By Sammy Naji
As the Securities and Exchange Commission greater asserts itself against non-compliant Initial Coin Offering tokens, an increasing number of ICO issuers have attempted to comply with SEC regulations by offering tokens pursuant to SEC exemptions or by framing the tokens as utilities rather than securities. Utility tokens are tokens that represent a service or a good to which the token holders are entitled. Notable brands like Kodak, Atari, and Telegram have already issued or are planning to issue such tokens as a way to raise large amounts of capital as well as to stimulate interest from the public to their services. The issuance of utility tokens typically involves two stages: a pre-functional phase and a post-functional phase.
1. Utility Tokens: Pre-functional Stage
During the pre-functional stage, the token is not yet usable and is considered a security under the last prong of the Howey test that requires an investor to have expectations of profits that arise predominately through the efforts of others. A pre-functional token meets this requirement since a buyer relies predominantly on the managerial efforts of the issuer in order to realize the value of the token. The SEC has already halted one such sale of a pre-functional utility token that was not registered nor offered pursuant to an exemption. Issuers of utility tokens that seek to avoid SEC scrutiny, including Telegram and Kodak, are therefore conducting their pre-functional issuance of ICOs pursuant to contracts for future tokens with accredited investors in accordance with the 506(c) exemption to securities registration. These contracts, known as Simple Agreements for Future Tokens (“SAFT”), entitle investors to a future right to a utility token once the token becomes functional in exchange for their funds.
2. Utility Tokens: Post-Functional Stage
Whether a token no longer constitutes as a security in the post-function phase is less settled. If a functional token is not a security, then the token can be issued and secondarily traded to the public without regard to SEC registration requirements and exemptions. The Cooley law firm takes the position that functional tokens are not securities and has issued a white paper regarding SAFTs as well as a standard form SAFT. According to Cooley’s white paper, after the token becomes functional, the token is no longer a security under Howey’s last prong since any expectation in the increase in value of the token beyond its consumptive value is based on market forces and not the managerial efforts of a third party or the promoter. On the other end of the debate lies the argument that tokens do not cease to be a security once they are functional as development teams and issuers do not actually cease their managerial efforts once the token becomes functional. Instead, the tokens remain very speculative investments whose value largely hinges on these ongoing efforts rather than pure market forces. Though a large amount of issuers have issued utility tokens pursuant to Cooley’s SAFT approach, it appears that Cooley’s approach is not adopted by the SEC given that a large amount of the SEC’s subpoenas have largely been directed at SAFT issuers.
3. Equity Tokens
Issuers who wish to issue SEC compliant equity tokens, instead of utility tokens, have relied on the post-JOBS Act exemptions from SEC registration, which allow for general solicitation of investment offers and the use of intermediaries that do not meet traditional broker-dealer requirements. Startup ICO platforms advertised as “SEC compliant” such as Startengine, Microventures, and Wunderfund thus allow for the issuance of equity tokens pursuant to either: the Regulation D 506(c) exemption which allows for unregistered sales of securities to accredited investors, the Regulation Crowdfunding exemption which allows for up to $1,000,000 to be raised with limits on the amounts each investor can invest based on their net worth, and the Regulation A+ exemption which allows for the sale of up to $50,000,000 dollars with no restrictions on resale trading but subject to strenuous reporting requirements. These platforms are also planning to provide wide access to secondary markets for investors of exempted securities that were typically off limits prior to an issuer’s IPO.
Though compliance with SEC sale and resale regulations is intricate, ICO platforms are automating SEC compliance by utilizing blockchain itself for automated verification of accredited investor status and verification of resale time restrictions before each token is sold. That being said, although ICO issuance is becoming more streamlined through these platforms and other technological innovations, attorneys must still exercise extreme caution in their advice to clients seeking to conduct ICOs especially given the SEC Chairman Jay Clayton’s warning to attorneys involved with ICOs that many of their approaches may be contrary to the professional obligations of the US securities bar.