A Dual Token Structure to Solve the Catch-22 of SEC “Compliant” Initial Coin Offerings

We just officially launched the sale of our EPIC tokens — a security token offering that includes revenue sharing rights and, more notably, an option to convert to equity ownership. At the same time, our blockchain-based platform for data provenance of usage of the epigenetic profiles we are generating is facilitated by a separate utility token called ECARE. The journey to this dual token structure was a long and challenging one, starting from as far back as August of 2017 in the midst of growing interest in Initial Coin Offerings (ICOs). Eight months and multiple attorneys later, we have finally launched a digital token offering that is fully compliant with SEC rules. And by fully compliant, we mean to the most thorough extent that is possible with the nature of digital tokens and traditional US securities laws. To understand how we got here, we need to take a step back and establish some background for our story that follows.

Tokenizing for Blockchain Utility

EpigenCare is offering a skincare test that generates an epigenetic skin quality profile of the consumer based on his or her DNA. A digital platform is being built such that one’s epigenetic profile can be matched to skincare products on the market that would be best suited for their skin. Because DNA is very sensitive in nature when it comes to privacy, we need to transparently indicate to the consumer that his or her data is used exclusively for his or her own benefit rather than being irresponsibly sold to other companies behind-the-scenes. To do this, we could leverage the anonymous transparency feature of the blockchain ledger to create data provenance on the Ethereum network. This is a simple yet perfectly effective implementation of one of blockchain’s primary facets, without the overcomplicated gimmick of many other blockchain-based platforms out there.

Tokenization on the blockchain not only serves to provide data provenance or decentralization, but also to facilitate a platform economy with a user incentivization system. The interesting nature of digital tokens is the simultaneously inherent utility and the variable value of them. The tokens, in themselves, can be used to represent and drive supply-and-demand aspects of a business model on a blockchain-based platform.

Navigating the Regulatory Seas

Regulations involving ICOs have evolved extensively since they first appeared on the market. Despite the revolutionary, versatile nature of combining smart contract utility and value into a digital unit, the ease of transmission of the tokens to external wallets beyond the platform along with the rise of supporting exchanges for fiat liquidity, attracts speculative investors. Subsequently, the values of these tokens derived from speculative investing have far outpaced the true values of their utility. And that doesn’t sit well with the US Securities & Exchange Commission.

The first sign of scrutiny was when the SEC stated back in July that the DAO was in violation of securities laws, and went on to suggest its relevance to digital tokens and ICOs. The watershed moment was in December when the SEC halted the Munchee ICO, clearly describing how Munchee violated securities laws by promoting expectations of profits despite claiming its token was a utility token. There was now at last a somewhat clearer case for other US companies to base their offering structure on, namely SEC’s position that a token sale should be based on the “economic realities underlying a transaction”.

Given this, EpigenCare had to now carefully assess how it would structure its token sale offering. The three options typically available for a token sale were as follows: (1) sell them as a utility token; (2) offer them through a SAFT (Simple Agreement for Future Tokens) instrument; or (3) offer the tokens themselves as securities under an appropriate registration or exemption. As we hoped to clearly attract investors and we intended to offer securities to raise capital, Option 1 was promptly eliminated. As for the SAFT security instrument, we realized that it was just a medium into a security inappropriately disguised as a utility — so this was out. Option 3 was the clear choice: find an exemption for us to issue our tokens as securities under.

Legal Compliance

Looking at the available exemptions under SEC rules, we encountered three that would fit us well:

1. Regulation D 506(c) — Available for accredited US investors
2. Regulation S — Available for non-US investors, no accreditation requirements
3. Regulation CF — Available to both non-US investors and accredited US investors through an authorized crowdfunding platform with a $1,070,000 maximum

Each one has its pros and cons, with some requiring more paperwork than others. Each one permits general advertising about the offer, albeit with some legal nuances between each other. These exemptions also require a one-year holding period by investors before they could be freely traded. It turns out that this SEC requirement suits us quite well, as it gives us time to ensure we build out our business and prevent pump-and-dump shills from over-hyping and then crashing the value of our token. It would also provide us time to build out a relationship with trading platforms that are looking to offer compliant security tokens. In fact, one year is nothing to accredited and institutional investors. After laborious back and forth with our attorneys, we decided to offer our tokens under all three types of exemptions concurrently.*

*Regulation A+ was not selected due to the involved costs, time, labor, and permanent reporting requirements not suitable for an early stage startup.

All seemed ready to go, marketing budget ready to fire, and yet there was still a problem.

