A Deep Dive into Token Launch, STO, ICO, and Crowdfunding Platforms in Canada and the USA
Amidst a hectic travel and speaking schedule, I have had little time to publish lately — apologies for my absence. However, when a US registered securities dealer makes unfounded or inaccurate claims about my Canadian home and native land, I just have to chime in. This article takes a deep dive into how various companies such as StartEngine, TokenFunder, Polymath, and others are taking varied approaches to tackling — or in some cases, altogether ignoring — securities and exchange regulations.
Now, I must qualify this with a few quick points of clarification. I have listened to Howard Marks share his opinion on a number of occasions, and while he has no formal securities law or finance background, he has done an impressive job with his crowdfunding platform StartEngine, which has raised millions for their clients. Beyond merely telling others that transparency and due diligence is important, however, StartEngine has walked the talk — filing their own Reg A with the SEC. Let’s take a look…
The company made a “whopping” $222,139 in 2015 and $308,370 in 2016 in gross revenues. With CEO compensation at $250,000/year and over $3M in operating losses in both years, StartEngine’s financials may serve as a cautionary tale for anyone who thinks launching a crowdfunding platform is as an easy or profitable business venture.
Now StartEngine is raising another $5M USD at a $63M post-money valuation — according to their financial statements and website. The $5M USD appears to be enough — subject to their 2017 financials — to cover the companies accumulated losses for 2015 and 2016.
Marks’ article, “Why Canada Hates ICOs”, actually does a decent job of summarizing a few of the US exemptions —however, ICOs are globally decentralized financial instruments and — IMHO — many projects who pay any attention to US securities regulations are operating as if they rest of the world does not have their own regulations. You can see examples of this on the projects that may file a Form D (read further below for an example) in the US but do not file any registration exemptions for major jurisdictions across Europe, Canada, coastal Asia, and Australia — all of these regions have clear cut requirements that do not necessarily mesh well with us regulations. Welcome to the world of raising capital in a global marketplace.
Although it appears Marks’ platform may be pivoting from their ECF (Equity Crowd Funding) module into the space of tokenized securities with a MadMoney-esque marketing campaign dubbed Initial Coin Opinions, there is little indication of any technical expertise — whether finance or blockchain related. In a recent webinar, Marks expressed frustration at how Canadian regulators required that Start Engine file an exemption in SEDAR (Canada’s version of the US’ EDGAR securities filing database) and how this was, according to Marks’, “not worth it for a country with a population 10% of the size of the US population”. Instead, StartEngine chose to ban Canadian investors from their platform, as seen below.
Pro Tip #1: Securities regulations are, for the most part, focused on the investor…not the issuer. This means you need to ensure you are filing accounts for each jurisdiction that even a single investor would be residing.
Interestingly, StartEngine does not mention European, Asian, Australian or South American regulations, disclosures, filings or investors, which suggests they are not engaged in markets beyond the United States. The platform appears to focus solely on compliance with ECF regulations in the US market which is problematic when you have no means of restricting a open and public blockchain token from being held by a foreign investor.
Also of note, StartEngine has no public history with distributed ledger technology, blockchain, or the technology to fulfill their requirements as a licensed and regulated exempt market dealer of registered securities. These requirements include a technical integration of trade and compliance data into the broker/dealer ATS network. When I asked Marks about this in a public forum, he responded that they could take care of this within the month — which is odd given that firms such as tZero and Templum have had to spend months to get their ducks in a row to overcome this same hurdle. That was over 6 months ago — StartEngine is still a US only firm.
As of November 2018, ICO broker dealer firms may also be required to integrate into the behemoth — and yet to be deployed— CAT (Consolidated Audit Trail) database. The CAT is an SEC initiative focused on bringing every US securities transaction — to the tune of about 240 Billion transactions daily — onto a single ledger to streamline regulatory reporting, record keeping, and audibility. This creates a new hurdle for any firm — such as StartEngine — looking to get involved in cryptographic assets such as coins and tokens.
