10 April 2018
Initial coin or token offerings (ICOs) can provide a great way for blockchain start-ups to quickly raise the capital they need to develop revolutionary new ideas – from decentralised renewable energy trading platforms to an Interplanetary File System. Almost US$5 billion has been raised through ICOs so far this year, following on from US$4 billion in 2017. This is huge given the technology is in its infancy. Indeed, research from Ernst & Young, published late last year, suggests that around 84% of ICOs are conducted in respect of projects that have not proceeded past the ‘idea stage’.
Therefore, while many of the ideas are inspiring, business failure risk is, inherently high. Moreover, because the technology involved is incredibly sophisticated, analysing that risk is not always easy. It is not entirely clear whether there is protection for the unwary against scoundrels within existing regulatory frameworks.
ICOs may create a new asset class but investing in tokens is somewhat like a holiday to an unfamiliar destination. Sure, there may be attractive upside (escapism and a touch of the exotic) but you really do need your wits about you, especially when wandering the streets late at night. Yes, there may be police around, but the risk profile is different. For instance, the use of a private code base or a centralised consensus mechanism, unclear token distribution and scarcity profiles, or limited token-holder rights, can all create significant investor risks.
So, like all new and exciting things, there is a balance to be struck between regulation and innovation – protection and creation. In trying to figure out where the regulators will draw the line, there is sentiment in international blockchain circles that if a token is designed for “utility” and not for investment – that is, it provides rights to goods or services produced by the blockchain platform (eg the right to access a decentralised social media service) – it should fall outside the purview of securities laws, which establish strict (and, for issuers, often burdensome) investor protections.
However, a recent assault by the US Securities and Exchange Commission (SEC) against “dozens” of ICOs reinforces the notion that even utility tokens may be deemed securities, particularly if they are issued in respect of a platform where purchasers are speculating on the token’s value. This approach relies on the US-based Howey test for an “investment contract” - a catchall in the definition of a security under US law. In summary, an investment contract is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the managerial efforts of others. The test is one of economic reality and manner of sale is key.
For example, consider the Munchee Inc case that the SEC settled late last year. The case involved an offer of MUN utility tokens, which provided the right to take part in a to-be-developed, food review “ecosystem”. The SEC noted in a press release that because ‘Munchee offered MUN tokens … to raise capital to build a profitable enterprise’ and that the ‘promoters emphasized that investors could expect that efforts by the company and others would lead to an increase in value of the tokens’, which, importantly, could be traded on a secondary market, they viewed the token as a security. In fact, just the other week, in submissions against Maksim Zaslavskiy for securities fraud over two ICOs that targeted the real estate and diamond markets, the SEC again emphasised that utility tokens issued in respect of undeveloped platforms are in the firing line: Zaslavskiy’s plan that the tokens would be useful in an ‘ecosystem that he had not built’ yet did not change the nature of his promise to investors. He ‘offered and sold the investment opportunity to profit from his development of that ecosystem’, which ‘bears all the hallmarks of a securities offering’.
For Australia, it is important to note that the test for an investment contract under US law is not too dissimilar to the test for an interest in a managed investment scheme (MIS) under the Corporations Act 2001 (Cth). While utility tokens are unlikely to fall within the MIS regime in a traditional sense (they typically deal with rights to participate in profit-sharing schemes – eg real estate investment trusts), in September 2017, ASIC provided ominous guidance that echoes the SEC’s views: ‘ICO issuers may frame the entitlements received by contributors as a receipt of a purchased service. However, if the value of the digital coins acquired is affected by the pooling of funds from contributors or use of those funds under the arrangement, then the ICO is likely to fall within the requirements relating to MISs’.
Thus, token issuers should be vigilant in how they manage the regulatory environment down under. Yes, there have been a handful of utility token ICOs for early-stage platforms in Australia recently, but these should not be relied on as a guide to ASIC’s future policy. Similarly, private token pre-sales to one’s closest 400 friends on Telegram is probably not wise either.
A popular US strategy worth mentioning involves the Simple Agreement for Future Tokens (SAFT). SAFT plays on the distinction between utility tokens issued in respect of a ‘functional’ and non-functional platform. And, while its intended effect has not been put to the test yet, it has been used to support fundraising from accredited investors (who are permitted to receive issued tokens without significant disclosure) prior to a platform’s development. Once a platform is “functional”, tokens are delivered to those investors and the argument goes that a retail ICO is then possible without those tokens being classified as securities. This is because the financial benefits that retail token-holders may receive from buying and selling tokens arguably stem from the forces of demand and supply in the market for the goods or services (ie the “utility”) that the token offers, and not the platform developers’ managerial efforts in bringing the platform to fruition. Supposedly, retail token-holders are simply taking on product risk not business risk.
