Katrina Arden is a frequent guest at the blockchain and ICO conferences; she gave interviews and provided comments on the ICO matters to various media and has been in discussions with the regulators of multiple countries on development and implementation of the blockchain and cryptocurrency law.
Recent developments in the blockchain industry and wide use of the ICO process to raise capital prompted regulators to respond, which, in some instances, created even more confusion among the market participants.
Below are the posts made by Katrina Arden commenting on the statements issued by the authorities and explaining how to perform an ICO correctly under the U.S. law.
October 20, 2017
Regulation of ICO: what each company should know
There have been many articles written about an ICO process being an unregulated activity, which led many startups to believe that raising funds through a token sale was perfectly fine. And even when the SEC issued a report following the investigation of The DAO, the fundraising efforts continued.
Many companies still do not realize that there are existing laws and regulations in place in many countries that can apply to the sale of tokens, including the securities law regulating the offering of securities, which was confirmed by SEC Commissioner Michael S. Piwowar at the 50th Annual Securities and Regulation Seminar. But tokens are not shares after all, so why should they be treated as securities?
Unfortunately, they do if they provide certain rights attributable to securities without even being connected to the equity in the company. The definition of securities is much broader than shares or stocks in the company; it includes a myriad of rights that could be offered to investors in exchange for the contribution. So even when the company is selling tokens that do not provide an equity but provide a share of the company’s profit, such tokens would fall under a definition of securities and their offering would be regulated by the securities law.
The same goes for fundraising activities. When tokens are sold to raise capital their sale is also regulated by the securities law to protect the investors just like in any other case of raising capital. For example, one of the most recognized methods of attracting capital is the initial public offering (IPO), where the company issues additional shares offered to the public in exchange for the funds to be used as a working capital. Because such investment opportunities available to a public at large and could be very risky for uneducated investors, the securities rules and regulations require registration of such offerings obligating the companies to provide a large volume of information about the companies’ business, financial, principals, etc. to allow investors to make a more informative decision. Selling tokens instead of stocks as a capital raising method does not relieve the company from the obligation to register their offering.
However, there are exemptions to the registration requirements if the company is willing to accept certain limitations such as the amount of capital being raised, the number and type of investors, the limitations on public advertising, etc. These exemptions are widely used by companies, which do not want to go through the lengthy and expensive IPO procedure. The same exemptions can also be used to sell securities tokens to the early investors and raise capital required to build a company’s product. Once the company’s product is build, the company can use the initial coin offering (ICO) process to sell utility tokens and acquire customers, while offering the early investors to exchange their securities tokens for the new utility tokens at a great discount. This way, the company will achieve the same result as it was planning to achieve by selling tokens to raise capital through the ICO, but it will be done in compliance with the securities law.
September 29, 2017
SEC brings charges against a promoter and two companies involved in Initial Coin Offerings (ICO)
Today, the Security and Exchange Commission (SEC) charged one individual and two companies alleging sale of unregistered securities and fraud.
According to the SEC, Maksim Zaslavskiy had been selling tokens through the Initial Coin Offering (ICO) promising the token holders sizeable return from the operations of the REcoin Group Foundation and DRC World (aka Diamond Reserve Club), while none of the companies had operations.
During the ICO, Zaslavskiy made many statements that were false and misleading, including overstating the amount of funds that he raised and the size of team behind the project, among the others.
The SEC filed a complaint in federal district court in Brooklyn, NY charging Zaslavskiy, REcoin Group Foundation and Diamond Reserve Club with violations of the anti-fraud and registration provisions of the federal securities laws. The SEC seeks permanent injunction and disgorgement plus interest and penalties. In addition to a permanent officer-and-director bar and a bar from participating in any offering of digital securities for Zaslavskiy personally.
If SEC succeeds, Zaslavskiy and his companies would be required to return the funds to the token purchasers and pay heavy fines. The possibility of the criminal punishment is unknown at this time; however, the referral of the case to the Department of Justice (DOJ) can be a possibility.
September 15, 2017
How to do ICO correctly
Recently, there have been many announcements made by authorities of various countries in regards to the ICO and digital tokens. Most of them warn the market participants that some of the tokens can constitute securities, a sale of which is regulated by the securities law in each country where such securities are sold.
However, many startups don’t fully understand what securities are and continue selling their tokens in violation of the securities law. For example, tokens can be considered shares or debentures, both of which are securities.
