Navigating the Crypto Equity Capital Markets: The Intersection of Securities Law and Cryptocurrency Financing

By David M. Otto
and Andrea K. Louie

I. Introduction

The recent rise in the use of initial coin offerings (“ICOs”) to raise capital compels an evaluation of the legal, structural, and operational issues impacted by this relatively new form of financing. Initial coin offerings, or crypto-equity financings, are outpacing the establishment of comprehensive, clear, and relevant guideposts under U.S. securities laws. As a result, every crypto-equity financing must be independently evaluated to ensure compliance with securities laws. This evaluation is impacted by various factors, such as distributed autonomous organizations, smart contracts, token functionality, and built-in rights for the cryptocurrency holder, such as managerial or voting rights.

A private token sale requires the utmost cross-functional cooperation and communication. From the lawyers, to the technologists, to the token designers, to the business teams—all participants must act in concert to protect the legal status of the sale. In designing a responsible token sale targeting purchasers in the United States, we took great care in ensuring that our client’s entity structure, sale structure, and token design complied with both the letter and spirit of applicable laws and regulations, namely providing purchaser protection and shields against fraud. Our forthcoming article will go into further detail on the logistical features of how we effectuated a private token sale in the United States.

This post will focus on the importance of federal regulators, specifically the United States Securities and Exchange Commission (the “SEC”) and the Commodities Futures Trading Commission (the “CFTC”), and the issues an entity must be aware of when effecting a token sale. Although we do not address them in this article, there are also several state-level regulators and filings that need to be addressed to complete a private token sale.

II. The SEC and Token Sales

The current legal and regulatory environment surrounding classification of cryptocurrencies and token sales is uncertain. The Howey test is the foundational lens through which one ascertains whether or not an instrument—or token—is deemed to be a security, SEC v. Howey, 328 U.S. 293 (1946).[1] The SEC has held that certain cryptocurrency issuances constitute the sale of securities based on the Howey test and, therefore, the failure to register the cryptocurrency or secure an exemption from registration violates federal securities laws. Also, Section 2(a)(1) of the Securities Act of 1933 (the “Securities Act”) and Section 3(a)(10) of the Securities Exchange Act of 1934 (the “Exchange Act”) define the term “security.” The Exchange Act includes a list of instruments the SEC deems to be securities, including “investment contracts.”

In Howey, the Supreme Court clarified the term “investment contract” and noted that investment contracts have long been used to describe instruments that are more variable in nature.[2] In its analysis, the Court set forth the following four-part test to determine whether an agreement constitutes an investment contract, and thus a security.[3] For an agreement to meet the definition of an investment contract, all of the following factors must be met:[4]

An investment of money;

In a common enterprise;

With an expectation of profits;

Solely from the efforts of others.

In the context of a token sale—where there is a provision of capital into a project and all token purchasers are expected, to varying degrees, to maintain and update the project’s network—it is generally undisputed whether there is an investment of money and whether that investment of money is in a common enterprise.[5] Thus, the inquiry into whether a token is a security narrows to whether there is an expectation of profits, and whether that expectation of profits is derived solely from the efforts of others. As courts have analyzed “expectation of profits” under the lens of “solely from the efforts of others,” the main inquiry for blockchain token financings surrounds the last factor of the Howey test.

Accordingly, creating a token that qualifies as an asset (i.e., an instrument that either provides inherent use and value, or one in which value is realized as the instrument is deployed by the purchaser) lessens the chance that the token will be considered a security. Further, the utility of the asset, and the ability of the purchaser to use the functionality of the asset and create value, decreases the likelihood that the token was purchased with an expectation of profits to be derived from the efforts of others. In sum, the more functionality built into a token and the more the purchasers either derive or create value from the deployment of the token, the more likely the token will be deemed to be an asset.