However, adopting the SAFT in Australia has its flaws. The Cardozo Blockchain Project offers a convincing critique, pointing out that the legal characterisation of each ICO will not depend on bright-line rules but rather on its relevant facts, circumstances and economic realities. For example, if the focus is on functionality, at what point does a platform become “functional”? Will the MIS regime be triggered if managers use token-holders’ funds to perform updates post-functionality?
Manner of sale and the question of whether there is a dominant expectation of consumption are more important focal points than functionality. The creator of the Project and leading US crypto-law academic, Prof. Aaron Wright asserts that the ‘functionality concept is an artifice’. The “key inquiry will likely turn on whether the tokens are being purchased and ‘used’ by their target market or are simply being acquired by investors seeking a profit. The SAFT and all of the other pre-sale structures are being sold to investors and thus run the risk of running into a regulatory buzz saw. If a project needs to raise capital, it can sell an interest in a legal entity and the tokens (if they are intended to support an online platform or service) can be sold to end-users.”
Wright’s view gels nicely with the unregulated crowd-funding market. Consider, a crowd funding campaign for, say, a movie. Funders acquire a right to receive a DVD of the new movie in the future. Although they take on the risk it falls through, most people choose to fund the project because they are keen to eventually see the movie! (Even if there are some wily folks looking to get their hands on a bunch of DVDs to resell if it is a hit.).
Similarly, the offer of utility tokens to mums and dads without a prospectus is more easily digested if their dominant purpose is to use the tokens to access an online platform or service – and not turn a profit. This is more likely, but not conclusive, if the platform is live when the offer takes place.
Mike Lempres, Chief Legal and Risk Officer, at crypto-exchange, Coinbase, recently addressed the US House Committee on Financial Services, stating that the US market is ‘being chilled’ by regulatory uncertainty. Blockchain entrepreneurs are either moving to friendlier jurisdictions or offering tokens to accredited investors under Rule 506 Reg D (eg via the SAFT), which restricts trading for up to 12 months.
Liquidity is also a problem. Most crypto exchanges are not licensed to trade securities, which means uncertainty over their listed tokens’ legal character puts the exchange in doubt. Earlier this month, the SEC indicated that it is targeting trading of unregistered securities. Lempres restates the chill: ‘the absence of regulatory clarity has slowed our willingness and ability to list new assets’. Goldman Sachs-backed Circle, on the other hand, sees the illiquidity as an opportunity, with plans to turn recently acquired (for US$400 million) crypto-exchange Poloniex into an SEC-licensed alternative trading system.
Some jurisdictions also view regulatory uncertainty as a gap in market. Canada, Singapore, the Isle of Man and Gibraltar have all made efforts to welcome entrepreneurs looking to launch ICOs. It goes without saying that Switzerland is the major player. The Swiss Financial Market Supervisory Authority published ICO guidelines last month that indeed draw a general distinction between the regulation of payment tokens, utility tokens and asset (or security) tokens. Tellingly, utility tokens are ‘securities only if their sole purpose is to confer digital access rights to an application or service and if the utility token can already be used in this way at the point of issue’.
Some US States are seeking to provide a guide to federal regulators like the SEC as to how a token may be dealt with under securities’ laws. Wyoming State legislature has recently approved laws to provide exemptions from the State’s security, licensing and money transmission regulations for tokens that are not marketed as an investment and are exchangeable for goods or services. The laws are awaiting approval by the Governor of Wyoming. However, if approved, compliance with US federal laws will still be required if the tokens are offered outside of the state of Wyoming.
Back home, it is encouraging to see ASIC in discussion with Australia’s fin-tech industry to determine the best way to promote the development of blockchain technology in our country. We applaud any further efforts to alleviate uncertainty and ensure that Australia is seen as facilitating innovation and access to capital, whilst providing a safe place for investors to transact in the market.
 CoinSchedule Cryptocurrency ICO Stats: 2018 and 2017 <https://www.coinschedule.com>
 Ernest and Young, ‘EY research: initial coin offerings (ICOs)’ (December 2017), page 16 <http://www.ey.com/Publication/vwLUAssets/ey-research-initial-coin-offerings-icos/$File/ey-research-initial-coin-offerings-icos.pdf>.
