ICOs at the End of 2017:
What We Think We Know and What We Don't Know
October 16, 2017
Initial coin offerings (ICOs), token pre-sales, and similar sales of blockchain-based coins and tokens are quickly becoming an important fundraising option, and an important method of attempting to seed a token-based platform with sufficient "currency" (that is, tokens) to permit the platform to function as intended. With the end of 2017 in sight, it is useful to catalog what we think we know and what we don't yet know about the regulatory landscape governing token sales.
What We Think We Know
Some tokens are and always will be securities. Tokens that offer holders dividends, interest, or profit or revenue participations, for example, generally are securities. Similarly, shares, partnership interests, and limited liability company interests issued in the form of tokens are still securities. These tokens typically will never lose their status as securities.
Tokens that are issued before they can be used generally are securities, even if eventually they may not be securities. In these cases, the value of the tokens at the time they are issued typically is largely dependent upon the sponsor of the tokens to develop and market the tokens and the platform on which the tokens will be used. This type of "reliance on the efforts of others" is a hallmark of determining when an instrument (like a token) is a security.
Tokens that are solely utility tokens should not be securities. If a token-based platform is fully developed and the tokens are widely used commercially on that platform, the tokens generally should not be securities.
The problem is that many token-based platforms will never be "fully developed." For many token-based platforms, the sponsor may always continue to develop or market the platform, or the continuing commercial viability of the platform may be dependent upon third parties who develop new applications to run on the platform. In these cases, even tokens that have some utility may still be securities, because the continuing efforts of the platform sponsor or others may have a significant impact on the future value of the tokens.
Simple Agreements for Future Tokens (SAFTs), as used today, almost always are securities. Most SAFTs involve the sale of tokens for future delivery, at a time when the tokens have not yet been created, or when the tokens relate to a platform that is not yet significantly developed or commercially used. In these cases, the tokens often are securities, because their future value depends significantly on the efforts of the token sponsor. The SAFT typically also is a security, because it is a contract to buy securities (tokens).
Tokens issued pursuant to a SAFT may still be securities. Whether a token delivered pursuant to a SAFT is a security continues to depend on whether the value of the token depends significantly on the efforts of the token sponsor (and perhaps on other third parties). The fact that the tokens were purchased on a delayed basis through a SAFT, rather than in a direct issuance, does not particularly affect the analysis of whether the tokens are securities.
Using an offshore entity to issue tokens does not change the applicability of securities laws to tokens offered and sold in the U.S. Tokens that are securities generally may be sold in the U.S. by the issuer only if the tokens are registered with the Securities and Exchange Commission (SEC), or if they are sold in a transaction that is exempt from the registration. This is true regardless of where the issuer of the tokens is located. Most token sales in the U.S. are exempt from registration because they are sold in private placements solely to accredited investors. Some token issuers also are considering registering the tokens, or qualifying the tokens under Regulation A+.
Convertible notes and Simple Agreements for Future Equity (SAFEs) do not necessarily convert upon an ICO or other token sale. Investors in an issuer's convertible notes, SAFEs, and similar convertible instruments should consider whether an ICO or other token sale by that issuer is an event that causes the instrument to convert to equity.
What We Don't Know
When do tokens that are securities stop being securities? This is a central question in the token community right now. Our current view is that once the value of the tokens is primarily driven by their commercial usage, rather than by the efforts of the token sponsor or other developers, the tokens should no longer be deemed to be securities. The SEC has not yet addressed this question.
How does a token platform operate when the tokens are still securities? As long as a token is a security, and unless it has been registered (or qualified under Regulation A+), holders of a token are subject to significant limitations on their ability to resell the tokens. We currently believe that a holder of an unregistered token generally can freely use the token to engage in commercial transactions on the related platform. However, the federal securities laws may restrict that recipient's ability to resell the tokens, which obviously would limit the number of people who would be willing to accept tokens for goods and services on the platform.
Are token trading platforms required to register with the SEC as securities exchanges or alternative trading systems? One entity in the U.S. already has announced its intention to become regulated as an alternative trading system (ATS) and to permit trading of tokens that are securities. A number of other platforms, often outside the U.S., also permit U.S. citizens and residents to buy and sell tokens. If the SEC requires such a platform to register as an exchange or as an ATS if it continues to accept U.S. purchasers, some of those platforms may seek to restrict U.S. persons from participating, which could significantly limit liquidity for U.S. persons holding tokens.
How will the states apply their securities laws to tokens? The industry has generally assumed that the states will analyze whether tokens are securities under state securities laws in much the same way as the SEC analyzes whether tokens are securities under the federal securities laws. While the SEC and the states typically do analyze these questions in the same way, that is not always the case in every state.
How will the states apply their money transmitter laws to tokens? We currently believe that most token sponsors do not trigger state money transmitter laws (or become a federal money services business, or MSB) by issuing tokens. Platforms and trading systems that facilitate the sale or transfer of tokens, however, may trigger MSB and money transmitter laws, which generally impose (among other things) anti-money laundering, customer identification and know-your-customer requirements.
How do the New York State bitlicense regulations apply to token issuers? These regulations (which only New York has adopted) impose a significant registration and compliance scheme on, among others, entities that "issue" virtual currency from or in the state of New York. Virtual currency is expansively defined to include, among other things, digital stores of value, which could apply to many tokens. The most conservative approach is not to offer tokens from New York or to New York residents, until the state clarifies whether it intends for token issuers to become subject to its bitlicense requirements.
Can income on token sales be deferred for federal income tax purposes? Most direct sales of tokens generate taxable income to the token issuer. We believe that an issuer may defer a portion of the income from the sale of a SAFT for one year if: (i) the purchaser of the SAFT receives some or all of the tokens deliverable under the SAFT in one or more years following the year the SAFT is issued; and (ii) the deferred amount is recognized as deferred income under applicable financial accounting rules. We are not confident that the Internal Revenue Service will respect deferrals for more than one year.
Can SAFTs be swaps? A swap is an agreement in which (among other variations) one party pays cash and the other party delivers cash, securities, or other consideration in an amount based on the economic performance of a specific security or other asset. Although the CFTC has not yet issued official guidance, we currently believe that most SAFTs should properly be treated as forward purchase agreements rather than as swaps. If SAFTs are swaps, they generally could be purchased only by investors with $10 million in assets, which is considerably higher than the $1 million net-worth test for "accredited investors" under the federal securities laws.
How will other countries apply their securities laws to tokens? While certain foreign countries are widely viewed as providing a less restrictive regulatory environment for tokens than the regulatory environment in the U.S., in many countries it may be too early to tell whether this position is fully justified. Several countries have indicated that they may treat some tokens as securities. Other countries have barred token offerings or otherwise encouraged issuers to proceed with caution. Token issuers should carefully consider local law when offering in jurisdictions outside the U.S.
For more information about initial coin offerings, the regulatory landscape governing token sales, or any related matter, please contact any member of the fintech regulatory practice at Wilson Sonsini Goodrich & Rosati.