In 2016, the SEC signaled its view of token sales and the application of the Howey test in SEC v. Traffic Monsoon.[6] While the case does not involve a token sale, Traffic Monsoon is instructive on this topic because the manner in which the federal court in Utah defined “security” could arguably include a token sale.

In Traffic Monsoon, Traffic Monsoon sold to its members a product called AdPacks that promised a certain number of visits to the members’ websites in exchange for a share in the company’s future revenues. In holding that the products did constitute securities, the court reasoned that the “economic reality” of the AdPack purchases was more akin to an investment than a purchase of services because the demand was “driven by members purchasing and repurchasing AdPacks in order to obtain the incredible returns on their investment, not by intense demand for Traffic Monsoon’s services.” Additionally, even though the purchasers were required to click on 50 advertisements every day in order to gain their share of Traffic Monsoon’s profit, the court deemed these efforts inconsequential as it held that the AdPack profits came “solely from the efforts of others” by calculating that the clicking of advertisements took an average of 4.1 minutes to complete each day.[7]

Additionally, on July 25, 2017, the SEC published an investigative report on The DAO ICO designating the DAO tokens as securities based on the agency’s analysis using the Howey test.[8] While the SEC concluded that Slock.it, the company that created The DAO, violated federal securities laws, its report emphasizes that “[w]hether or not a particular transaction involves the offer and sale of a security—regardless of the terminology used—will depend on the facts and circumstances…” (emphasis added). [9]

When determining whether investors’ expectations of profit were derived from the efforts of others, the SEC report highlighted its concern regarding who has meaningful control over the operation of the business and the use and deployment of the asset—the issuing entity or token purchasers. In its discussion on whether the DAO token holders’ expectations of profits were “derived from the managerial efforts of others,” the SEC looked to the lack of (i) meaningful management opportunities, (ii) voting decisions, and (iii) communications capabilities given to the DAO token holders. Given that those three elements were lacking, the SEC determined that The DAO’s management tokens were purchased in transactions with the expectation of profit derived from the efforts of others, therefore, the DAO tokens were securities.

Further, the SEC pointed to the fact that Slock.it and its co-founders had significant control over the enterprise and that DAO token holders had limited voting rights. In The DAO case, Slock.it selected “Curators,” individuals who had substantial power within the enterprise, to confirm that (i) proposals for funding originated from an identifiable person or organization and (ii) confirm that the smart contracts associated with any such proposal properly reflected the code a contractor (someone who submitted proposals to The DAO entity) claimed to have deployed on the Ethereum Blockchain. Importantly, the Curators—not The DAO token holders—determined the criteria by which to select proposals for a vote by The DAO token holders. Additionally, the SEC concluded that The DAO token holders’ voting power was not meaningful because their ability to vote was a perfunctory one and the use of pseudonymous identities inhibited token holders’ abilities to communicate and coordinate with other token holders.

It is imperative, therefore, that the design, functionality, deployment, and purchaser participation in the business that is engaged in a token offering align such that (i) the purchasers have a meaningful opportunity to participate in the market sought to be addressed by the token, (ii) the token has significant and important functionality required by the issuing entity, (iii) and that the purchasers have direct voting power to effect change in the business endeavor consistent with their participation.

III. The CFTC and Token Sales

In addition to the SEC, there are other regulatory concerns involving the sale of cryptocurrencies. The CFTC deems cryptocurrencies to be commodities[10] and, therefore, within the CFTC’s regulatory jurisdiction. A token and its corresponding sale will likely be within the CFTC’s jurisdiction if the sale is a swap, option, or futures transaction. For example, if as part of the token sale, the token issuers have an option to purchase back the token if the token price either falls below or rises above a specified price, this would constitute an option contract and, therefore, fall within the CFTC’s jurisdiction.

