Launching An ICO — Have You Done Your Compliance Homework?
On average, I speak to 5 to 7 firms each week — all of whom are looking to launch a new ICO (Initial Coin Offering). Most of them want to go to market with their idea ASAP yet, in their rush to launch, an alarming percentage of these prospective ICO’s have not sought appropriate regulatory compliance advisory. In the same conversation they will mention their desire to target US investors which is acceptable because their token is considered a utility token. Having proper and experienced legal advisory helps with token structure and is imperative for a successful ICO launch.
“I believe every ICO I’ve seen is a security.” — Securities and Exchange Commission Chairman Jay Clayton
FOMO (Fear of Missing Out) is not just affecting investors, it’s touching every part of the community including those with just a crypto website, a countdown ticker and a barely developed white paper, and those whom have, potentially great projects, all wanting to ride the ICO wave. I have seen ICO sales start then stop, switch jurisdictions and then start over. I have seen ICO’s delayed for months due to a lack of or improper legal counsel. Wasted time and money that could have been avoided had they engaged an attorney from the beginning.
I can’t stress getting early regulatory advisory enough. Now with the SEC and other regulatory bodies also looking at not just corporate management but also marketing companies, celebrity spokespersons, law firms and bounty hunters; anyone involved in promoting an ICO can potentially be a target.
I spoke with Toronto, ON Securities Law expert, Jack J. Bensimon LL.M, an advisor to various crypto exchanges, ICOs and conference speaker on crypto and asked him some of the common questions I get asked about ICO’s, jurisdictions and the infamous SEC.
Question: The US has a large investor pool but strict regulation. Several companies are now in trouble with the SEC due to claiming to be utility tokens when they were in fact classified as security tokens. If an ICO is marketed to US investors, what do you recommend for that ICO to be compliant?
Answer: This is a salient consideration and a coordinated, explicit strategy with drill-down tactics must be developed and executed. Otherwise, the token issuer faces the prospect of unnecessary fines, penalties, and reputational risk in jurisdictions they never considered. You want to ensure your marketing and communications teams are on the same page and speaking the same language here.
The US SEC (Securities & Exchange Commission) views over 99% of tokens issued in the US as security tokens, with utility token issuers being the exception. The SEC has issued over 400 subpoenas to token issuers. The Howey test developed in 1948, still rules the day in determining whether it is a security or not. Unfortunately, the Securities Act (1933) could not have reasonably considered the prospect of digital currencies, and consequently, hasn’t adapted to this new, tokenized, digital asset trading environment. It’s clear that the SEC doesn’t see either blockchain nor crypto disappearing anytime soon. However, it is the overriding mandate of the SEC to ensure that sufficient investor protections are implemented from a public policy perspective.
Independent of where an ICO is domiciled, it must consider the jurisdictions it will sell its token and the nature of the token — whether it meets the threshold of a security token or a utility token, or in some cases, a hybrid of each. We have ICO clients that are deliberately blocking the sale of their token in selective jurisdictions in non-ICO friendly countries as they don’t want the regulatory exposure. The US is at the top of that list if they don’t want to file for the SEC Reg D exemption under Rule 506(c).
Question: I have come across some marketing companies and Industry web sites that will not conduct business with an ICO if it is US-based and sells to US citizens. Do you suggest this as a simpler, safer, and clearer path to ICO success — just stay away from the US and the long arm of the SEC?
Answer: For an ICO to avoid or block the US strictly based on residency and regulation, such an approach may be short-sighted. Other factors should come to bear. For example, is the product or service likely to have broad appeal to US customers. Ignoring the largest consumer and capital market in the world based on a narrow analysis of factors, may not be in the long-term best interests of the company. At the end of the day, the purpose of the ICO is to promote and finance a business that is here to stay over the long-term.