Finally, StartEngine uses something called Crowdcheck, a patent-pending software solution, to verify their statements as a registered dealer of crowdfunded securities. It would be interesting to hear Crowdcheck’s perspective on StartEngine’s most recent claims.
Enter the Great White North
Canada also has crowdfunding and ICO securities platforms. Interestingly, each chose to raise capital and file under registration exemptions that differ from StartEngine’s approach. More interestingly, the USA regulators have never approved an ICO offering — Canadian regulators, on the other hand have allowed multiple ICOs, including both securities and utility token offerings. Let’s test StartEngine’s claims about Canada hating ICOs and go over a few of their Northern competitors…
FrontFundr
Yikes. Not a good start — I suspect this is just a certificate renewal issue — but not a great confidence booster when your web platform exists to manage people’s money. Let’s dig into the financials in their SEDAR (Canada’s EDGAR) filings…
Frontfundr has a one year head start on StartEngine, however that first mover status can be a curse —because, among other things, your competition can learn from you. Financial statements were not available beyond 2015 but what we do see, gross revenue of $10,559 and $2,417 over these two years isn’t very compelling and certainly not near the traction StartEngine has seen.
Like StartEngine, what Frontfundr has done an excellent job of was the use of a securities regulator approved registration exemption. Reading their filing you can see they went through considerable effort to be transparent and disclose the risks of the business to their investors. I would love know what percentage of their investors have ever read the document but this is not on them and more on the need for modernization in filing requirements and disclosures.
What is different, and exceptionally innovative, about Frontfundr’s offering is the specific securities exemption they used — the Offering Memorandum, or ‘OM’. When compared to the Reg A offering the OM has several significant advantages including; unlimited capital raise, unlimited number of investors, access to global investors using specific “wrappers” (that’s securities lawyer speak for additional disclosures specific to various jurisdictions outside your own), and the ability for investors to trade subject to board approval.
Whether you are looking at Reg D, Reg A, Reg A+, or Equity Crowdfunding exemptions none of the choices in the USA hold a candle to the flexibility of the OM when you consider the perspective of using a securities token or an ICO.
Pro Tip #2: If you plan to use a securities exemption to raise capital with an ICO (initial coin offering), you are going to have to do your homework on how that exemption plays into your token economics, liquidity in secondary trading (i.e. peer to peer, crypto exchanges, decentralized exchanges, etc), and whether your exemption covers other jurisdictions.
Since inception, Frontfundr’s platform has raised less than $10 million CAD for all of their projects combined. It is also important to note that, like StartEngine, Frontfundr recently started a pivot towards crypto — time will tell what this actually means .According to the StartEngine website, this pales in comparison to the millions already raised in their client’s currently open offerings. While it might appear that Frontfundr went to greater lengths in terms of transparency, due diligence, and multi-jurisdictional securities regulation compliance — their own financials, and platform performance suggest that investors may not see the value proposition from these additional efforts. Personally, I would say this is a signal to Canadian regulators for the need for greater direction, clarity, and support for innovation than on Frontfundr who are simply trying to enable greater access to and distribution of wealth.
Impak Finance
While not a crowdfunding platform, Impak is relevant to the discussion because they were they first ICO in the world to have issued a compliant securities token offering according to Canadian and US regulations. This appeared to be the main (if not only) selling feature of their crowd sale.
Impak’s vision was inspiring as well, if you can find it beyond the promotion of having filed out some legal paperwork — to use blockchain to streamline governance, compliance, and back office processing for an investment organization that actually cared about, and invested in community, environment, and social enterprise. However, they raised less than 20% of their $10 million target — hardly a success when compared to most of the 1,031 ICOs issued from the US in 2017 where the average raise was in excess of $28 million USD.
Pro Tip #3: After 85 years of the US Securities Act, investors expect securities issuers to be compliant. Claiming to be a ‘legal offering’ is not a selling feature, nor is it optional. If your value proposition stops at ‘look at all the legal forms and documents we filled out’, you may not have a viable business — or maybe you just need a new PR firm.