Moreover, the timing of the sale or the occurrences of particular events within a sale may trigger CFTC action. While the focus of this article is on the intersection of securities law and cryptocurrency, it is important to note the role of other potential regulators. Although the CFTC has asserted that cryptocurrencies are considered commodities as defined in the Commodity Exchanges Act (the “CEA”), the agency’s primary duty is policing the derivatives markets rather than buy-sell transactions of commodities. Further, under the CEA, the CFTC has regulatory jurisdiction over derivatives like futures, options, and swaps—transactions that have an element of risk, speculation, or hedging. In contrast, a spot transaction occurs when there is a sale or purchase of a commodity for immediate delivery. So long as the token sale is structured to be a spot transaction, the token sale will likely be compliant with applicable CFTC regulation and largely remain out of its jurisdiction.

IV. Designing the Token

The features and functionality of blockchain tokens vary from token to token and are dependent on the project’s purpose, the token issuer’s business and financial objectives, and the role of the token holder. To create a well-designed token that has inherent value, companies should build numerous rights and capabilities into their tokens. For example, companies should grant token holders the right and/or ensure purchasers have an obligation to perform the following functions:

Participate in the creation, operation and expansion of designated “nodes” that will help run the network;

Program, develop, or create various functionalities and features on the new blockchain network;

Access, sell and/or license various features on the network;

Contribute labor or effort to the network;

Use the network and its outputs;

Sell products on the network; and

Vote on additions to or deletions from the network in terms of features and functionality.[11]

By completing and implementing these practices in the token sale, an issuing entity has a better chance of ensuring that its token will be designated as an asset and not a security.

V. Other Regulatory Considerations

As an issuing entity navigates the regulatory unknowns, our goal is to help find and create certainty in an uncertain climate. By creating and extracting clarity with respect to an issuing entity’s transactions, transparency and active participation in governance is ensured, thereby upholding the spirit of the existing regulations by protecting purchasers and innovating responsibly.

Currently, the CFTC is actively seeking to learn more about blockchain technology and cryptocurrency and has set up a group within the agency, called LabCFTC, in order to further its knowledge in this area. Based on the CEA, we know the CFTC regulates commodities in swap, option, or futures transactions. By shaping a token sale transaction as a spot transaction (i.e., an instantaneous or almost instantaneous exchange of payment for commodities), we have certainty that the CFTC regulatory jurisdiction will not apply to this transaction.

Less certain, however, are the potential actions of the SEC. In analyzing the SEC’s published opinions, reports, and actions, we know that in order to classify a token as an asset and not as a security, it must have at least one objectively useful function. From the SEC’s July 2017 report on The DAO, we know that a perfunctory voting right is insufficient to overcome the Howey test’s requirement that a purchaser not derive profits from the efforts of others. As such, the issuing entity should incorporate objectively useful features and functions in its token, and require purchasers to become members of the entity’s community by participating in the growth and development of the business. Additionally, an issuing entity should uphold the SEC’s overarching goals by putting measures in place to protect purchasers and ensure that all purchasers are seeking to purchase tokens through and for legal means.

Other securities-related issues that can impact cryptocurrency transactions include the SEC’s jurisdictional reach and SEC Rule 10b-5, which targets fraud with respect to the sale of securities. In Traffic Monsoon, the SEC asserted, and arguably enlarged, its regulatory jurisdiction. Traffic Monsoon was a U.S.-based company that sold to non-U.S. buyers. The Traffic Monsoon court held that because “significant steps in furtherance of the violation” had occurred in the U.S. and that individuals in the U.S. promoted the company, the company was subject to enforcement action by the SEC.

Even if a decentralized organization that is not formally established in the U.S. is issuing tokens, the SEC can assert jurisdiction over the sale if some of the token purchasers are within the United States or if the SEC deems that the entity issuing the tokens took significant actions in the U.S., including the promotion of the sale. Consequently, any entity not wanting to engage U.S.-based purchasers should still be mindful of its U.S.-based actions if it does not want to fall within the purview of the SEC.

