How to do an Initial Coin Offering (Part 2)
How to know if your Token is a Security
Disclaimer: My opinion is not legal advice. I am not a lawyer. This in no way should be considered legal advice, and my views do not represent the views of my employer, investors, or partners. Moreover, nothing written here should be construed as investment advice either — please consult a professional, many of them are pretty cool…
**Update: August 1, 2017. Monetary Authority of Singapore (MAS) Clarifies regulatory position on the offer of digital tokens in Singapore(you will find that this post is consistent with the new guidance in Singapore)
end of update**
An Initial Coin Offering or “ICO” is not the first scheme employed for raising capital in a unique way. Many have been devised in the past in an attempt to avoid the application of securities laws.
These schemes have been analyzed by the courts, and in this case I will compare Singapore and US definitions, to determine whether these novel schemes are “investment contracts,” and therefore “securities”.
The Financial Action Task Force defines cryptocurrency as
a digital representation of value that can be digitally traded and functions as (1) a medium of exchange; and/or (2) a unit of account; and/or (3) a store of value, but does not have legal tender status (i.e., when tendered to a creditor, is a valid and legal offer of payment) in any jurisdiction. It is not issued nor guaranteed by any jurisdiction, and fulfils the above functions only by agreement within the community of users of the virtual currency.
The de facto standard ie. American, for understanding if your token is a security is the “Howey Test”, which was created by the US Supreme Court for determining whether or not certain transactions would qualify as “investment contracts.”
Think of this as the: if it walks like a security, and talks like a security, it’s probably a security — test.
It basically breaks down to understanding the nature of your token within the following 4 parameters
- Is it an Investment of money?
- From an expectation of profits?
- Is it arising from a common enterprise?
- Is it dependent solely on the efforts of a promoter or third party?
The “investment of money” dictates that the investor commits his or her assets to the enterprise in such a manner as to subject the investor to financial loss.
Although the term “money” is used, this has expanded to include investments of assets other than money. Eg, which means this could be a cryptocurrency as defined by the FATF and by most jurisdictions around the world as a form of “good”, “asset” or “property”
A “common enterprise” means that investors pool their money or assets together to invest in a project and the model concerns whether any profit that comes from the investment is largely or wholly outside of the investor’s control.
if the investor’s own actions largely dictate whether an investment will be profitable, then that investment is probably not a security.
Why this is important
This is important for Initial Coin Offerings/Token Generating Events, as you need to be clear on what your token provides the token holder, so that it is clear, easy to understand, and unambiguous for individuals to assess the rights associated with your proposition and platform.
In order to be deemed a security, the offering would have to meet all 4 tenets, and under the legislation, and transactions that do would be considered securities, and therefore subject to certain disclosure and registration requirements, except for securities offered or sold in exempt transactions.
Promotions and Materials
In an ICO the promotional materials associated with your sale will be examined in determining whether it is a security, and therefore you should seek the counsel of a lawyer to review all your offering documents, your website, and your token terms, so that no language misrepresents what you are offering to your community.
In determining if something is an offering of securities there will be a focus on your materials and how you are promoting your offer eg what the investors are being offered or promised, how the offer is distributed, and the economic inducements held out to the prospect.
If the materials promise things like “great returns” or “guaranteed income”, regulators will almost certainly find the instrument to be a security, and therefore subject to securities regulations in almost all jurisdictions.
A secondary test that is applied in the United States is the “risk capital test” which was formulated to test for whether something is a security which considers the following:
- are funds are being raised for a business venture or enterprise;
- is the transaction is offered indiscriminately to the public at large;
- are the investors are substantially powerless to effect [sic] the success of the enterprise; and
- is the investor’s money is substantially at risk because it is inadequately secured.
“Singapore, like most jurisdictions, does not regulate virtual currencies per se, as these are not considered as securities or legal tender” 
“MAS currently does not regulate Bitcoins. They are not legal tender like the notes and coins issued by MAS. They are also not considered securities under the Securities and Futures Act” 
This is consistent with Section 2(1) of the SFA, which defines “securities” as;
inter alia, debentures or stocks issued by governments or private corporations, any right or option or derivative in respect of any such debentures or stocks, any unit in a collective investment scheme, or any unit in a business trust or its derivative.
Hong Kong has also taken the same stance as many other countries and as defined by the FATF
“bitcoins are not a legal tender, and their value is not backed by any physical items, issuers or the real economy”
“We therefore consider that bitcoins and other kinds of virtual commodities do not qualify to be an e-currency, having regard to their nature and current circulation in Hong Kong.
They are, in most cases, be regarded generally as commodities or virtual commodities for individual speculative activities. It is also unlikely that bitcoins, given its circulation, will pose a significant threat on Hong Kong’s financial system. 
As such, the Government does not consider it necessary to introduce at the moment new legislation to regulate trading in such virtual commodities or prohibit people from participating in such activities.
However, with the advent of Ethereum and “Smart Contracts” which allows developers to make more advanced autonomous entities and constructs; new and novel approaches are being attempted without the proper understanding of the laws that they may fall under, precipitated by a lack of clear guidance and active participation by regulators.
Distinct from the purchase and exchange of cryptocurrencies themselves, smart contracts and decentralized autonomous organizations can be designed to mimic regulated investment structures such as ETFs, derivatives, venture capital, or hedge funds in ways that are faster, borderless, and self executing.
What this means
If you develop a protocol that mimics these types of vehicles, the default securities laws of most jurisdictions will apply, and these cryptocurrency investment products, or investment schemes will most definitely fall under securities regulations.
I suspect that in the future these laws will be challenged when the technology gets advanced enough to create autonomous entities on a blockchain that can learn and act, and evolve on their own, but that is a post for another day.
Hopefully, this basic introduction on how to know if your Token is a Security will send you off in the right direction. If you want to learn the basics, read my original article: How to do an Initial Coin Offering.
You can also find part 3 here: How to Choose the Best country for an Initial Coin Offering or Blockchain/Cryptocurrency Startup
I keep a pretty open door policy at Intrepid Ventures to anyone who wants to learn more, just hit me on Twitter, or email me directly with your questions, and I will try to respond, but answers are not guaranteed.
If you’re still having trouble understanding blockchain technology and how it might apply to your project, I suggest you start with my article: How the Blockchain Works