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How to Do a Compliant ICO — Part 1


Today, blockchain startups are finding themselves in a similar position as traditional startups. That is, they must create products that are attractive to consumers and convince investors to invest. In the blockchain space, startups now find that in order to secure funding, they must create tokens that are both attractive to investors and customers alike. While this is good for creating blockchain products that solve actual problems, founders may find themselves selling tokens as investments to investors and as products to customers. This can be challenging from a marketing, product, and compliance perspective.

If you’re thinking of selling tokens, it’s important for you to understand the definition of a security and when your tokens may be considered securities before you sell them.

When Your Tokens May Be Considered Securities

In order to understand how to discuss your token project, you have to first understand what exactly is a security. The SEC oversees offers and sales of securities in the United States.

In cases where the SEC deemed blockchain tokens to be securities, it applied Howey test. Under the Howey test, a token is an investment contract when money is invested in a common enterprise and profit is expected from the efforts of the promoter or issuer of the token.

A simple way of determining whether your tokens are securities to ask yourself whether buyers are buying your tokens because they expect you to make them a profit. For example, when people go to an arcade to buy tokens, they simply expect to use the tokens to play games in the arcade — they don’t expect you to make them a profit. In this scenario, the tokens are simply products meant to be consumed.

On the other hand, if you offer to sell the same tokens by describing all the things you’ll do to make the tokens more valuable — for example, making improvements to the arcade, attracting more customers to the arcade, and creating a marketplace for buyers to sell their tokens — buyers now have an expectation of profit from buying your tokens due to your efforts in making the tokens more valuable, and your tokens are probably securities.

Although the Howey test was developed over 70 years ago, it was created to adapt to a variety of situations where companies attempt to raise money on the promise of profits. Jay Clayton, chairman of the SEC, has confirmed that the SEC is not changing the securities laws in response to ICOs, specifically stating, “We are not going to do any violence to the traditional definition of a security that has worked for a long time.”

The SEC also made it clear that simply calling a blockchain token a “utility token” and giving it some utility does not automatically exempt you from securities regulation. The facts and circumstances surrounding the offer and sale of your tokens will determine whether you are selling securities.

"Utility TOkens" May Be Securities Depending on How You Advertise them

Some entrepreneurs mistakenly believed that by selling a “utility token,” they are exempt from following U.S. securities laws. The SEC proved this belief incorrect when they made an example out one unlucky company, Munchee, Inc (“Munchee”). Munchee offered and sold, self-proclaimed “utility tokens” and even engaged in their own Howey analysis, concluding that the U.S. securities laws did not apply to them.

Munchee’s tokens did have a utility in that they were meant to be used to buy food and advertising. However, at the time the tokens were sold, they had no use whatsoever. In addition, Munchee targeted their advertising specifically to investors and discussed various efforts they would use to increase the value of the tokens, including creating a market for the tokens, convincing customers to purchase the tokens, and even creating scarcity by removing tokens from circulation.

Looking at the Munchee transaction as a whole, the SEC concluded that Munchee was unlawfully offering and selling securities and ordered them to stop and return all investment proceeds to investors.

Following the Marketing Plan of Other BlockChain Startups Can Get You in Trouble

Although the SEC has only targeted Munchee for its sales of utility tokens, Munchee could have been any blockchain company. Their marketing was not unique. They followed a similar formula as other blockchain startups selling tokens before it, but were only unlucky enough to get caught. The marketing plan that Munchee followed was so typical that the SEC created their own fake ICO using the elements commonly seen in ICOs in order to educate potential investors.

To Avoid SEC Enforcement, Don't SEll Products as Securities and Securities as Products

Munchee’s story could have turned out differently if they had reviewed their product and marketing materials through the lens of the Howey test prior to public distribution. Although they claimed to have been selling a “utility token” and not a security, their messaging indicated that they were indeed selling a security but merely called it by another name.

The SEC has repeatedly stated that the nature of a token as a security depends on the specific situation under which the token is sold. This includes all marketing and promotional materials. Any securities violation analysis may very well hinge on the communications that you’ve distributed or endorsed.

If Munchee’s intent was to sell their tokens as a product, rather than targeting people who were looking to profit from buying their tokens, they should have targeted potential customers, such as restaurants who would have been interested in buying their tokens for advertising. If their goal was to simply raise money by selling their tokens to investors, they should’ve used an exemption to registration and communicated with their investors in a way that is line with their chosen exemption.

In part 2 of this article, we will go over some tips on how you can create a communication strategy to help you promote your tokens to different audiences for different purposes.

This article is also posted on Medium.

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This article is provided for informational purposes only and should not be construed as legal advice. Read our disclaimer here.

#ICO #TokenSale #securities

 
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