INITIAL COIN OFFERINGS: A TALE OF TWO TOKENS
Blockchain and cryptocurrencies have revolutionized the way companies raise capital through the use of initial coin offerings (ICO) and regulators are now taking notice. Notably, the importance of how ICOs are structured is becoming increasingly clear. To avoid securities registration, investors and blockchain developers are encouraged to enter into what is essentially a derivative contract for the underlying coin, or token, after the token becomes functional in a developed network.[1] A coin or token can take the form of either a security or a commodity, depending on its intended function, both of which are changing how companies raise capital.
In the early 1600’s, the Dutch East Indian Company sought to raise new capital by issuing stocks and bonds to the public in what was the first initial public offering (IPO). In short, going public provides a company access to capital by offering shares of the company for sale to the public. As history often repeats itself, ICOs offer new methods of raising capital—approximately $3 billion to date.[2]
Two categories of tokens are currently in circulation—securities tokens and utility tokens. Securities tokens are more akin to traditional securities in that they grant ownership rights to the holder. Alternatively, utility tokens have intrinsic value, power decentralized, distributed networks, and function as a consumptive good for network users. The intrinsic value (arguably) derives from the networks use. For example, when a network such as bitcoin is completely functional as a payments system, the token takes the form of a currency with its own intrinsic value, which can be traded for fiat currencies and other cryptocurrencies. It is clear that securities tokens require Securities and Exchange Commission (SEC) registration. On the other hand, the offer of utility tokens in connection to an ICO can be structured to potentially avoid SEC registration requirements.[3]
Federal law requires financial devices classified as securities to be registered with the SEC absent an exemption status. Essentially, the goal is to structure the initial offering to fall outside the definition of a security to avoid costly registration fees. One often determinative factor is whether the expectation of profit derives from the managerial efforts of the company. If so, assuming other requirements are met, the financial device is a security.
Under a direct token presale model, the defining characteristic is that tokens are sold widely to the public at a time when purchasers are still reliant on the developers to build the functional network. In this sense, value or the expectation of profit is based on managerial efforts to develop the network.[4] As such, these tokens are classified as securities and require registration.
Alternatively, ICOs could be structured to resemble a derivative rather than a stock. In an already-functional network where its development and value does not depend on management, the value of the token is determined by a myriad of market factors and not solely on managerial efforts--namely, supply and demand. Accordingly, the right to purchase the token at a future date in a fully functional network takes the form of a derivative, with the expectation that the value of the underlying asset (cryptocurrency/token) will rise. After the network becomes functional, the derivative (likely an option-like instrument) becomes exercisable, allowing the investor to purchase the token at a discount and sale it at its then-current market price, presumably at a profit. But the profit is not based on the efforts of others because the network at that time is fully-functional. Rather, it is based on market factors that drive the price of the token. For this reason, among others, ICOs structured in a manner that offers already-functional tokens could potentially avoid being classified as a security for registration purposes.
Nevertheless, derivatives are regulated by the Commodity Futures Trading Commission (CFTC) and they could assert jurisdiction when used or where there is fraud or manipulation involving the virtual currencies themselves. Generally, if the contracting parties are commercial users then the derivative is exempt and the CFTC cannot exercise jurisdiction. Here, because the investor is likely to sale the underlying asset, there is no commercial use, rendering the derivative subject to CFTC oversight.[5] Generally, the CFTC regulates derivative exchanges--exchanges that involve standard derivative transactions, known as futures. The CFTC has yet to test this theory concerning the regulation of ICOs and the use of derivative instruments. In connection to virtual currencies generally, the CFTC has really only commented on derivative exchanges rather than ICOs specifically.[6]
In terms of the SEC, ICOs will remain under scrutiny for purposes of securities registration and fraud. Most recently, the SEC’s new cyber unit brought its first ICO fraud case against PlexCorps, which offered to sale nonexempt unregistered securities that promised an unrealistic 1,354% return on investment.[7] Additionally, the SEC halted a multimillion-dollar ICO for failing to register its security tokens.[8] In the coming months, it will be interesting to see if the SEC will view the already-functional arrangement as a security and, if not, whether the CFTC would have oversight of the arrangement.
[4] Id.