Disclaimer: Nothing in this document constitutes legal advice. No representation is made as to the completeness or accuracy of this information. This information is provided as reference material only. You should not rely on this information and should consult an attorney skilled in the matters discussed herein before taking any action regarding the matters discussed.
If you are considering launching a token, you are entering uncertain territory. You should start from the default position that any arrangement you use to raise capital for their project is itself a security. Almost every form of bootstrapping a project begins with a founder developing a good idea that needs capital for implementation. Regardless of the type of asset created, an arrangement, contract, or scheme between an active builder and a passive investor who contributes money to a project with an expectation of a financial return is an investment contract, which is a security under US law.
From the default position that fundraising will create some form of security, you should consider whether to register the security or to raise capital pursuant to an exemption. Before you go to market to raise funds, the first thing to do is to get a lawyer to help you think through the near and long-term goals of your project to consider how and at what point the planned token launch fits into the broader plan. With an experienced securities lawyer, you should consider whether an exemption best suits your long-term plan.
In most cases, founders will choose to raise capital from private sources via Regulation D. Some founders may want the ease of access to public markets offered by Reg A+, the lack of US nexus offered by Reg S, or the benefit of an intermediary offered by Reg CF; generally, the speed and lack of bureaucracy offered by Reg D wins.
Often founders will raise equity capital for a traditional business through a SAFE agreement and, as part of that raise, they will have a token warrant that permits the investor in the SAFE to purchase any token issued by that traditional company at a later date. The warrant generally contains an explicit statement that clarifies there is no guarantee that the company will ever issue a token. The warrant specifies that if a token issuance does occur, the investor will have the ability to participate on predefined terms. The warrant, like the SAFE, is generally viewed as a security.
Following a capital raise, the founder and the capitalized company develop a robust plan for the token under the consistent oversight of an attorney. When the plan is complete, the company creates the network that will generate the token. The generation event mints tokens that are locked in smart contracts that restrict the transferability of the tokens for a vesting period (often one year). After the vesting period, investors might be able to transfer their tokens, either because the token is not a security (which bears the risk of being incorrect) or through an exemption for the sale of a restricted security (such as Rule 144).
Founders have to ask: is the token a security when it is launched? That is a deeply fact-based consideration that depends on how a judge and jury would review the facts in light of a Supreme Court case, SEC v. Howey. The Howey analysis considers whether the token launch is an arrangement, contract, or scheme that “involves an investment of money in a common enterprise with profits to come solely from the efforts of others.” If the token purely represents a bet that investors are placing on a founding team to create capital appreciation for the investor who stands idly by, the argument that the token represents a security is strong. However, if the token represents a utility, a voting right, or an access right, there may be merit to the position that the token is not a security. The law remains uncertain.
If a token is a security when it is launched, does it always remain a security? This is a contentious question. Proponents of the argument that the classification of a token as a security or not a security generally point to decentralization as a means of altering the classification. Decentralization would render the “efforts of others” consideration of the Howey test meaningless, because a decentralized network does not rely on the specific efforts of identifiable persons. The full SEC, as distinguished from its staff lawyers, has neither accepted nor rejected this theory.
You should consider the specific points of the Howey test with your lawyer as part of your network design. If you and your lawyer determine that your initial launch creates a security, your lawyer may counsel you to have a strict lockup period during which investors are not able to transfer their tokens. Depending on your facts and circumstances, your lawyer may determine that executing on a decentralization plan during the lockup period may be the best path forward.
As a founder, you need to know the landscape of the securities law well enough to understand how to build alongside the advice of an informed attorney. Too often, founders approach attorneys who are not competent in securities analysis; and, possessing no knowledge of the issues in securities law, the founders are not aware of their lawyers’ lack of knowledge. Lack of knowledge leads to inaction in law. “Don’t do anything” is the safest answer. It is worth your time to familiarize yourself with the basics of the securities considerations in order to procure sound legal advice and act in accordance with it.
The rest of this discussion includes a summary of the issues that founders may face while designing tokens in the US along with reference materials for deeper discussions with their attorneys.
Securities laws are the subject of intense debate in the United States. Securities are regulated in the US by the Securities and Exchange Commission (SEC). Securities are required to be registered with the SEC, which administers a host of rules requiring issuers of securities to report information to investors and / or the public. The SEC also oversees the conduct of securities issues in order to protect the public from fraud, false information, and malfeasance.
For founders considering token issuances, there are three questions to ask: (1) am I issuing a security?; and (2) if so, does the issuance fall within an exemption?; or, (3) do I need to register?
Step 1 (Security?): The first question that arises when a founder considers launching a tokenized product is whether any agreements adjacent to a token issuance create securities that needs to be registered with the SEC. Generally, the analysis looks to the nature of the agreement to see whether the issuer has entered an “investment contract” with investors as part of the issuance. Investment contracts are securities. What creates an investment contract follows from the analysis that the Supreme Court applied in Howey.
Howey involved a hotel that sold land containing orange groves to tourists along with a contract that leased the land back to the hotel and gave the purchasers a share in the net profits of the orange harvest, which was the product entirely of the hotel operator’s effort. The Court determined the arrangement created a security through a four-part test. The takeaway is that the underlying asset (oranges, trees, tokens) does not determine what creates an investment contract; the conduct of the parties involved and the nature of their agreement is what matters.
On the heels of the ICO boom, SEC staff members commented publicly that the issuances of the 2017-18 period were almost all securities in the Commission’s opinion. As a notable counterpoint, in 2018 the SEC’s Director of Corporate Finance, William Hinman, gave a speech that suggested that Ethereum is not a security because it has reached a point at which it is “sufficiently decentralized.” The SEC has emphasized that Hinman’s speech is not binding commission policy and is not binding law; however, Hinman’s discussion of decentralization generated a legal theory that many lawyers believe supports a path for issuers to create decentralized networks in which tokens are not securities. SEC Commissioner Pierce has nodded to the theory in acknowledging