Like Frontfundr, Impak filed an OM and in a single raise this ICO raised more than Frontfundr — a centralized platform specializing in raising capital — has been able to raise for themselves across multiple raises. Compared to the ‘traditional’ crowdfunding model Impak was a big success. However, when compared to Filecoin’s $257 million USD or Telegram’s $850 million USD raised, the project may be restricted in it’s ability to compete against a plethora of competitors in a massively funded, global ICO market.
In addition to all of this, Impak Finance did something else very interesting — in their securities exemption filing the company blended the boring old school filing of the OM with the new ICO standard, the whitepaper.
If you are considering issuing an ICO, I would highly recommend reviewing both how Impak Finance fulfilled their disclosure obligations without clean formatting, graphic design, and fonts compared to the link above where Frontfundr’s same registration exemption filings appear similar to the output of a 1990’s PC Law document generation engine.
Tokenfunder
For companies in Canada, TokenFunder is one of the ones I am most excited about — despite the limited success of their own raise. Firstly, they are focused on solving a real problem — reinventing venture capital with a token launch platform. Secondly, in comparison to both StartEngine and FrontFundr, they appear to have some solid technical capabilities in blockchain.
TokenFunder’s approach to regulatory engagement also demonstrates a new ‘best practice’ that many decentralized financial platforms should take note of. They engaged their local securities regulator, the Ontario Securities Commission (OSC), early on — with the help of a highly qualified legal team — to discuss what their business model, tokenomics, and more.
For our own blockchain compliance software, we took a similar approach and engaged regulators around the world with product demos, discussions on our own business model, and fostering an open dialogue. For iComply, it was critical to ensure our software is capable of meeting the compliance monitoring, record keeping and reporting needs of token launch platforms, crypto-exchanges, and decentralized fintech networks.
The outcome of TokenFunder’s OSC engagement hasn’t been entirely rosy and was likely a driving factor in why their ICO was unable to reach it’s target. On the good side, TokenFunder was accepted into the CSA Sandbox — enabling them to operate under the close oversight of the regulator. On the other hand, their exemption only lasts for one year — which is almost over and they have yet to release their platform. Furthermore, their investors have virtually zero liquidity as seen in the excerpt below on point 3.
Pro Tip #4: Investors want liquidity, healthy capital markets need liquidity. Anyone who has every tried to raise capital before has heard the words “Where’s my exit?” from a prospective investor. Capital always flows in where there is the least friction.
Polymath
Where one Canadian ICO zigged, others zagged. Polymath took an entirely different approach than the other securities token platforms — rather than using an approved regulatory exemption Polymath issued using the controversial SAFT (Simple Agreement for Future Tokens), originally proposed by Cooley, a US law firm and although the company is based on Toronto, Canada they used a complicated structure to issue from the Caribbean instead (further research into tax and securities considerations of ‘mind and matter’ could make for a whole new series of articles).
The SAFT was conceptualized as a means of bypassing securities regulation. But changing the title of a document from “Simple Agreement for Future Equity” (SAFE) to “Simple Agreement for Future Tokens” (SAFT) is hardly the same as meeting regulators where they are at today. Many 2017 offerings claimed to be “not a security” simply because they used a SAFT. However, as seen in the widely reviewed and publicized “Response to the SAFT” by the Cardoza Law Project there is a strong argument to be made that using the SAFT may in fact be a way to ensure an ICO is deemed a security.
Where my opinion (not a lawyer), differs from the Cardoza paper is in the concept that being deemed a security is a risk without many corresponding benefits to consider. This was actually my own feedback during the drafting of the paper and why I declined to add my name to the agreement. Quite often, where there is risk there is also reward — such is the case of issuing securities. The fact is that the securities market is valued in excess of $160 TRILLION USD (according to Boston Consulting Group) which dwarfs the current ICO market of a few billion USD.
