The explosive growth of ICOs around the world in 2017 has been doubled in the first half of 2018 with over $13.7 billion raised by ICOs this year, according to a report from PwC and the Swiss Crypto Valley Association. Among other countries, US remains a leading ICO destination. However in the latest few months, it seems as the number of ICO projects in the U.S. fell apart, and there are not a lot of new initial coin offerings. Many lost faith in coin offerings because of the large volumes of poor-quality projects it attracted, vast number of illegal schemes and recent prosecutions of the government agencies. It seems as the other countries are faced with the same tendency. However, this paper will focus on the U.S. ICO market and its issues.
I. Fundamental problems in the U.S. ICO market.
One of the main problems of ICO is that tokens sold in an ICO don’t usually make the issuers responsible to the investors. Although an issuer of ICO also raises capital, it happens not in the traditional way as it usually happens with initial public offering or crowdfunding. Traditional ways of fundraising make companies accountable to their shareholders. Each share guarantees an apportioned part of the profits. Depending on kind of stock the shareholders have particular rights (rights for dividends, voting rights, to get a part of the equity in case of liquidation). Company’s directors report to the shareholders on the company’s progress and can be dismissed in case of failure to successfully manage the company. Following traditional fundraising issuers have to disclose the particular information and have a deeply prepared project.
ICO allows a company to raise funds only on the basis of White paper. Issuers of ICO arbitrarily decide how deeply to disclose the information to the investor. Investors are contributing to an idea, not a tangible product or a service. They do not have any rights as shareholders in the company and cannot expect apportioned part of the profit, but only a benefit from the increased demand the token might have in the future.
In ICO investors are not protected by governmental rules and shall make its own due diligence and own investment decision whether to contribute or not based only on the White paper and information about the team of the project.
Another problem of ICO is lack of existing project model. Developers write a multi-page White paper with a lot of technical details, but cannot confirm their representations and calculations in practice. Some White papers contain the representations that their tokens would not meet the Howey test and are not the securities (for example, Munchee White paper), that creates the misleading expectations. ICO is tended to offer tokens to “common people” but do not use “common language” in order to explain the project, investor’s rights and obligations, as well as possible risks of the project.
Another big issue is the lack of a company’s history. Many projects assembled the team just before making ICO. The issue of a team is crucial for startup, as investors who contribute in ICO, in fact, contribute to the idea and team as there is no product or service yet. Investors usually got information about the team from a White paper or a presentation of the project and did not communicate with the team directly.
There is a lot of criticism about the fact that ICO projects do not have the lock-up period for founder’s and adviser’s coins. So that the founders and advisers can sell their coins as soon as they want. In such a case founders do not have the incentive to work on the project, as they have gotten money already, and they are not interested in their tokens. As a result, some used it in pump and dump schemes. During ICO, the entrepreneurs behind the token speculate massively on the coin, driving the prices up and getting investors attracted. Once this is done, and the investors bought the tokens, the founders cash out, leaving the investors with worthless coins that have little or no value.
Another issue is tiered pricing. ICOs often give out tokens based on a tiered pricing structure. Those who invest first get tokens at the most favorable prices, and vice-versa. By adding a tiered structure, it gives early movers a bigger incentive to contribute. The earlier you get in — the bigger discount you will be able to get. It looks like the standard method of marketing the product, but on the other hand, it created the hypo around the projects without real product and created excessive expectations of investors.
As the investors are not owners of the shares in ICO, there is no control over the money received by the company in ICO. In other words, how this money will be spent and used. For example, the proceeds from the PlexCoin ICO “were not destined for business development but instead were intended to fund developer’s expenses including home decor projects.”
As a result of the uncertainty of legal regulation of ICO, there were so many fraudulent, misleading projects and scam schemes.
The situation began to change from July 2017 as SEC issued its report on DAO ICO and warned the entrepreneurs that tokens could be securities. Since SEC has made a great work by analyzing projects and tokens and making a statement what rules shall be applied to existing and future ICO. The main position of SEC is that a token is not something extremely new, but the digital asset which shall be regulated by the existing legislature and rules.
But can all these problems of ICO named above be solved by the existing regulation? Or existing regulation merely bans all ICO?
II. Howey test
Commission has determined that DAO Tokens are securities under the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”) and applied the Howey test.
Under the Howey test a financial instrument is security when all the following requirements are met:
(i) there is an investment of money;
(ii) there is an expectation of profits;
(iii) the investment of money is in a common enterprise;
(iv) any profit comes from the efforts of a promoter or third party.
In Howey case, an investment in orange groves was deemed to be an investment in a security. In Howey “A hotel operator sold interests in a citrus grove to its guests and claimed it was selling real estate, not securities. While the transaction was recorded as a real estate sale, it also included a service contract to cultivate and harvest the oranges. The purchasers could have arranged to service the grove themselves but, in fact, most were passive, relying on the efforts of Howey-in-the-Hills Service, Inc for a return.”