One of the most common idea for the startups when they sell tokens is to offer profit from the company’s future operations. Of course, it is very attractive for the token buyers to buy the tokens that offer a continuous stream of passive income. However, such tokens are securities and their sale has to be registered with the respective authorities unless an exemption applies.
Another common mistake that may land a company in hot water is an offer to purchase back the tokens in a future. This may also constitute an offer of securities because under these circumstances, a token can be viewed as a debenture, an instrument that evidences the debt of the company to the token holders.
Because there are many rights that tokens can represent, it is very important to check whether such rights fall under those typically granted by the securities instruments. Each country has a statutory law, which defines securities and lists their types. Important to note, that many countries have very similar securities laws; however, the registration process and exemptions may vary significantly.
That is why selling tokens that are securities through the global ICO may be very complicated for startups. It is better to limit the sale of such tokens to a specific country to comply only with one set of regulations or to avoid selling securities all together and create a utility (product) token instead.
A utility (product) token is a token that grant its owner the rights other than those attributable to securities. Such rights can be as follows: a license to use software, a membership to a club, a discount to purchase a product, etc. Utility (product) tokens don’t grant voting or profit sharing right in the startup. Sale of utility tokens is a pure sale of the startups’ product or a useful benefit not associated with securities. The sale of utility (product) tokens is governed by the consumer law, which is relatively similar in most jurisdictions and does not require any specific registrations. Therefore, startups are able to sell their utility (product) tokens worldwide.
September 5, 2017
Hong Kong makes a statement in Initial Coin Offerings (ICO)
Following the United States and other countries, the authorities of Hong Kong made a statement on the Initial Coin Offering (ICO) today. In its statement, the Securities and Futures Commission (SFC) explains that some tokens issued as the result of the ICO could be securities in Hong Kong depending on the circumstances.
The statement is similar to the one issued by the SEC of the United States following the investigation of The DAO. However, SFC explains in greater details what type of tokens could be considered securities. For instance, tokens that provide equity or ownership interest in a company may be considered “shares” and tokens that are creating or acknowledging the debt or liability owed by the company may be considered a “debenture.” The tokens can also be regarded as a “collective investment scheme” (CIS) when token sale proceeds are used by the company to invest in projects for the purpose of providing token holders with a share of the project’s returns.
The statement also warns that the sale of tokens-securities, dealing in or advertising such tokens not only by the Hong Kong companies but also to the Hong Kong public must be regulated by the Hong Kong authorities according to the local securities laws. Such activities are regulated and require license or registration in Hong Kong.
In the same time, SFC indicates that virtual commodity itself is not a security. Therefore, a correct structuring of tokens makes a significant difference in how the sale of tokens will be regulated in Hong Kong as well as in all other countries under their securities laws.
August 28, 2017
The SEC goes after the publicly traded companies for participation in the Initial Coin Offering (ICO)
Recently, the SEC suspended trading of common stocks of First Bitcoin Capital Corp., CIAO Group, Strategic Global, and Sunshine Capital (all publicly traded companies), who made claims regarding their investments in ICOs or touted coin/token related news.
The SEC is concerned that while token investment activities may provide legitimate investment opportunities, they may also be used to affect the price of the company’s common stock when companies publicly announce ICO.
Very often stocks of the companies go up simply because of the news or announcements made by the companies, including the news about exposure to or participation in the new technology. The blockchain technology, in particularly related to the ICOs, has been a hype in a recent couple of years. And, as such, announcements of the ICO related activities, which already generated a combined amount of over 1 Billion of U.S. dollars for participating companies, could be used as “pump-and-dump” and other market manipulation schemes to grow the price of common stock of the publicly traded companies.
August 21, 2017
The announcement of the Chinese authorities banning ICOs shook the market
Today, the Chinese authorities made an ICO related statement, which scared the market and provoked a number of news about a total ban for ICO in China.
However, the actual translation of the Chinese announcement made by Coindesk suggests that only certain ICO activities are prohibited in China, particularly, the token fundraising activities, which are further defined as a “process where fundraisers distribute digital tokens to investors who make financial contribution in the form of cryptocurrencies such as bitcoin or ether.”
Although there is no word “securities” used in the announcement, the definition of the token sale activities provided by the Chinese regulator is limiting the ban to the fundraising activities only, which make us to believe that the sale of utility tokens through the ICO shall not be affected. During the sale of the utility token, the company essentially is selling its product to the worldwide customers rather than raising capital. The later constitutes a sale of securities in many jurisdictions and, therefore, is illegal if not performed in accordance with the relevant regulations. While the former is subject to consumer laws.