There are many factors that contribute to the success of an ICO, such as effective and sustained marketing, a clear and succinct whitepaper, uniqueness of the blockchain DLT (Distributed Ledger Technology) to the platform, and the company’s secret sauce, such as its IP, to list just a few. Token issuers often underestimate the importance of strategic and tactical marketing efforts and spend to generate enthusiasm and pent-up demand for their token.
Question: Would you favor an ICO if it is based in Canada or the USA?
Answer: When launching an ICO, a global strategy and framework must be developed. Blockchain is global and borderless, and the same applies to your ICO. Domestic biases will likely impair your ability to complete the ICO funding cycle. The reality is that, for now, crypto trading activity is heavily concentrated in Asia. For example, reports show that 60% of all crypto buyers and sellers are in Japan, while nearly 8% are in the US. When marketing an ICO, demographics matter and should form part of your strategy to assist in which countries to focus on, earmark resources, and which ones to outright avoid.
As a general rule, companies conducting ICOs should block countries that are, at a minimum, considered high-risk ICO jurisdictions. These are countries that are at a minimum not friendly to cryptos and/or hostile to cryptos via regulation or other punitive measures. High-risk countries that ICOs should avoid include Indonesia, Bangladesh, and Nepal. Lower-risk countries that ICOs should avoid include Macedonia, Algeria, Bolivia, Ecuador, and Libya.
Incidentally and unsurprisingly, none of these countries form part of the G-20, which is where the majority of either security or utility token buyers are likely to be identified with serious interest. It’s the G-20 countries that matter in the final analysis. The G-20 countries are calling for crypto regulation recommendations this July, while this is likely to be delayed. The biggest challenge in succeeding with this initiative will be regulatory coordination among the G-20 due to varying capital market structures, maturity, political imperatives, and liquidity preferences. Luckily, blocking the jurisdictions above shouldn’t materially affect the universe of token solicitations nor the efficacy of the ICO funding campaign.
Question: Should a marketing company that has worked with a US based ICO be concerned about the recent crackdowns by the SEC on all parties involved in selling the ICO including marketing companies and celebrities?
Answer: A marketing company looking to advise an ICO issuer should conduct extensive due diligence on the principals of the company to avoid the incidence of fraud, misrepresentation, malfeasance, or other risks. You want to avoid risks that can potentially harm your professional reputation and brand.
It’s important to have a clear and verifiable audit trail in conducting the due diligence if issues arise down the road, or a regulator requests information from you in connection to a securities related breach or offense. This way you can show that you took reasonable steps to investigate and ensure the integrity of the ICO and its management team. This can go a long way with regulators.
The main role of an effective and seasoned marketing company during the ICO funding cycle is to generate awareness, promote the brand, create excitement and buzz, and most importantly, to not materially mislead prospective and existing token purchasers as to what the token can (and cannot) be used for and promises of bounties, rewards, dividends, and token performance metrics.
Give the sheer size of the amount of capital raised and the number of ICOs in 2017 and this year, it’s not surprising that the tide of lawsuits is beginning to bear fruit by way of class actions and SEC enforcement actions. If this wasn’t the case, it would be evidence of a lax regulatory system that has its eye off perpetrators. I expect more litigation to ensue in the next 3–5 years. This is not necessarily an unfavorable development, but instead will cleanse the system and provide for an element of deterrence for fraud artists, scammers and other bad actors that can give ICOs a bad rap.
Question: Does the regulatory reach of the SEC extend beyond US borders?
Answer: This is an issue of the SECs extraterritorial reach in other jurisdictions beyond its borders. As a lead statutory securities regulator, the SEC yields tremendous authority, ferocity, power, and enforcement that should never be underestimated. The SEC has been known to exercise its extra-territorial reach far outside its borders as far as Australia in the case of SEC v. National Australian Bank, for example. Unlike other, smaller securities regulators (e.g., OSC in Canada), the SEC has a $1.6B USD budget (compared to $100M USD for the OSC, where over 80% of all capital market activity in Canada is). Such a budget allows the SEC to investigate, enforce, and prosecute for securities breaches both at home and around the world — the long arm of US securities laws. The SEC can and will prosecute non-resident companies that breach US securities laws. However, the SEC only has jurisdiction over breaches of its own rules under the Securities Act (1933) and Securities & Exchange Act (1934).