At first glance, it is a huge distance between orange groves and cryptocurrency. But the Supreme Court featured that “Form [is] disregarded for substance and the emphasis [is] placed upon economic reality.” The real estate transaction was found to be an investment contract and thus a security. Applying Howey test to DAO ICO SEC found that investors provided funds with expectations to get profit and relied on the efforts of founders and DAO curators.
The definition of ICO to be a security served a specific purpose – to protect the investors from scam projects and fraudulent schemes, as well as to provide investors with the sufficient information necessary to make an informed investment decision. As soon as ICO is a security than organizers of ICO shall comply with the registration and financial reporting requirements. But in their current form, it can paralyze the crypto market instead of integrating it into the existing economy.
The application of Howey test to ICO has been criticized a lot.
First, the developers of coins are usually not huge corporations but small startups. “They do not have the financial, political or legal clout to do their own research, so to speak, on whether their initial coin complies with applicable security regulations.”
Second, the barriers to entry for token developers are substantially raised if they shall be registered as securities. Tokens often depend on an initial coin offering to give the project a start. “If those offerings cannot be held without first diving through expensive regulatory hoops, the project risks dying on the vine.”
As soon as ICO is a security than it is a long and time-consuming, difficult and expensive procedure.
On the one hand application of existed security laws to ICO reached the purpose to protect American investors at the same time dramatically decreased the amount of ICOs. Foreign developers began to ask – are you a citizen of the U.S. and denied the U.S. investors in participating in ICO in order to escape the possible responsibility under the U.S. security legislation.
Despite all the seeming drama of the situation strictly speaking it is still possible to raise funds for cryptocurrency projects through existed exceptions from security rules and private placements. But such ICO will no longer be a classical ICO of the 2017 year, but some kind of new STO (security token offering) and will comply with all security restrictions and regulations.
In general, all securities offered and sold in the United States must be registered with the SEC under the Securities Act or must qualify for an exemption from the registration requirements. The registration forms a company files with the SEC provide essential facts, including:
(i) A description of the company’s properties and business;
(ii) A description of the security to be offered for sale;
(iii) Information about the management of the company; and
(iv) Financial statements certified by independent accountants.
It is clear that small startups do not need and cannot make a classical issue of securities. The applicable way for them to raise money is through the exceptions.
Not all offerings of securities must be registered with the SEC. The most common exceptions include private offerings to a limited number of persons or institutions, the offering of limited size, intrastate offerings, certain off-shore offerings.
III. Key registration exceptions.
The Jumpstart Our Business Startups (JOBS) Act provides potentially effective securities law exemptions for crypto-developers to raise capital by soliciting accredited and unaccredited investors. The key exceptions which can be used by crypto-developers are Regulation D (including Rule 506 (c) established by JOBS), and new rules of JOBS – Regulation CF and Regulation A+.
Regulation D under the Securities Act provides a number of exemptions from the registration requirements.
Rule 504 of Regulation D provides an exemption from the registration requirements of the federal securities laws for some companies when they offer and sell up to $5,000,000 of their securities in any 12-month period. Securities can be sold only to accredited investors.
Companies relying on the Rule 506 exemptions can raise an unlimited amount of money.
Rule 506(b) provides a “safe harbor” for an issuer engaged in a non-public offering to persons who may or may not be “accredited.”
Under Rule 506(b) the issuer shall satisfy certain requirements, including the following:
(i) The company cannot use general solicitation or advertising to market the securities.
(ii) The company may sell its securities to an unlimited number of accredited and up to 35 other purchasers. All non-accredited investors, either alone or with a purchaser representative, must be sophisticated—that is, they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.
(iii) Companies must decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions of the federal securities laws. Companies must give non-accredited investors disclosure documents that are generally the same as those used in registered offerings,
(iv) The company must be available to answer questions by prospective purchasers.
Under Rule 506(c), a company can broadly solicit and generally advertise the offering and still be deemed to be in compliance with the exemption’s requirements if:
(i) The investors in the offering are all accredited investors; and
(ii) The company takes reasonable steps to verify that the investors are accredited investors.
The general rule is that securities under Rule 504 and 506 are “restricted securities”, meaning that the securities cannot be sold for at least six months or a year without registering them. Companies that comply with the requirements of Regulation D must file what is known as a “Form D” electronically with the SEC after they first sell their securities and should take care to provide sufficient information to investors to avoid violating the antifraud provisions of the securities laws.