 See generally, Peter Van Valkenburgh, ‘Framework for Securities Regulation of Cryptocurrencies’ (Coin Centre Report, January 2016 <https://coincenter.org/wp-content/uploads/2016/01/SECFramework2.5.pdf>.
 See also statements from SEC Chairman Jay Clayton in December 2017: ‘Prospective purchasers are being sold on the potential for 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. These are key hallmarks of a security and a securities offering.’ <https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11>
 See section 77b(a)(1) of the Securities Act 1933.
 SEC v. Howey Co., 328 U.S. 293 (1946) at 301; and United Housing Foundation, Inc v Forman, 421 US 837 (1975).
 See United Housing Foundation, Inc. v. Forman, 421 U.S. 837 (1975) at 849.
 SEC v Munchee Inc (Administrative Proceeding File no 3-18304).
 Importantly, the SEC has not ruled out the concept of a utility token that does not function as a security entirely. For example, see statements from SEC Chairman Jay Clayton in December 2017: ‘a token that represents a participation interest in a book-of-the-month club may not implicate our securities laws, and may well be an efficient way for the club’s operators to fund the future acquisition of books and facilitate the distribution of those books to token holders. In contrast, many token offerings appear to have gone beyond this construct and are more analogous to interests in a yet-to-be-built publishing house with the authors, books and distribution networks all to come’. <https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11>
 SEC v Maksim Zaslavskiy (Government Opposition to Defendant’s Motion to Dismiss - 17 CR 647 (RJD))
 Generally, a managed investment scheme has the following features:
(iii) the members do not have day-to-day control of the scheme.
While the analysis in this article focuses on interests in MISs, it is also important to remember that a token may meet the definition of other forms of financial products (eg derivatives, non-cash payment facilities and securities) under the Corporations Act 2001 (Cth).
 See ASIC Information Sheet 225 (published September 2017) <http://asic.gov.au/regulatory-resources/digital-transformation/initial-coin-offerings>.
 Marc Hochstein and Bailey Reutzel, ‘SEC ICO Probe Underway, But Stories Conflict on Size of Sweep’ (1 March 2018) <https://www.coindesk.com/sec-ico-probe-underway-stories-conflict-extent-sweep>.
 Juan Batiz-Benet, Marco Santori, Jesse Clayburgh, ‘The SAFT Project: Toward a Compliant Token Sale Framework’, Protocol Labs and Cooley (October 2, 2017).
 See Cardozo Blockchain Project, ‘Not so Fast – Risks Related to the use of a “SAFT” for Token Sales’ (research Report 1, 21 November 2017). <https://cardozo.yu.edu/sites/default/files/Cardozo%20Blockchain%20Project%20-%20Not%20So%20Fast%20-%20SAFT%20Response_final.pdf>
 See, for example, Burton & Ors v Arcus & Anor  WASCA 71 -, which notes that the definition of “managed investment scheme” imports a purposive element – the money or money's worth must be contributed for the purpose of acquiring the relevant rights to benefits (see par 19.6 of the explanatory memorandum to the Managed Investments Bill 1997). Similarly, the purpose of the pooling or use of funds in a common enterprise must be to produce financial benefits, referring to ASIC v Enterprise Solutions 2000 Pty Ltd  1 Qd R 135, 144 .
 For a great in-depth look at the issue, see Jonathan Rohr & Aaron Wright, ‘Blockchain-Based Token Sales, Initial Coin offerings and the Democratization of Public Capital Markets’, (working draft, 9 February 2018).
 See also case law in the US that supports the proposition that a transaction will not involve a security if the purchaser is motivated by a desire to use or consume an underlying good or service: Rice v Braninger Organisation, Inc 922 F.2d 788, 791.
 Written Testimony of Mike Lempres before the House Committee on Financial Services, ‘Examining the Cryptocurrencies and ICO Markets’, March 14, 2018 <https://financialservices.house.gov/uploadedfiles/hhrg-115-ba16-wstate-mlempres-20180314.pdf>
 SEC, Divisions of Enforcement and Trading and Markets, Statement on Potentially Unlawful Online Platforms for Trading Digital Assets, March 7, 2018 <https://www.sec.gov/news/public-statement/enforcement-tm-statement-potentially-unlawful-online-platforms-trading>
 FINMA, ‘Guidelines for for enquiries regarding the regulatory framework for initial coin offerings (ICOs)’, 16 February 2018 <https://www.finma.ch/en/news/2018/02/20180216-mm-ico-wegleitung/>
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