Issuing a security comes with many business, legal, regulatory, compliance, and governance risks (talk to your lawyer for considerations on your own offering) but the reason companies do this is because it also comes with opportunity. Polymath however, used the SAFT as a security and filed a Form D under regulation 506(b) in the USA.
There is some irony here, as a platform promoting the sale of compliant securities tokens funds their own development by raising capital from a global pool without — to my knowledge as of this writing — disclosures or sufficient documentation in most of the jurisdictions. Polymath claimed their offering was legal and upon closing $59 million using the SAFT has generated a sizeable network effect as can be seen in their Telegram channel.
However, Rule 506(b) may pose multiple problems for Polymath and although I have no legal or financial opinion on their offering a number of facts stand out.
First, the 506(b) securities are restricted, meaning they cannot be traded with filing a registration statement. In specific cases where they can be traded they are still required to not trade for a minimum of 1 year, or 6 months if the issuer files reports under the Exchange Act. In contrast, as of February 1, 2018 Polymath’s tokens began freely trading with zero KYC, AML or terrorism financing screenings in place and well under 6 months of their initial token sale of September 9, 2017.
While this article is focused on how various token launch platforms are navigating securities and exchange regulations there are a number of other regulations that apply — including regulations with much bigger teeth such as the US Patriot Act — to the secondary trading of tokens and coins. If your token is a security in the USA — such as when you file a Form D — and you take on US investors you can be liable for breaching trade sanctions. For example, offering a token today while filing a Form D and then letting someone from Libya (a US sanctioned nation) purchase your token or coin can put your entire company, and management team in jeopardy. I will leave a deep dive into this topic — and how iComply’s Prefacto technology can solve it — for another article.
If you are like me you have many legal questions about how Polymath was able to navigate regulations with a single registration in a single country, whether regulators actually approve of this approach, and will be interested to watch their story unfold. Specifically, I am curious to learn the following:
- How was Polymath able to avoid mind and matter considerations from the Ontario Securities Commission and the Canada Revenue Agency?
- Is their SAFT issued, non-equity, securities token taxable to Polymath and in what year? Since their team is in Canada do they have to pay tax in Canada?
- What about the law firms, software partners, consultants, advisors, and team members who received payment in this non-equity security token — how is their tax burden calculated and in what country(ies) do they have to file their taxes?
- Did they file local registration exemptions to their European, Canadian, Asian, and South American investors? If so, why can’t I find them in the disclosures registries throughout these jurisdictions?
- What will happen to the value of the Polymath token if the SEC or another regulator engages in investigation or enforcement actions? How will this impact the fiscal viability of their partners who are being paid in Polymath tokens and left holding them after the fact if they are sanctioned?
- How does the Polymath network screen on-chain capital inflows of cryptocurrency to ensure the funds are not proceeds of crime, that their token is not used for money laundering or terrorist financing?
In time, I am certain we will see the answers to many or all of these questions. However, what may be most concerning about the Polymath approach is the lack of governance, risk management, and compliance in their offering. Their KYC and ID provider, IdentityMind Global, has agreed to accept the Polymath token as payment for their services without screening the funds themselves for money-laundering, criminal activity, or terrorist financing. Does this in itself create a unique conflict of interest? We were engaged by Polymath to provide our own compliance software to their network however our own legal advisers felt that accepting payment in the Polymath token posed a number of conflicts of interest to us as a company built around objective compliance auditing, monitoring, investigation, and disclosures. In the long term I am hopeful that we can work to support the Polymath network as I suspect many of their current partners will need to address the project to address this as well.
In terms of the ability to raise capital — which is the entire purpose of a securities offering — Polymath takes the other crowdfunding platforms — StartEngine, Frontfundr, and Tokenfunder — to the cleaners. $59 million is more than most ventures ever hope to raise by a Series B round. However, in terms of securities regulation the platform leaves a lot of questions. One has to wonder how well their securities lawyer must be sleeping now that the SEC Chairman has directly mentioned lawyers as targets for their enforcement division, or the Attorney General of New York has initiated an investigation into these same questions.
