Token Offerings and the SEC
Want to allow as many people as possible into your token offering, including US capital markets, which account for about 40% of the global capital market? Then, you should give a bit of thought to the SEC.
Note: I’m not a lawyer. This is from a legal-layman, founder’s perspective.
Two extreme viewpoints
In crypto, I see two different extreme views on tokens and security regulation.
Extreme 1 — the SEC chairmans:
- “I believe every ICO I have seen is a security.” ~ Jay Clayton (former SEC chairman)
- “I find myself agreeing with Chairman Clayton.” ~ Gary Gensler (current SEC chairman)
Extreme 2 — the chad web3 innovators:
And then there are moderates:
“The SEC’s view [is] that certain tokens may constitute securities.” ~ Brian Brooks (timestamp)
Why not be a chad? What are the potential downsides to offering a security token without complying with the SEC. Maybe the benefit is worth the cost/risk. To understand that, let’s examine some of the companies that the SEC took action against.
What’s the downside of ignoring the SEC?
There are two important categories of enforcement actions:
- SEC takes (nearly) all of the ICO funding.
- SEC takes a single-digit percentage of the ICO funding.
Examples of SEC taking (nearly) all of the ICO funding:
- Telegram, a non-US company, had to return all of its ~$1.2 billion to its investors who participated in its ICO and pay the SEC a $18.5 civil penalty on top of that (source). This is despite Hester Peirce, one of the five SEC commissioners, not supporting the SEC enforcement action (source).
- BitClave had to return all of the $25.5 million it raised in its ICO + $3.4 million in interest + pay a $400,000 penalty (source)
- Unikrn paid a $6.1 million penalty, which was all of the company’s assets (source). And this is despite Commissioner Hester Peirce, saying “I do not concur in my colleagues’ opinion that Unikrn’s token offering constituted a securities offering” (source).
- Others like ParagonCoin were driven into the ground from legal fees incurred fighting the SEC enforcement action (source).
Examples of the SEC taking a single-digit percentage of the ICO funding:
- Blockchain of Things (BCOT) paid a $250,000 penalty for the $13 million they raised in their ICO and had to return funds to investors who requested. So the SEC’s take rate was only 2% in this case (source).
- Block.one (think EOS) paid a $24 million fine, which is only 0.6% of the $4 billion they raised (source).
- Enigma paid a $500,000 penalty for the $45 million they raised in their ICO and had to return funds to investors who requested (a common stipulation in these SEC settlements). So the SEC’s take rate was only 1% (source).
In the above cases, the SEC has some reasonably small take rates: 2%, 0.6%, and 1%. For comparison, Apple’s app store take rate is 30% and mob bosses take rates could be as high as 40%.
What’s the difference between these two dramatically different types of outcomes? Who knows. Decrypt wrote the following about Block.one:
“It’s possible that the deal was a result of long drawn-out negotiations between Block.one and the SEC […] But what’s unclear is how Block.one managed to achieve such a small settlement” (source). That said, even though, some of these companies pay low percentages to the SEC, if you’ve run an unregistered securities offering, your investors can file civil suits that can potentially cost up to the amount of funding you raised.
Now that you hopefully have an idea of how risky you’re feeling with respect to the SEC, let’s take a look at the various types of token offerings and the SEC risk associated with them.
Types of raising and SEC risk
All of the above run a (potentially) high risk of the SEC getting involved (see their extreme viewpoint at the beginning). However, the above options are attractive to people because (a) they typically offer to non-accredited investors, (b) these offerings don’t have funding caps, (c) they don’t have to wait for SEC approval, (d) they can advertise the offering publicly, (e) their token is freely tradeable, etc. Below, we consider securities token offerings (STOs), which have much lower risk from the SEC, but they have many different restrictions that you must consider (note: keep in mind that some simplifications are made in the table):
Reminder that the above table presents a simplified view of these exemptions. For example, with Regulation S, you must follow the laws of whatever non-US country you’re doing the Regulation S offering in.
ICOs, IEOs (initial exchange offerings), and IDOs (initial DEX offerings)
If you’re one of the crypto chads depicted in the meme at the beginning or you’re confident enough that your token will not be classified as a security (e.g. using the Crypto Rating Council’s Scorecard), this is the way to go. As the previous SEC chairman and present SEC chairman have both stated, they view many ICOs as securities offerings. IEOs are just ICOs on exchanges, and IDOs are just ICOs on DEXs, so they carry the same regulatory risk from the SEC as ICOs.
Airdrops
Yes, unfortunately, even if you airdrop your token, the SEC might still come after you. You might think that airdrops don’t satisfy the first rung of the Howey Test (“an investment of money”), but it turns out that “money” is interpreted very broadly, and this rung can be satisfied if the token issuer receives any kind of benefit. This benefit could be as obvious as people promoting the token or people doing tasks to be part of the airdrop. Or it could be something much less obvious like the creation of a public market for the token or the general idea of decentralization, which are both beneficial to the token issuer. Here’s a short article and a full academic paper on this stuff, in case you want to read more.
INOs (initial NFT offerings)
Alright, so honestly, modern NFTs look way more like art or products than securities to me. However, that doesn’t mean that many won’t be deemed securities in the future; if airdrops can pass the Howey Test, despite the fact that they look like they avoided the first rung, then I could totally see the SEC saying various NFTs pass the Howey Test as well. However, I only say that because it looks like the SEC is trying to have as broad a scope as possible; if I were just a layperson who hadn’t looked into the SEC, I’d say that NFTs are obviously not securities. One approach that could make sense is to just do your INO, and then, if the SEC later shows that they think NFTs like yours are securities, then self-report yourself to them; this is what Gladius Network did with their ICO, and they weren’t fined at all. They just had to return funds to any investors who request returns and register their token as a security (source).
STOs (securities token offerings)
If you want to minimize the risk that the SEC comes knocking on your door to take everything or at least their minimum take rate, this is the way to go. See the various exemptions in the table above to see which one is right for you. Unfortunately, it might be the case that none of them are perfect (e.g. if you want to be able to advertise your token, sell it to everyone, and not have to wait a long time for SEC approval).
Conclusion
If one of the above rows in the tables and corresponding paragraphs vibes with you, maybe that’s the one for you. Maybe you’re a crypto chad; maybe you’re a trendy airdropper or INOer; maybe you’re an STO nerd. Maybe you need to talk to a lawyer (probably).
Check out my Twitter (@CasualBrady) for more web3 stuff. If you want to work on awesome stuff, check out our AI DAO, where we’re helping people and organizations make better decisions: https://discord.gg/2Bcpksx47e. Website: oogway.ai. If you want to engage with a bunch of great crypto legal people, check out LexDAO too!
Thanks to gefilte.eth and James McCall for reviewing early drafts and helpful suggestions.
None of the above is legal advice. See the ABA disclaimer: https://www.americanbar.org/groups/criminal_justice/disclaimer/
