensures that every token holder is a known party who passes KYC/AML and other tests.
ICO fundraising has impacted innovation across the industry, democratizing global capital access and allowing passion-driven developers to accomplish their visions. Investors have to quickly ensure that their ICOs are compliant with securities and other laws to prevent it from getting shut down by regulators and private litigation. It is the need of ICO issuers and issuing platforms to embrace the Regulated Token Standard, and to that end, they should execute the necessary restrictions on issuance and secondary trading. Despite the growing demand for ICO fundraising, many investors don’t comply with the securities laws. It is high time the industry protect their ICOs and token sales from being strangled by law enforcement, private litigation, and new regulations. PICO with the proper implementation of permissioned tokens will allow this new financial system to flourish.