If a non-resident, foreign company breaches US securities laws, it doesn’t necessarily escape US securities regulatory scrutiny; US securities laws are the most stringent in the world and carry the greatest fines, penalties, reputational damage, and prison sentences for breaches. The US is the largest and most sophisticated capital market in the world, and consequently, enforcement mechanisms must never be ignored nor underestimated with the SEC. This is no different than in the crypto space where many security tokens are often being sold and marketed as unregistered utility tokens, often violating US securities laws. The SEC Howey test is used to determine whether a token issued is either a security token or a utility token. For example, the best example of a true utility token is Canadian Tire fiat currency. This currency nullifies each of the four prongs of the Howey test. I’ve seen very few utility tokens that actually meet this litmus test.
We’re also seeing a coordinated approach among securities regulators to fend bad actors in the crypto space. Last week alone, for example, there was a regulatory sweep between the OSC and SEC in cracking down on a few ICOs that were seen to be shady and suspect. This coordination should give comfort to token investors and purchasers in Canada and the US, especially given how quickly both regulators reacted and investigated.
In fairness, although the SEC has taken a hardline approach to token issuers generally, actual enforcement has not nearly been as harsh as the regulatory environment would predict. We’ve seen the start of a few class-action lawsuits filed against Paragon Coin on behalf of the investor class, and SEC enforcement action against Tezos and Munchee, for example. We should expect these actions in light of the US being the largest and most powerful capital market globally.
On the other hand, the most ICO-friendly jurisdictions are Singapore, Malta, Switzerland, Japan, and various Caribbean islands. These countries are crypto friendly and receptive to ICO marketing for the sale and distribution of tokens. We will continue to see more regulatory arbitrage, where ICOs are marketed in jurisdictions that have the least path of regulatory resistance. This carries their own separate risks for token holders.
Regulatory arbitrage is likely to be more nuanced and multifaceted. For example, a token issuer has both crypto securities regulation and tax regulation as major risks and concerns. It’s perfectly conceivable, for example, for a security token issuer to select Switzerland for its banking jurisdiction, Panama for taxes, Malta for its exchange (e.g., Binance, the largest crypto exchange in the world processing $5.6B USD in crypto transactions, formerly based in Hong Kong, recently moved its operations to Malta), and Isle of Man for its gaming. In effect, this creates a form of “virtual jurisdiction” that takes regulatory arbitrage to new heights.
Question: There are rumblings in the Canadian Community that regulators are slow to react and that in fact Canada is loosing blockchain development to other countries. Do you see this happening? If so why is it happening?
Answer: The OSC (Ontario Securities Commission) is the lead statutory regulator in Canada where most of the jurisprudence and case-law stems from. On a relative basis and in fairness, the OSC published guidance last year through an OSC staff notice. They also developed the OSC launch pad, a voluntary disclosure service for token issuers. These are important steps to give industry ways of considering ICOs and the treatment of cryptos. Similar to the SEC’s token analysis, the OSC has used the Howey test and the less well known Canadian test, the Pacific Coast Coin test. There are subtle differences between both tests.
In my experience in communicating with the OSC on behalf of token issuer clients (utility and security tokens), they have been cooperative, collaborative, and helpful in managing this uncertain and nascent regulatory environment. I have not found there to be a hostile or unfriendly environment towards crypto, but rather the OSC is developing the building blocks of a system to protect unsuspecting investors. What is missing from regulators around the world, however, is a holistic contextual framework of analysis to develop cohesive regulation. We’re likely to see a convergence towards harmonization and synchronization across jurisdictions. This avoids a regulatory “race to the bottom”.
