In 2017, startups raised over $5.6 billion through Initial Coin Offerings (ICO’s). These were highly speculative offerings. Many entrepreneurs launched ICO’s with little more than a white paper describing what they planned to build. Unsurprisingly, nearly half of these offerings collapsed by early 2018.

These figures, combined with many fraudulent offerings, attracted the attention of regulators around the globe. In December 2017, The United States Securities and Exchange Commission released a public statement clarifying that ICO offerings are often securities. Distributed-ledger/blockchain technology’s altered offering structure does not change the fundamental nature of a security. In 2018, during a Senate hearing on cryptocurrency, the Chairman of the SEC noted that “every ICO I’ve seen is a security.”

Despite the heightened scrutiny ICO’s face, not every ICO is a security. In this article, I will explain what a security is in the context of an ICO and give a few pointers on how to navigate the shifting legal landscape of this powerful fundraising tool.

Securities as an Investment Contract

For purposes of an ICO, a security is an investment contract. In 1946, in the case of SEC v. W. J. Howey Co., the Supreme Court developed a four-prong test, now known as the Howey test, to determine whether a simple contract is an investment contract. The Howey test finds an investment contract if the following four questions are answered affirmatively.

1. Is there an investment of money? (Note: later court rulings clarified that assets also meet this test)
2. Is there an expectation of profit from the investment?
3. Is the investment in a common enterprise?
4. Do the profits come from the efforts of a promoter or other 3rd party?

The Company involved in this landmark case was a Florida based citrus producer that sold tracts of land and offered a service agreement to tend the land, as well as harvest and market the produce. The majority of the Supreme Court found that the substance of the combined agreements constituted a security and the offering was illegal since it failed to meet the disclosure and reporting requirements of the securities act.

Given this broad definition of an investment contract, most early-stage companies avoid the requirements of the act by limiting their offerings to investors who meet a qualifying exemption. This often means limiting early investment to accredited investors and company insiders. Since 2012, there have been several attempts to develop less burdensome securities regulations that allow non-accredited investors to purchase a stake in early-stage businesses (See my earlier article on Washington Intrastate Equity Crowdfunding).

The Utility Token

ICO’s can take many forms, conferring a variety of rights and/or obligations on the holder. The utility token is one form which avoids securities regulations, allowing the coin to be offered without expensive legal filings. Some analogize the utility token with an arcade token. However, I find this definition limiting since utility tokens can offer more complex and interesting services than those offered by arcades.

Wyoming recently passed legislation explicitly exempting utility tokens from Wyoming securities regulations if the offering meets a three-prong test (note: an ICO could avail itself to this law by incorporating in Wyoming and registering under the act).

1. The issuers do not market the tokens as investments.
2. The tokens are currently redeemable for a product or service.
3. The issuers do not actively support the development of a secondary market for such tokens

The second prong’s “currently redeemable” requirement implies the tokens are issued in connection with an operational product or service. However, this definition is untested and may include crowdfunding type pre-sale offerings supported by outside service agreements or other contracts.

According to the SEC, one example of a valid utility token is a book-of-the-month token. As the name implies, the token would grant its holder rights to a new book each month. In this case, tokens may be an efficient method to fund the acquisition of books, distribute those books, and might also help administer other bookclub type activities such as voting on next month’s book.

Other Novel Concepts

One problem with the book-of-the-month example is its failure to consider how distributed blockchain technology adds value to the product or service offered. I’m interested in opportunities to develop distributed organizations that actively benefit from the distributed nature of blockchain technology. Two areas of particular interest include international non-profit organizations and investment clubs; however I’m confident there are many other novel applications.

Non-profits pass the Howie test, and thus aren’t securities, since they don’t have an expectation of profits. They also benefit from the distributed nature of blockchain technology by both helping administer an international membership base as well as easily transfer funding across borders to support international programming.

Investment clubs are more heavily regulated unless limited to 100 members. However, investment clubs can also pass the Howie test, and avoid securities regulations, if all members are actively involved in the profit-seeking efforts of the organization. For example, by actively involving all members in the investment decisions, the profits are not derived from the activities of the promoter or a 3rd party, but instead from the cumulative contributions of investment club members.

In both cases, I am particularly interested in the possibility of developing utility tokens or smart contracts which offer the service of setting up these organizations and leaving the fundraising to the purchasers of the distributed organization.

Complying with Securities Regulations

For applications of blockchain technology that can’t avoid securities regulations, there is still a path to launching an ICO. Regulation A+ was designed as an option for mid-sized companies to raise up to $50 million from the general public. Bitzumi was the first company to conduct an ICO under Regulation A+. However, I expect this may become a trend, especially if pending legislation passes raising the fundraising cap.

It should be noted that Regulation A+ is a substantial undertaking, involving a financial audit and significant disclosures. Fortunately, Regulation A+ allows testing-the-waters campaigns which can build momentum before taking on the expense of registering an offering. And with momentum from the testing-the-waters campaign, a company could use an agreement as simple as the aptly named Simple Agreement for Future Tokens to raise the funding necessary to launch a Regulation A+ offering (note: a SAFT would be limited to accredited investors).

This covers the basics of what a security is in the context of ICO’s by highlighting the Howie Test, recently emerging utility token legislation, and the Regulation A+ offering. As a primer, it does not contain in-depth discussion of the fact-specific application of these tests nor consider other laws which might impact particular offerings. If you have a concept for a unique application of blockchain technology, be sure to discuss the idea with counsel early in the design process. This will allow your counsel to help direct your design efforts towards a legally compliant offering and inform you of any risks inherent to your particular offering.