The Catch-22

In March, we realized a critical problem with tokens even if we were to go fully compliant with SEC regulations under an exemption (or even a registration) offering. Namely, if we were to mix (a) the allocated tokens for security issuance for fundraising together with (b) the allocated operational tokens under the exact same token type, then the operational tokens wouldn’t have a qualifying exemption since this batch was never “issued” under one. In other words, the investor tokens would never be able to flow into the platform, and the users of the platform would never be able to withdraw tokens to an external exchange. This is due to the fact that the platform users were never technically issued tokens under an exemption (e.g., users are gaining access to tradeable tokens through the platform yet never went through KYC/AML/Accreditation processes) and we wouldn’t be able to distinguish which tokens were which once mixed together. Thus, this disconnection means that the token value between traded markets and the platform use would be non-existent, nullifying the inherent tokenomics.

The dual function of utility and security in a single token was impossible to fit into the SEC’s current regulations, prompting us to look for an alternative solution. Until the SEC addresses the current law’s constraints for the novel technology of cryptographic tokens, we will have to find a way to make our platforms operational. This means we needed to design an explicit separation between the utility side and the security side of the token, and the only way to do that was to actually create two distinguishable tokens.

A Dual Token Structure

Our proposal is for our utility tokens called ECARE to be of fixed value and inflatable supply to act as loyalty points, a reward incentive, and a transactional associator of our generated epigenetic profiles with the data provenance aspects of the blockchain. ECARE would operate within the confines our ecosystem in a clear utility manner. Our second token, EPIC, is a security token, which offers an option to convert into equity shares to encapsulate the value of the company in its entirety. To bridge EPIC’s value with ECARE, all holders of EPIC would be entitled to an ongoing 5% revenue share of all ECARE-based transactions generated on the blockchain for our skincare testing and advertising sales. Additionally, the clear separation of EPIC as a security token allows it to be legally qualified to be traded on upcoming SEC-registered exchanges.

We have so far seen a few companies propose a dual token structure, and it appears that this is the most valid route to take to ensure full compliance with the SEC. In fact, we believe that this is the route that the Commission is implicitly guiding blockchain startups towards, at least in the meantime. StartEngine, the crowdfunding platform that is helping us carry out our Regulation CF offering, recognizes this trend. Their CEO Howard Marks recently wrote about the need to distinguish between security and utility, and emphasized the need for a dual token system. He further proposed two instruments RATE (Real Agreement for Tokens and Equity) and DATE (Debt Agreement for Tokens and Equity) which offers both utility tokens and security tokens representing equity shares.

The Future of Digital Tokens

It is becoming apparent that the existence of utility tokens is being threatened. We have seen exchanges such as Bittrex delist 82 tokens, probably as an emergency reaction to SEC’s series of crackdowns on players in the ICO market. This trend is likely to continue as utility tokens, even existing ones, become increasingly in the crosshairs of authorities. With investigatory revelation of the amount of fraud and lies that many unregulated ICOs have committed, such as the recent arrest of Centra Tech’s executives, the stronger regulation is much needed in the token sale and ICO space. The clean-up will tighten up company actions, eliminate the shell company schemes, instill investor confidence, and finally encourage legitimate startups in need of capital to successful raise money for real projects.

We have seen the value of the cryptocurrency market plummet from a record high of over $800 billion to $300 billion at the time of this writing. Although there are many forces at work, including a necessary correction from a parabolic rise, much of it is due to the sobering effects of regulatory activity and the realization that most of the previous ICO companies will unlikely achieve their roadmap milestones. As more tokens go to zero, we believe that investors will look for stronger investments in the crypto space which could result in another booming market for legally compliant cryptographic investment assets.

Companies like tZERO, and possibly Poloniex through their acquisition by Circle, are already seeking to become ATS (Alternative Trading System) exchanges that would be registered with the SEC so that they are authorized to trade crypto securities. As utility tokens become less liquid and continue to be removed from exchanges, more investors will likely turn to trading tokenized securities that are tied into a separate blockchain utility, and ultimately seek out instruments futureproofed for legal compliance.

It is apparent that the SEC is not hesitant to pursue previously completed ICOs, such as in Centra Tech’s case, which makes both existing utility tokens and new utility tokens offered by current ICOs on the market at risk of being investigated and shut down. Nearly all of these tokens, even ones boldly offered by daring US organizations, will likely fail to pass the test of the “economic realities of the underlying transaction”. To minimize risk for investors, it is probably best for them to concentrate their investments in compliant Security Token Offerings (STOs) with dual token structures.

If you liked this op-ed of EpigenCare, learn more about our business at https://www.epigencare.com and the detailed structure of our Security Token Offering (STO).