On the home front, measures are in process with Parliament to amend the Currency Act to enable digital currencies, or crypto, to be considered “money” under the statute. The Currency Act states that any contract involving the payment of “money” must be denominated in fiat currency. This creates a legal challenge for contracts denominated in digital currency. The other option is to strictly treat crypto as a commodity for business transactions. However, given the pace of crypto fragmentation, this approach is not sustainable nor efficient for commerce. We are confident such changes will be made to allow crypto to be a common medium of exchange in business. The statutory definition of “money” is archaic and doesn’t reflect the digital realities of global commerce.
Whether there is an outflow of intellectual capital to other countries as a result of an uncertain and under-developed regulatory environment in Canada, is difficult to say. I haven’t seen evidence that points in either direction. We need to distinguish between the small but slowly growing VC community for private blockchain companies and its affect on the ability of these companies to sufficiently fund themselves without resorting to ICOs. These are two separate and distinct issues. The small VC community in Canada, for example, can often propel companies to raise capital via an ICO by tapping an international and decentralized network of investors (e.g., security token) and purchasers (e.g., utility token) with lower agency costs.
Question: What tips would you provide an emerging ICO?
Answer: After advising multiple ICOs spanning various jurisdictions and industry verticals, there are key lessons that all ICOs should consider:
Whitepaper: Provide full, true, and plain disclosure in the whitepaper — communicate in plain English. This includes outlining the full spectrum of investing in the security token or purchasing a utility token. This is the one document you can’t afford to get wrong or provide any semblance of potential misrepresentation to prospective buyers. Regulators view this document similar to a mini or short-form prospectus.
Security token vs. Utility token analysis: Although after reviewing your business model and project you have independently concluded that your token is a utility token, this involves an intricate analysis from a securities law perspective. You may want your advisor to conduct a token analysis to provide additional insight before you launch your token. The threshold to be considered a utility token is by exception, not the rule. See the above example of Canadian Tire fiat currency. Very few tokens qualify as actual utility tokens from a securities law perspective and consequently, from a regulatory perspective.
Token Listing: When listing your token on a crypto exchange, conduct due diligence on the listing exchange to ensure they are credible, provide effective cybersecurity safety measures, and are capable of generating meaningful liquidity for token holders. List your token only after there has been a meaningful and attractive story built supporting the token. This requires ongoing marketing and branding. Many token issuers rush too early to list without a story behind the privately issued token. Listing on a less-than-satisfactory exchange can impair the token brand, price, liquidity, and raise the spectre of unnecessary regulatory scrutiny.
Advisory Board: Recruit and develop a highly credible and reputable advisory board consisting of vetted professionals with depth and breadth of experience in your industry vertical. Big names or Hollywood celebrities alone don’t add much value — you need people that can execute and are going to help move the needle forward for your company.
Monetization: What we’re seeing now is similar to the dot-com bubble from 1999–2002, where many dot-com companies spent inordinate amounts of time acquiring “eyeballs” and “page views”, while failing to generate a viable revenue model. Monetizing your business will increase your valuation and demand for your ICO. You’re building a business for the future, not just a silo project — carefully and strategically determine how that fortress or “moat” will be protected.
Jack J. Bensimon is a seasoned securities law / banking law professional in the securities industry and advises various regulated financial entities, including ICO’s, crypto exchanges, banks, broker-dealers, fixed income dealers, MSBs, ATS, regulators, trust and insurance companies, Portfolio Managers, Exempt Market Dealers, Investment Fund Managers, mutual funds, energy companies and issuers. The firm also provides ongoing CCO regulatory compliance services to registrants with securities regulators.
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If you are considering doing an ICO, you need to start thinking about getting an experienced and seasoned securities law advisory in the initial stages. If you wait too long, it may end up costing you much more time and money.
Audrey Nesbitt, Official Startups
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