Initial coin offering, security token offering, or initial token sale – whatever you call it, there are important legal issues to consider when selling digital assets or digital coins.
Initial coin offerings are all the rage for companies looking to raise capital for projects. According to Coindesk there were almost 350 ICOs in 2017, and as of April 2018, there have been 200 ICOs. The success of these offerings (and their underlying projects) has varied considerably.
The Securities and Exchange Commission (SEC) has taken an interest in ICOs. According to the Chairman of the SEC, coins or tokens sold in ICOs are securities that should either be registered with the SEC or must be sold pursuant to an applicable exemption from registration.
Here are a few considerations if you are planning on conducting an ICO for your company:
- Is the coin a security? – A coin is subject to same securities law analysis as any other instrument. The SEC has set forth the following criteria in determining whether an instrument is a security: (1) an expectation of profits arising from (2) a common enterprise that (3) depends upon the efforts of others.
In practical terms, this means that if the ICO is to be used to finance the completion of a project, then it will be considered a security, which means that the offering of the coins must either be registered with the SEC or sold pursuant to an applicable exemption.
Even if the coin’s underlying asset is an already completed project (for instance, real estate), then it could still be considered a security, because the purpose of the coin is to vest ownership in or pass on returns from the underlying asset.
- Could the token be considered another type of instrument, such as a commodity? – It may also be necessary to consider whether the coin is also another type of interest, such as a commodity interest. A federal court recently ruled that virtual currencies are commodities for purposes of the Commodity Exchange Act, which requires commodity contracts to be sold only on commodity exchanges registered with the Commodity Futures Trading Commission.
- What other legal requirements apply to the company’s business? – Depending on the business plan of the company issuing the coin, additional non-securities law legal requirements may apply. For instance, if the company issuing the coin is intending to make loans which will be represented by the coins, then state lending laws may apply. These laws often require registration with state authorities and state interest law caps may apply.
- How will the coins be sold? – The ICO itself is a public affair, with the coin issuer advertising the offering. That means the manner in which the coins are offered must fit into one of the following categories:
- Rule 506(c) – With this exemption, there is no limit on how many coins can be sold or how much capital can be raised. However, all investors purchasing the coins must be accredited investors, and the accredited investor status of each investor must be verified. Self-certification by the investor (i.e. checking a box) is not sufficient. Coins sold under Rule 506(c) are considered restricted securities, which means that they must be held for at least one year before being resold. In order to sell coins under a Rule 506(c) exemption, a private placement memorandum is advisable in order to describe the issuer’s business, management, project, and risk factors.
- Regulation A+ – Regulation A+ offerings go through a process similar to SEC registration. The issuer must prepare and file with the SEC an offering circular (similar to a prospectus) that describes the issuer’s business, management, and risk factors. In addition, audited financial statements are required. Once the offering circular is declared effective by the SEC, then there are certain ongoing compliance requirements, such as filing semi-annual and annual reports with the SEC, as well as current reports for certain extraordinary corporate events. Coins sold to investors in a Regulation A+ offering can be freely resold, which makes Regulation A+ an ideal process for most ICOs. ICOs conducted pursuant to Regulation A+ are limited to $50 million.
- Fully registered offering – In a fully registered offering, a full registration statement (that includes a prospectus) is filed with the SEC. Audited financial statements are also required. In this sense, it is similar to a Regulation A+ offering. However, once the SEC has declared the registration statement effective, the issuer is required to file annual, quarterly, and current reports with the SEC on an ongoing basis. In addition, registration is also required at the state level for securities sold in a fully registered offering. The benefits of a fully registered offering are that the coins can be freely resold by non-affiliates and there is no limit on the amount that can be raised.
- Regulation S – This exemption allows coins to be sold to non-U.S. investors only. The coins may be freely resold outside the U.S.; however, they may not be resold to U.S. investors for one year. Investors purchasing in a Regulation S offering are required to certify to the issuer that they are not a U.S. person.
If the goal of the offering is to have the coins trading so that initial investors can sell the coins, then Regulation A+, a fully registered offering, or Regulation S are the only available options. As noted earlier, coins sold under Regulation S cannot be resold in the U.S. for a year; however, they can be resold to investors outside the U.S., subject to compliance with any applicable non-U.S. securities laws.
Often, coin issuers planning an ICO will undertake a pre-ICO raise from established angel investors or venture capital investors in order to raise capital for the expenses associated with the ICO. These offerings can be conducted in reliance upon a different and more permissive offering exemption if the offering is not advertised. If the issuer and its principals have pre-existing relationships with these investors, then the pre-ICO raise can be accomplished fairly easy with no SEC registration of the offering required. However, these coins will be considered restricted securities with a one year holding period unless they are registered for resale under a Regulation A+ offering or fully registered offering, or resold in a compliant Regulation S offering. In addition, depending on the structure of the ICO, there may be a waiting period required between the pre-ICO raise and the ICO.
- Who will the coins be sold to? – This factor harkens back to the available offering methods described above. If the coins are to be sold to non-accredited investors in the U.S., then the ICO will have to be conducted under Regulation A+ or fully registered with the SEC. If the offering is limited solely to accredited investors in the U.S., and the issuer verifies the accredited investor status of the investors purchasing coins in the offering, then the offering can be conducted under Rule 506(c). If the offering will be limited to non-U.S. investors, then Regulation S will apply. In certain cases, it is possible to “mix and match” these offering methods to permit sales to different types of investors.
Additional requirements may apply to the offering methods described above. In addition, this is not an exhaustive list of all requirements that may be applicable to a particular ICO or ICO issuer. For instance, non-U.S. securities laws and other non-U.S. legal requirements may apply if the coin issuer sells coins to non-U.S. investors or has business operations in other countries.
The final thing to keep in mind is that conducting a legally compliant ICO costs money, and the necessary advisors don’t take coins or agree to be paid contingent upon a successful offering. As a result, you will need to have funds available before starting the ICO process.
If you are ready to conduct your ICO, STO, or ITS after taking into account the above considerations, contact Zahane LLP Attorneys at Law. Our corporate finance and securities law expertise will help you conduct your offering in compliance with applicable laws.