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A compliant framework for fundraising from American investors and distributing newly issued cryptocurrency that is never considered a security

Applying the time-tested shareholder property dividend model to cryptocurrency distribution.

The SEC considers 99.9% of token fundraises as unregistered offerings of securities. Instead, we propose a methodology for distributing cryptocurrencies & digital assets that are NOT SECURITIES and don’t violate securities laws.

TLDR — Skip below to “SOLUTION — An alternative, fully compliant cryptocurrency issuance framework”

Why fundraising on a SAFT, SAFT-e, or selling “utility tokens” is doomed in the US

Many startups and teams saw the 2017 opportunity to raise money easily from investors for their startups, using the same process that Ethereum foundation followed by selling the promise of tokens to investors. For people who have been in a coma in 2017, here is how it worked.

  1. A team announces a project, which includes a product or a network.
  2. The network has not been built yet.
  3. The purported network will use a token either as an internal currency or as a way to reward participants for actions within the network.
  4. The supply of tokens is limited.
  5. The team pre-mines some or all of the tokens and sells them to people who will purchase them, presumably, for use in the network.
  6. The money will be used to create the network.

But this has created legal and regulatory problems for the teams that sold these tokens in the US because many were deemed securities by the SEC.

The sale of securities in the US is governed by The Securities Act of 1933, which regulates initial offerings of securities while the Securities Exchange Act of 1934 governs the subsequent exchange of those securities.

In making the determination that many of these token sales were unregistered securities sales, the SEC used the Howey test, in addition to several other criteria set forth by both the 1933 & 1934 securities acts (which include, but are not limited to all pre-sale communications by the team, the sale mechanics, specific promises of returns made to investors, and post-sale actions such as enabling secondary markets for “digital assets”, etc).

However, the primary determinant of whether a sale is considered a sale of securities is called the “Howey Test” which refers to a test developed by the Supreme Court in a 1946 case, the SEC vs W.J. Howey & Co, for determining whether a certain investment contract qualifies as a security.

Under the Howey Test, a fundraise transaction is a securities sale, if:

  1. It is an investment of money…
  2. …In a common enterprise
  3. …With an expectation of profits
  4. …Which [substantially] come from the efforts of the promoter or a third party.

If a transaction does not meet any of the four “prongs” of the Howey Test (“fails the Howey Test”), it is not a security.

Why many token sales were deemed securities

Most token sales clearly are investments of money in common enterprises, so the first two criteria are met. Also, some projects were explicit in their marketing as to value increase, which strengthens the argument that the buyers/investors bought them expecting profit rather than with the intent to use those tokens for the utility of the network. This complies with the third part of the Howey Test. If the network is designed in such a way that the value of tokens will appreciate predominantly due to the efforts of others and not the buyers themselves, all 4 prongs of the Howey Test are met, and the token is clearly a security.

However, if you design your network and your company the right way, you can potentially avoid triggering the last two parts of the Howey Test. Let’s see how this is possible.

Failing Part 3 of the Howey Test: “With the expectation of profits”

If your token is bought with an expectation of profits, you’ve passed part 3 of the Howey test. Many token sales in 2017 promised future utility on non-existing networks, which were easily considered a sale of securities. Over the years, however, we’ve seen the SEC still prosecute these as unregistered securities sales even if the token had immediate utility on a fully functional, decentralized network prior to the sale.

Failing Part 4 of the Howey Test: “Profits which solely come from the efforts of the promoter or a third party”

If your token becomes more valuable to users solely from the actions the team takes, it passes the 4th part of the Howey test. However, if receiving a digital asset requires the user to perform an action that strengthens the network and therefore increases the value of the network, the 4th prong of the Howey test does not apply. In the Bitcoin network, every bitcoin is created by performing PoW mining, which increases the network hash rate, strengthening the network’s security barrier against attacks, as well as validating transactions(which increases the network utility), thus simultaneously increasing the value of the Bitcoin network. This is independent of what Satoshi did then or what the Bitcoin Core team does now. This is a perfect model to emulate in designing your network and your digital asset mechanics.

Despite compliant mechanics, another factor can tip your digital asset into being a security:

Token issuers assisting in secondary market trading: Even if all other guidelines were followed, if the team promotes or enhances the tradability of the token (by helping list the token on an exchange, for example, rather than by natural or external occurrence), it shows the team’s intentions for the token to act security-like.