Accredited investors under the Reg D. There are several categories of accredited investors, among them are certain enumerated entities with over $5 million in assets (trust, partnership formed without specific terms of acquiring the securities offered), regulated entities such as banks and investment companies, who are not subject to the assets test, and wealthy individuals. Most individuals who invest in a Regulation D offering accredit via financial thresholds - income or net worth. Under the current rule, to accredit via income, an investor must have an annual income of $200,000 (or $300,000 if filing jointly with a spouse) within each of the last two years. To accredit via net worth, an investor must have a net worth of $1,000,000 excluding their primary residence. See 17 C.F.R. § 230.501.
The main disadvantages of making ICO under Reg D are:
(i) Lock-up period. This is good if the investor is an optimist and believe that the issued token will grow in its liquidity, but bad if the investor is a pessimist, as he will be unable to sell token if something goes wrong.
(ii) Financial thresholds for individuals. ICO under Reg D excludes “not wealthy” people from participating in the project. According to the statistic in 2016 there were 12,417,040 Accredited Investor Households in America, 9.86% of all American Households. It seems as a great number of people are excluded from the possibility to participate in such kind of investments.
(iii) Documenting accredited investor status. Company shall take certain steps to verify that the investor is an accredited investor, which can be time-consuming and expensive.
Under the Regulation Crowdfunding (Reg CF) the company can offer and sell securities following with the rules:
(i) all transactions shall be taken online through an SEC-registered intermediary, either a broker-dealer or a funding portal;
(ii) a company can raise a maximum aggregate amount of $1,070,000 in a 12-month period;
(iii) individual investors can invest only limited amount across all crowdfunding offerings in a 12-month period;
(iv) require disclosure of information in filings with the SEC under “Form C”.
Securities purchased in a crowdfunding transaction generally cannot be resold for one year.
Regulation Crowdfunding issuances in contrast to Reg D welcome unlimited number of unaccredited investors but contain some disadvantages.
Crowdfunding offerings may only accept slightly more than $1 million compared to an unlimited potential raise through Rule 506. Crowdfunding must be completed through a regulated broker-dealer or portal (nowadays there are only some of them deal with cryptocurrency). Form C seems to be more onerous than the Form D. Despite this disadvantages Crowdfunding can be attractive for blockchain startups as it is possible to reach the distributed audience which can help to build a more successful network. Still, this rule is applicable only for small projects.
Regulation A+ offering involves a public sale of an issuer’s securities to investors. The offering under A+ usually called as “mini IPO”.
Under Reg A+ the company can raise in Tier I up to $20 million and in Tier 2 - up to $50 million both tiers within a 12-months period.
Both Tiers are subject to certain basic requirements but have some differences. In Tier 1 the company must register or qualify the offering under the applicable “blue sky law” in any state in which the company seeks to offer or sell securities, while Tier 2 offerings are also subject to additional disclosure and ongoing reporting requirements. Companies conducting Tier 2 offerings would be subject to (i) a requirement to provide audited financial statements, (ii) to file annual, semiannual and current event reports, (iii) a limitation on the amount of securities non-accredited investors can purchase in a Tier 2 offering of no more than 10 percent of the greatest of the investor’s annual income or net worth.
Reg A+ is a quite new tool for crypto-projects, which has some good benefits:
(i) it is a public offering; public advertising is permitted;
(ii) securities can be solicited to accredited and unaccredited investors,
(iii) investors have immediate re-sale opportunities and no lock-up period,
(iv) the higher limit of fundraising comparing to Reg CF,
(v) there is no limitation in the number of investors;
(vi) no limitation in the amount of funds investors can invest within the offering in Tier 1.
There are still some disadvantages – the Tier 1 does not preempt state regulation, Tier 2 requires filing a regular report to SEC, and in whole the disclosing procedure seems to be more onerous than in Reg D.
IV. ICO in Switzerland
Switzerland is always referred to as “crypto-valley” for its friendly approach to crypto-projects including ICO.
The main feature of the Swiss approach to ICO is that the Swiss Financial Market Supervisory Authority (FINMA) recognizes three different types of tokens:
(i) Payment tokens are synonymous with cryptocurrencies and have no further functions or links to other development projects;
(ii) Utility tokens are tokens which intended to provide digital access to an application or service;
(iii)Asset tokens are tokens which represent assets such as participations in real physical underlying, companies, or earnings streams, or entitlement to dividends or interest payments. Regarding their economic function, the tokens are analogous to equities, bonds or derivatives.
The classification is not strict, there can occur hybrid tokens, for example, a utility token can be a payment token at the same time.
Under this classification FINMA’s current practice is that:
(i) payment token ICO: such tokens are not securities if they are intended to function as a means of payment and already can be transferred;
(ii) utility token ICO: such tokens are not securities only if their sole purpose is to provide digital access rights to an application or service and if the utility token can already be used in this way. If a utility token functions solely or partially as an investment in economic terms, FINMA will treat such tokens as securities;
(iii) asset token ICO: such tokens are securities under Swiss securities laws.