Fraud is another issue that is a concern when an entity is raising funds during a presale (i.e. before the underlying blockchain is launched). While an issuing entity can insert notices in its documentation stating that the launch of the blockchain is not guaranteed, if the promoters, namely the core development team or the board, are the only individuals benefiting from the token sale, the SEC may look at the core team in any fraud and misrepresentation analysis under SEC Rule 10b-5.

Rule 10b-5, however, only applies in connection with the purchase or sale of a security. For a plaintiff to bring a cause of action under 10b-5, he or she must have actually bought or sold a security.[12] In the case of an issuing entity, where the underlying business purpose and rationale for raising funds is not deceptive, and does not involve the purchase or sale of securities, it is nonetheless important that the entity avoid misstating or omitting material facts that surround a particular transaction or set of transactions relating to its token and/or business. [13] At a prelaunch stage, this applies to statements forecasting the growth of the network, utility of the token, and the associated financial results anticipated.

Another potential problem under Rule 10b-5 is insider trading. In general terms, insider trading occurs when someone within a company uses material, non-public information to buy or sell securities. With the long jurisdictional arm of the SEC and the uncertainty surrounding whether it will accept the issuing entity’s token’s designation as an asset, it is even more uncertain whether the SEC will use Rule 10b-5 to prosecute “insiders” who later trade their tokens on a cryptocurrency exchange. However, due to the blockchain-based organizations’ commitment to transparency, decentralized authority, and open, equal access to information, there will be fewer opportunities for insider trading as it is traditionally seen. Furthermore, all transactions related to the purchase or sale of a token are public on the blockchain. Nonetheless, we advise issuing entities to frequently update its community about information it receives on issues regarding the purchase and/or sale of its tokens and/or the utility and functionality of its blockchain.

VI. Conclusion

At the 2017 Consensus conference, an SEC spokesperson said, “Whether a token is a security or not is a fact or circumstance-based thing and you have to really pick it apart.”[14] Creating a token that can transact as an asset in the current regulatory climate is a complex task that requires one to design strategically (i) the structure of the entity issuing the token and the sale platform, (ii) meaningful voting power and rights for participants, and (iii) the features of the token in a manner such that they all work in concert to establish that the token is an asset that is useful, functional, and valuable when deployed (as opposed to being held passively) in the hands of the purchaser. There are currently very few bright-line rules regarding how to ensure the sale of a token does not constitute the sale of a security, but by following the industry’s best practices and the recommendations set forth in this article, we are confident that an issuing entity’s tokens will be rightly designated as assets and the sale of these assets can be properly effected at the intersection of securities laws and cryptocurrency financing.

[1] The Supreme Court reaffirmed the Howey analysis in 2004 in SEC v. Edwards, 540 U.S. 398 (2004).
[2] Howey, 328 U.S. at 298.
[3] Id.
[4] See SEC v. Edwards, 540 U.S. at 390.
[5] See Woolridge Homes, Inc. v. Bronze Tree, Inc., 558 F. Supp. 1085 (D. Colo. 1983).
[6] Securities and Exchange Commission v. Traffic Monsoon et al., No. 2:16-cv-00832-JNP (D. Utah filed July 26, 2016).
[7] Id.
[8] Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: the DAO. https://www.sec.gov/litigation/investreport/34-81207.pdf.
[9] Although concluding that the DAO Tokens are securities, the SEC has determined not to pursue enforcement action in this matter.
[10] In the Matter of Coinflip, Inc., d/b/a Derivabit, and Francisco Riordan
[11] A Securities Law Framework for Blockchain Tokens, http://www.coinbase.com/legal/securities-law-framework.pdf
[12] See Blue Chip v. Manor Drug Stores 421 U.S. 723.
[13] See Ernst & Ernst v. Hochfelder, 425 U.S. 185.
[14] Gertrude Chavez-Dreyfuss, U.S. SEC urges companies issuing tokens to protect investors: hhtp://www.reuters.com/articles/us-sec-blockchain-idUSKBN18K05Q.