SOLUTION — An alternative, fully compliant digital asset issuance framework:

The important question that needs to be answered is how one can create a decentralized network that has increasing value while having the ability to bootstrap the network.

First, create the network:

  1. Create a network that is truly decentralized; meaning the instant the network goes live it is in the complete dominion and control of the network’s node operators. Follow the example set forth by Satoshi.
  2. To bootstrap the creation of the network and to reward early contributors, you may form a corporation (for-profit) that consists of early contributors (both founders and investors can be shareholders).
  3. As holders of equity in a for-profit corporation, shareholders can be rewarded for creating, seeding, and strengthening the network. The corporation may mine the coins just like anyone else — but by being the creators, they have an early advantage in accumulating the network cryptocurrency. [REMEMBER, THIS DOES NOT GIVE THE CORPORATION ANY RESIDUAL NETWORK CONTROL. THE NETWORK SHOULD REMAIN TRULY DECENTRALIZED.]
  4. Since the “digital assets” being mined by the corporation becomes its property, the company is free to distribute them to its shareholders in any way that its board and bylaws allow.
  5. A good way to distribute the cryptocurrency to founders and investors is NOT through “digital asset” issuance and vesting schedules (which has its roots in the securities world) but as monetary payment owed to shareholders through a dividend mechanism (below).

How shareholders may receive a non-security “digital asset”:

  1. Company raises money by selling equity in the corporation to accredited investors. (Can be raised on a SAFE or other convertible note so long as conversion to equity occurs prior to token distribution)
  2. Company creates a closed test network with plans to decentralize it by relinquishing control to a group of facilitators and node operators the instant it goes live.
  3. Node operators and facilitators acquire the network’s “digital asset” using a PoW mechanism.
  4. Market forces establish an initial USD par value for the non-security “digital asset”.
  5. Any of the “digital assets” the company acquires become the property of the company and can be paid to all its shareholders through a USD-denominated dividend distribution, as one of the elected currencies of the dividend. Note this last part is important. At the time of dividend distribution, shareholders must have the option to receive that dividend in the form of other property held by the company, such as equal value of either fiat, Bitcoin or other widely accepted cryptocurrencies, OR your network “digital asset”.

Why this fundraising and token distribution mechanism works

  1. The “digital asset” was never sold to anyone, and can be mined by anyone inside or outside the company, and therefore, neither a “securities offering” nor an “unregistered sale of securities” has taken place.
  2. Aside from any “digital assets” they may own, the shareholders also benefit from the success of the corporation with a time-tested Silicon Valley model (the corporation’s primary job being selling ancillary services or products that make the network more valuable).
  3. In most registered fundraises, investors are “locked up” for a period of time (in accordance with some SEC rules). Plus, Reg D securities offerings (this is the typical tech startup private fundraise) are limited to accredited investors; and any secondary resales are also limited to accredited investors. Trading is only allowed on a regulated, licensed exchange. If tokens were sold through (or tied to) a Reg D fundraise, not only would the tokens be securities, but the investors would not be able to resell except to other accredited investors, and at that, only after holding for a full year. Instead, in the dividend distribution model, “digital assets” — from a live network that are paid as the shareholders’ choice of dividend — would be freely spendable and commonly redistributable to all.

Why not just issue the “digital asset” as the dividend itself? Why does it need to be a USD-denominated dividend payment with choice of currencies?

An earlier model was explored and published in CoinDesk Jaron Lukacievics. It established a token issuance direct to shareholders via dividend, decoupling the token from the security that issues it and circumvents trading restrictions (mentioned in 3 above).

The problem here is the token’s use hasn’t been properly established as a non-security, and by directly tying its distribution to a security (equity) — rather than as a USD-denominated property paid out as per the shareholder’s choice — the token also becomes a security.

A derivative of a security is also a security.

Why this new model matters?

If done right, we believe that this new structure allows teams to monetarily benefit from their contributions in building a network, while still preserving decentralization of the network. Teams will be able to build networks of great importance without being hamstrung by the fear of securities laws violations.

PS: Thanks to our long-time friend Ryan Singer from Chia.network for first suggesting this strategy, to long-time friend Jaron Lukasievicz for his FACTS model precursor, and to Rick Levin, fintech and regulation chairman at Nelson Mullins, for educating us on the minutiae of securities laws.

(Disclaimer: I am not a lawyer or an accountant, and this is not legal or tax advice. Please check with your attorneys for legal advice on how to design your cryptocurrency project.)




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Chandra Duggirala MD

Chandra Duggirala MD


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