At first glance, the approach of Switzerland seems to be more flexible than in the U.S. FINMA directly prescribed what criteria must be met for the token not to be a security. But it seems as the main idea is just the same, when there is a raising of funds for the project with investment purpose and without existing token than such investment shall be recognized as security.
V. Future of STO: challenges and opportunities.
Nowadays crypto-community discusses the topic “what’s wrong with ICO” and “how it can be replaced.” Some suggest calling it “Token Sale”, some others - “Initial community offering” or “Token generation event”, some raise the issue that the problem of ICO is that the abbreviation is too similar to IPO, and that’s why create the similar expectations of protections. It is necessary to remember the words of the Supreme Court: “Form [is] disregarded for substance and the emphasis [is] placed upon economic reality.” If we are talking about issuing the tokens with the purpose of raising the money, it will be security offering which shall be qualified with the security rules. “These requirements apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using the U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology.”
Since the Securities and Exchange Commission Chairman, Jay Clayton, stated that he believes all ICOs constitute securities, the time is now ripe for security tokens. However, STO will allow to solve some of the fundamental problems of ICO.
First, it will solve the problem of lack of rights and obligations provided by the tokens in ICO. When someone buys tokens in an ICO, he gets access to a specific network, platform, or service, but does not acquire rights or obligations of a traditional share. Since security tokens are actual financial securities, then, depending on whether they are equity shares or bonds, investors will get rights for dividends, voting rights or for interest. Security tokens are backed by something tangible like the assets, profits, or revenue of the company.
Second, STO will provide more protections for investors, as issuers shall first go through governmental legal due diligence and then through investor’s due diligence. The security tokens are intended to be compliant with KYC/AML requirements as well as securities laws.
Third, STO will induce security token issuers to prepare a more thoughtful and clear White paper and disclose enough information for the investors in order not to be liable for security fraud under Rule 10(b)-5. This means that any information a company provides to investors must be free from false or misleading statements. Similarly, a company should not exclude any information if the omission makes what is provided to investors false or misleading.
Forth, the company in STO will be accountable before its investors, that will provide some kind of control over the proceeds of the token offering.
Nowadays STO in its development can be faced with the following challenges:
(i) Listing on exchanges. The big exchanges are not yet supported the security tokens. It is necessary to work in the direction of creating the STO ecosystem.
(ii) The increase of legal costs and the increase of fees for a transaction on the blockchain. Compliance with the security, AML/KYC rules require additional expenditures.
(iii)It seems as there is no ideal exception from security rule for every crypto-project, so it will be necessary to analyze every possibility and make a choice about priorities. If there is no need in public advertising of a project than Rule 506 (b) can be a good option as it allows to collect an unlimited amount of money and solicit to limited number of non-accredited investors. If there is a small project on a small amount of money but will benefit from the dispersed community than Reg CF can be useful. If a company wants to go public without too onerous disclosure than Reg A+ can be used.
(iv) Lack of equal access to investment opportunities in new technologies. The description of the accredited investor does not allow all interested people to participate in the token sale. STO is more oriented on the institutional investors rather than individuals. The main idea of ICO was to sell tokens to users and to create a special ecosystem. More users are involved, more popular the network is. As a result, the token grows in price. Moreover, the participation in the token offering of “common people” provides democratization of the capital markets – anyone, regardless of geographical location, race, religion, or wealth can raise capital and invest in startups. STO within existing regulation mitigate this advantage of ICO and makes it more difficult to reach the distributed audience which can help to build a more successful network.
The future development of STO can be by reaching the consensus between the regulators and crypto-community. It seems as each party shall make some concessions. For example, crypto-community accepts the necessity to deal with the security token through exceptions and comply with the regulation.
On the other hand, regulators can make some changes to the legislation to reflect the occurred changes in technology and market. For example, it seems as SEC could revise the definition of the accredited investor and lower the financial thresholds to allow less wealthy people to participate. It looks as it can be useful to make some kind of “knowledge” restrictions or “experience” restrictions instead of financial thresholds. Or there can be worked out the “special for STO” exception from security regulations which will reflect the most essential demands of crypto-market.
 See SEC v. Edwards, 540 U.S. 389, 393 (2004); SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946).
 Bill Hinman, Director of the SEC’s Division of Corporation Finance, June 14, 2018 speech.
 Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO/Release No. 81207 / July 25, 2017, SEC
 Digital assets and the SEC, Kenneth M. Raisler, Ryne V. Miller, Sullivan & Cromwell LLP
 The Brooklyn Project, Telegram chat
 See SEC v. Edwards, 540 U.S. 389, 393 (2004); SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946).
 Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO/Release No. 81207 / July 25, 2017, SEC
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