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ICO Law and Compliance: Is Your ICO Subject To Regulation?
The United States Securities and Exchange Commission (SEC) is in charge of regulating financial markets in the U.S., and they have jurisdiction over new ICOs when they’re investment products sold to American consumers. While it’s possible to create an ICO that’s legal in the United States, the SEC follows a set of rules known as the Howey Test to determine if the ICO is a tradable security or not. ICOs that fail the Howey Test are subject to all the same regulations as public stocks, and they must be registered and follow strict securities law.
The financial and logistic burdens of creating a compliant, publicly-traded security are high for most companies, let alone startups on the blockchain. Therefore, if you want to launch an ICO that’s available to American consumers, it has to clearly pass the Howey Test. Regulations in the European Union also closely mirror the Howey Test’s guidelines. This article is not legal advice and shouldn’t replace hiring a lawyer if you’re launching an ICO. However, it will give you guidelines and best practices from other crowdsales on how to create a compliant ICO.
Regulations Around Investment Vehicles and Securities
With the recent boom in Ethereum-based ICOs, regulators have begun to turn their attention toward cryptocurrencies. Securities commissions exist to protect consumers from dangerous or fraudulent investments, and the recent increase in ICOs has also meant an increase in pump and dump schemes where the tokens have no inherent value. Regulators are understandably concerned about fraudulent ICO activity. In many cases, it’s difficult to perform an audit of an ICO or to evaluate a token’s legitimacy.
As such, the SEC has issued guidelines to consumers thinking of investing in ICOs, but they haven’t issued clear guidelines to ICO creators on how to stay compliant, beyond the advice to consult a lawyer. In the absence of ICO-specific regulations, the SEC has resorted to sorting ICOs into two basic categories: security and not a security.
Securities are publicly traded investment opportunities. In the United States, you can create a security via an Initial Public Offering of a corporation’s stock or via lighter-weight regulations known as Regulations D, S, A+, or Crowdfunding. Once registered with the SEC, securities are subject to audits, anti-money laundering (AML) laws, and Know Your Customer (KYC) rules, complicating the process of creating and administering an ICO.
However, over the past year most ICOs have sought to avoid classification as a security to reduce regulatory issues. ICOs hoping to avoid regulatory hurdles often emphasize the utility of the token they’re issuing as a form of currency on a new software platform. By so doing, they hope to give the token a clear value, almost as if the consumer were purchasing a gift card or license to use the future platform.
The other option many ICOs are taking to avoid securities regulation is to structure the ICO as a donation initiative to a not-for-profit organization. Contributions to the ICO are therefore considered donations, not purchases of a tradeable security.
While both of these approaches may make sense for some ICOs, they’re not foolproof to prevent security classification. The Howey Test provides a clearer outline for what constitutes a security.
What is the Howey Test and How Does It Work for ICOs?
The Howey Test comes from a 1946 United States Supreme Court case known as SEC vs. Howey Co., in which the Supreme Court created a simple test for determining if a transaction is considered an “investment contract” and is therefore subject to securities law and regulations. Over seven decades later, this test is still the standard by which new financial instruments are judged in the United States, including today’s ICOs.
According to The Howey Test, a transaction is an “investment contract” if…
Money is invested in a common enterprise or company
The investor expects profits from the investment
The profit comes from the efforts of someone other than the investor
In the case of ICOs, the second point is the most important. If you’re promoting your ICO as a way to make money, then you are promoting a security, according to the SEC. If, on the other hand, you’re promoting your new tokens as a pre-order of a future product with no future return on investment, then you’re likely in the clear with regulatory compliance.
However, according to Andrew Chapin who spoke with the SEC about his ICO, while the Howey Test forms the foundation for the SEC’s classification of ICOs, the SEC reserves the right to make judgment calls about new ICOs on a case by case basis.
Another Option: Exclude U.S. Investors
Rather than deal with the uncertainty of whether an ICO passes the Howey Test, many new companies choose to forego U.S. investment altogether. Nearly every major token sale in the past six months has excluded U.S. investors. If U.S. citizens want to purchase a token, they have to wait until it is listed on public exchanges.
The exception to this rule is accredited investors in the United States who the SEC has certified to participate in speculative investments. Otherwise, strict KYC practices generally exclude American investors and keep new ICOs out of reach of the SEC.
The keys to creating a compliant ICO that follows the Howey Test are simple. First, make sure that token purchasers do not expect to profit, and say so publicly before the launch starts. Second, make it clear that your token has a specific purpose and utility. Buyers should know what they’re getting in return for their purchase. Alternatively, you can forego the SEC entirely by excluding U.S. investors from your token sale.
Coinbase, Coin Center, Union Square Ventures, and Consensys have developed a free report on securities law for ICOs. In the report, they offer excellent guidelines for best practices before, during, and after your token sale to avoid having your ICO classified as a security. Of course, their most important advice is to consult with a lawyer before your ICO to review your specific situation. At draglet, we recommend the same.