However, even utility tokens that do not fall under the statutory definition of securities could be considered regulated activities if the token sale proceeds are used to fund the development of the product that is being sold through the ICO. However, in some instances, keeping funds in escrow until the product is developed can help to avoid regulation.
August 1, 2017
Challenges in selling securities tokens through ICO
The blockchain technology allowed companies to raise capital faster and less costly. But the greatest advantage is in the fact that a token can provide a token holder with the right to participate in a share of the company’s profit without founders giving up the equity.
However, sale of security tokens is subject to the U.S. securities law, which requires registration unless some exemptions apply. The registration process, just like in the IPO of traditional stocks, may be very complicated, lengthy and expensive. As expressly stated by the SEC, offering of the tokens that are securities has to comply with the U.S. securities law regardless whether such securities are offered on blockchain or not.
The U.S. securities law provide some exemptions to the registration process for the companies that are willing to accept certain limitations imposed by those exemptions. For instance, some exemptions may have a limitation on the total amount of capital raised by the company, some may impose restrictions on the type of investors allowed to participate in the offering, some may require companies to register with the state authorities, etc. Issuing securities would also subject the company to certain reporting requirements imposed by the SEC.
Important to remember that each country has its own registration requirements and exemptions, which makes a global offering of tokens even more complicated. Also, in the U.S., each State has its own securities law, establishing a registration procedure for a sale of securities to that State’s residents.
But even if the company complies with all of the requirements imposed by the securities laws and issues its security tokens to the public, those tokens cannot be traded on the secondary market because, as of today, there are no licensed exchanges that can accept security tokens for trading. The available exchanges only list tokens that do not have characteristics of the securities and require a written opinion letter from the U.S. based attorney to validate such fact.
The penalties for violation of the securities law vary among the countries; however, they are never small. In most cases, the regulating authorities seek a disgorgement along with the interest and civil penalties. In some jurisdictions, criminal punishment may also be imposed under certain circumstances.
July 25, 2017
SEC issues the Investor Bulletin pertaining to the Initial Coin Offering (ICO)
Following the investigation of The DAO, the Securities and Exchange Commission issued an Investors Bulletin, which explained the nature of the Initial Coin Offering and warned public that some of the tokens issued on blockchain could be securities required to comply with the U.S. securities law.
The SEC provided key points to consider when determining whether to participate in an ICO or not, such as:
- Check if the tokens are registered as securities and their offering is performed in compliance with the U.S. securities laws and regulations;
- Check if the promoters of the tokens are licensed or registered to offer and market securities, if the offered tokens are securities;
- Ask if the blockchain is open to public and whether it has been independently audited;
- Verify the facts and use good judgement when the offer is too good to be true;
- Be aware that digital tokens and currencies may be susceptible to fraud, technical glitches hacks, or malware.
The SEC also warned that the recovery could be limited for multiple reasons.
Unfortunately, there have been many ICOs performed in violation of the U.S. federal and state securities laws. The token buyers should be very careful when they are offered to invest in tokens and to expect a profit, when sale of such tokens is not registered with the securities authorities.
July 25, 2017
SEC issues Investigative Report concluding that The DAO Tokens were securities
The Securities and Exchange Commission (SEC) issued a very important Investigative Report today, concluding that the securities law of the United States applies to the sale of tokens through the Initial Coin Offering (ICO).
The SEC investigated the virtual organization “The DAO,” which sold tokens earlier raising an astonishing amount of $168,000,000 in return of offering a share of the profit to the token purchasers, and determined that the tokens issued by The DAO on blockchain were in fact securities. And, as such, their sale had to comply with the registration procedures established by the U.S. securities laws unless the appropriate exemption was claimed.
The importance of this SEC’s Report of Investigation for the ICO industry is significant. While previously most of the market participant thought of it as an unregulated field, where companies were selling tokens without any legal compliance, it is apparent now that sale of tokens is regulated by the securities laws and, therefore, subject to registration compliance applicable to the Initial Public Offering (IPO).
However, not all tokens are securities. Their nature largely depends on the rights and benefits that tokens provide to the token holders. As indicated by the SEC, whether a particular transaction involves the offer or sale of securities would depend on the facts and circumstances, including the economic realities of the transaction.