The network effects of these risks may have the potential to erode the entire business model of the Polymath network — as banks, law firms, ID, and KYC providers will have to answer to their own audits on fraud, money laundering and terrorist financing.
Pro Tip #5: It’s entirely futile to spend a dime on KYC, AML, ATF, and the rest of the compliance alphabet soup in your ICO if you do not ensure this is managed for every peer-to-peer, exchange, swap, or other secondary trade.
Tools like iComply’s Prefacto Compliance Protocol enable real time governance, risk mitigation, and compliance for security and utility tokens by creating “compliance guard rails” for token trading in secondary markets. Our iComplyKYC solution is the only solution on the market capable of meeting global standards for both traditional KYC/AML but can also identify ‘on-chain’ risks surrounding the wallet, and the funds themselves, have been involved in financial crimes, or do these funds originate from a sanctioned country (see Libya example above)?
As announced by Bloomberg Law, cryptoexchanges, ICO issuers and token launch platforms — such as StartEngine, Polymath, Frontfundr, Tokenfunder, Indiegogo, and others — can use these tools to assess compliance risks and generate immutable record keeping and reporting that their compliance procedures were in fact executed successfully.
For a securities regulator, the data is compelling: grey area issuances and blatantly illegal offerings have exponentially outperformed the issuances that choose to operate by the book. This creates a risk for both the Canadian and the US economies as companies choose to issue from jurisdictions like Barbados, Grand Caymen, Gibraltar and Singapore.
Number of security tokens approved by securities regulators to date?
USA = 0, Canada = 2
So back to that claim by StartEngine on Canada and the ICO, a quick look at the history of securities tokens offerings would suggest that Canada has been a much more favourable (that’s favorable to all you ‘Mericans) jurisdiction to date.
For us at iComply, we have found the regulators in both Canada and the US to be willing to engage and voice the concerns before we take action. This is reassuring to us, and our investors, as we can implement regulatory feedback into our product development lifecycles. In my opinion, this puts Canada on the map as a leader globally and creates exciting business and corporate development opportunities for our customers.
What About Utility Tokens?
This is where the claim that “Canada hates ICOs” sounds exceptionally bizarre. Jay Clayton, Chairman of the SEC, has been crystal clear on numerous occasions that in the eyes of the regulator every ICO bears the hallmarks of a security. However, the SEC’s review of Ethereum showed the regulator acting quite differently in their recent announcement that Ethereum was not a security. But this is the USA, what has Canada done so far?
In 2017, I was brought in to advise on the technical architecture of an ERC721 token and token sale from a compliance perspective. Axiom Zen, a Canadian tech venture-builder firm renowned for innovation and hiring all the top talent, engaged the BC Securities Commission early on in their development of the Ethereum clogging CryptoKitties ICO — in this case ICO means “initial cat offering”.
The project was a huge success, reportedly raising over $26 million and bringing much needed attention to scalability problems of public blockchains by swallowing up over 30% of the Ethereum network in the first days after launch. More importantly, the BCSC advised that the offering was not a security and outside of their jurisdiction — all hail Tamagotchi, in cat form, on the blockchain! — CryptoKitties became the first ICO that could legitimately claim ‘utility’ status.
Number of ICOs classified as “not a security” by the issuer’s regulator to date?
USA = 0, Canada = 1
Sorry Howard Marks, looks like Canada may be taking the US to school in more than just hockey. Don’t worry, we have a few more tricks up our sleeve, just keep reading.
Matthew Unger is CEO of iComply Investor Services, a compliance software company that enables ICO issuers, token launch platforms, cryptocurrency exchanges and investors to both launch and trade tokens in compliance with global securities, financial, identity, and privacy regulations.
You can find @iComplyICO on LinkedIn, Facebook, Twitter, and Telegram
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