(This article is based on a presentation Jim Verdonik and Benji Jones did at Cryptolina18 – a Crypto Currency conference on June 15, 2018.)
We jumped into the Coin and Token offering world in 2017, because we were doing a lot of Crowdfunding work and we realized that Coin and Token offerings were just the next logical evolution of Crowdfunding. Having invested a lot of time mastering Crowdfunding (including writing books about it and writing a state Crowdfunding law), we knew that we could use this expertise in the Coin and Token worlds.
Types of Offerings and Securities
Initial Coin Offerings (ICOs) and Security Token Offerings (STOs) are taking over the capital raising world where traditional crowdfunding left off. New platforms are being launched to capitalize on both the initial offer and sale and on post-transaction resales.
The rise of Security Token Offerings (STOs) gives us 20-20 hindsight to see that ICOs and STOs are really both offshoots of Crowdfunding. Most STOs involve selling assets that no one would ever argue are not securities. They generally involve having a common type of security (such as stock or a promissory note or a SAFE) be evidenced by a Token instead of by a stock certificate or other piece of paper
Some people are calling STOs JOBSICOs (after the JOBS Act that created Crowdfunding).
We are also getting hybrid types of offerings.
SAFTs and other hybrids start out as securities offerings and then hope to morph into something called a “utility token,” which is sometimes a security and sometimes not a security depending on who you talk to.
Other offerings give investors a choice between receiving a utility token or a Coin or an equity or a debt security.
Just when some people thought you could never do a Coin offering in the United States, the SEC has opened the door to considering both whether Coins and Tokens are securities on a facts and circumstances basis, which is a retreat from earlier statements that Coins and Tokens are always securities. As we discuss in another blog post, the most important development is that SEC has endorsed the concept that a digital asset can start out as a security and later not be a security.
Analyzing Early Mistakes
By now, we know that the people who thought Initial Coin Offerings (ICOs) were something totally new were totally wrong – and they are suffering for it. The Securities and Exchange Commission is bringing dozens of enforcement actions against ICO sponsors.
All this was avoidable, if only people had been paying attention.
To illustrate why the way ICOs were conducted were always doomed to violate securities laws, let’s look at the big picture. ICOs were just an evolution from Crowdfunding – and Crowdfunding is all about securities laws. The pyramid below illustrates how ICO’s evolved from Crowdfunding and Crowdfunding evolved from traditional securities laws.
The link between ICOs and crowdfunding of course, was the Howey test, which the SEC loudly reminded everyone was not simply related to selling orange groves.
The Howey test provides the missing link, because investment contracts were not just something the SEC used in 1946 and then forgot about. The SEC has consistently used investment contracts to regulate things we would not normally consider to be a security. Investment contracts have long played a major role in real estate finance for many decades.
- Condos that are run like hotels are often deemed to be securities based on that they are investment contracts
- Companies that invest in real estate are often deemed to be “investment companies” that are subject to the Investment Company Act because of contracts associated with the real estate ownership
- Tenants in Common (TICS). Real estate developers have long argued that breaking real estate into a large number of ownership pieces is not a security. The SEC has long rejected the arguments of the TICS.
- Limited liability companies are another case in point. Some LLCs are run like a general partnership, which is not a security. Others are run in accordance with Howey Test principles.
Given this long history of using Howey test principles in many finance situations, it’s not surprising at the SEC applied the Howey test to ICOs.
Of course, a single link like the Howey test could easily be ignored if there were no other similarities between ICOs and Crowdfunding. But people who couldn’t find many other similarities just weren’t looking, because the similarities are obvious. , which we list below:
Following the Evolutionary Evidence
Simply following the same rules that paleontologists use to trace human evolution back to the apes will bring you to the inevitable conclusion that ICOs evolved from Crowdfunding.
As we can see from the table above ICOs and Crowdfunding share many common traits including:
- Selling to a Crowd of smaller less sophisticated investors rather than to institutional investors
- The absence of long agreements
- Relatively little due diligence
- The need to provide detailed and easily understood disclosures to investors
- Using software to effect the transactions
- Using platforms and social media to find investors instead of investment bankers
- Investors who are looking for shorter term investments, which requires developing exits through secondary trading markets
- Producing businesses that are quasi-public, because they have large numbers of unrelated owners, but are still private because they do not file reports with the Securities and Exchange Commission.
- Many offerings are international
- Preselling a big part of the deal to create excitement is an important tactic
- Giving discounts to early investors
Lessons for Avoiding Future Mistakes
The lessons we learn from this evolutionary tale is that business practices, technology and legal analysis is evolving very quickly.
This change means that ICOs are just the first of a series of new capital raising tools.
Dealing with these new tools will require many types of advisers (from financial consultants to lawyers to software engineers to PR and social media people) to work more closely together to help clients raise capital.
Lawyers will need to know what functions the software performs, how it generates value for developers and users and why old laws might apply to new products. Also, with the rise of morphing assets that are securities at the beginning but later change to something else, we will be called on to pinpoint he time when an asset changes from a security to something that is not a security.
Because regulators can’t keep up with changes, lawyers can’t just look up precedent. We have to be able to predict the future.
Knowing what happened in the past is only valuable to clients if we can use that knowledge to connect the dots and predict how regulators will interpret the new pictures our clients are creating.
Advisers who learn these lessons can add real value beyond just documenting a deal.