Over the past year, I have attended a number of blockchain networking events in Manhattan. A message I hear repeatedly from the software community is there is no clear case law for companies to follow in order to market coins to finance new software businesses.
Understandably, many new companies are running into legal problems. A few have ask me about legal guidance with regard to this new technology which is why I am writing this blog.
Here is the context. Small companies are offering coins — referred to as initial coin offerings — in order to develop software because the usual methods of financing are too onerous and expensive. Typically, these newer coins are paid for with Bitcoin or other established cryptocurrency.
NUANCES IN MESSAGING
Nuanced messages from the government typically occur with most newer legal issues. It is very rare that your facts and the facts of cases and regulations will fit together exactly.
For those not in the legal profession, it helps to know that the law is backward looking. Lawyers and courts will defer to the past to garner what relevant facts they can to build an argument that something does or doesn’t fit in the current legal framework. This deference creates stability in the development of the law, which is very slow moving.
The government is going to look back at case law that doesn’t exactly fit, but the cases are in line with reasoning regulating the industry.
With regard to coin offerings to finance software development, the legal cases to date offer up facts that typically relate to shares sold in a company. The subject matter for these cases are orange fields and whiskey futures. None of the cases relate to computer code because they haven’t been litigated yet.
Look for patterns in enforcement. This is an emerging pattern now.
EMERGING ENFORCEMENT PATTERN
The SEC (like the IRS and ICE in the Department of Homeland Security) will follow up on an anonymous tip. Anyone attending a networking event from the public could be a potential source. Anybody working in the company can make an anonymous tip.
Recently, a high level Security and Exchange Commission Official clarified which factors the SEC may looks at in order to regulate a blockchain software company offering coins. (Source: https://www.sec.gov/news/speech/speech-hinman-061418 )If a company is unregistered and doing these things, it is very likely that there will be an enforcement investigation should there be a tip.
CHECKLIST OF FACTORS
1. Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?
Answer: If your company is offering over a million tokens (selling them on exchanges that people in the US and all over the world have access to) and you have only two formal users of your software product, the token is not commensurate with the needs of users. In this case, the token would be a security.
2. Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading?
Answer: If there is a person or coordinated group that is working actively to develop or guide the development of the infrastructure of the network – this person or group could be founders, sponsors, developers or “promoters” in the traditional sense – then it is a securty.
3. Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment?
Answer: For example, when someone buys a housing unit to live in, they are using it. When somebody buys a “token” and is not able to use it in a software application immediately (can only hold and sell it later for investment) it is a security.
Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent?
Answer: See answer to #1 above, regarding a million tokens and two users.
4. Are the tokens distributed in ways to meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?
Answer: If you don’t know the answers to these questions, you probably have a security.
SEC Chairman Jay Clayton has stated… entities that allow for payment in cryptocurrencies, allow customers to purchase cryptocurrencies on margin or otherwise use cryptocurrencies to facilitate securities transactions should exercise caution, including ensuring that their cryptocurrency activities are not undermining their anti-money laundering and know-your-customer obligations.
5. Is the asset marketed and distributed to potential users or the general public?
Answer: Can you say who has your token now? If the answer is no, then you are marketing to the general public. I would also use the example of the networking event I attended in Manhattan. If coins were marketed to a seamstress or beauty salon owner investing and trading in her free time, you may have a difficult time arguing this investor is utilizing the token in the blockchain.
6. Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?
Answer: It is easy to apply the Supreme Court’s “investment contract” test to an investment of money in a common enterprise with an expectation of profit derived from the efforts of others. Where the purchasers are passive, relying on the efforts of others for a return, this is an investment contract. In an important case, the Supreme Court stressed: “… the emphasis [is] placed upon economic reality.” Calling something a “utility token” will not take it out of the enforcement environment.
7. Is the application fully functioning or in early stages of development?
If you have a fully functioning application – with, for example, long term technology licensing and royalty streams and utility tokens that only function within the software environment with an incentive to use and not sell or transfer – you are probably on the right track!
I hope this article will answer some of the questions that apply to financing a start up blockchain business and reveal possible SEC investigation triggers .