Monetizing Digital Tokens Under US Security Laws

In Chapter 2, STO – Security Token Offering, we covered traditional fundraising methods such as angel funds, venture capital (VC) investors, private equity funds, and initial public offering (IPO). We briefly discussed the general financing cycle from the seed round at the formation stage of a start up to the IPO. We compared this financing process to an initial coin offering (ICO), which takes a different path. For an ICO, at the formation stage, a startup bypasses the private fundraising steps—and directly turns to the public for investments.

Security token offerings (STOs), the most promising alternative to ICOs, will likely support future growth of the blockchain industry after the ICO bubble bursts. Therefore, in this chapter, we will discuss STOs from the legal perspective in detail.

More specifically, we will...

What is an STO?

A security, in a general sense (but not according to the legal definition), is described as a financial instrument secured by a certain type of valuable asset. Securities can also be backed by revenues or profits in a company. Historically, a security is issued and purchased by signing the transaction documents on paper, such as share-purchase agreements or subscription agreements. The offer and sale of any security by any issuer in the US is subject to the federal and state securities laws and regulations.

A security token (a token classified as a security) performs a similar function as a traditional security, except that it confirms ownership through blockchain transactions rather than paper documents. Security tokens provide some key financial rights to the investors that include shares of revenue, shares of profit, equity, dividends, rights to vote, and some...

Overview of US securities laws

Before getting into the analysis of how an STO would be subject to the US securities regulations under the Securities and Exchange Commission's (SEC's) radar, first let's look at an overview of the US securities laws that govern securities offered or sold in the US.

The first issue is jurisdiction—whether the offer and sale of security is subject to regulation in the US.

For an issuance of security to be subject to US federal and state securities, such issuance should be targeted toward potential US purchasers. Hence, for an STO to be regulated under US securities laws, the STO should be exposed to public or targeted purchasers in the US.

The offer and sale of securities in the US are regulated under both federal and state laws. In some types of offerings, the federal laws will preempt the state laws. For other types of offerings...

Federal regulations

In this section, we will cover some important federal regulations in the blockchain space.

Section 5 of the Securities Act of 1933

The federal securities law governing the offer and sale of a security is covered under the Securities Act of 1933, (the Securities Act). The purpose of the Securities Act is to protect the general public from making investments in fraudulent schemes. The Securities Act requires the disclosure of information that will be significant for the investors to make investment decisions. This is the main reason that the SEC requires issuers that offer and sell securities in the US to file registrations of such offerings.

Under Section 5 of the Securities Act, generally, an offer or sale...

State regulations

The following cryptocurrency regulations were issued in US states:

• The New York State Department of Financial Services (NYSDFS) issued the requirements to acquire a BitLicense in order to trade virtual currencies, including bitcoin, in the state of New York.
• The Uniform Regulation of Virtual Currency Business Act (URVCBA). In July 2017, the Uniform Law Commission completed a uniform model state law, known as the Uniform Regulation of the Virtual Currency Businesses Act (URVCBA or the Act).

Each state has its own securities laws and regulations, as well as its security registration requirements.

Resale of securities Rule 144/144A/Section 4(a)(1½ ) / Section 4(a)(7)

Securities issued in an unregistered offering under the exemptions mentioned previously are restricted securities. In order to transfer or resell the restricted security by the holder, it has to be either registered or exempt from the registration requirement, which is a separate requirement from its initial offering.

The secondary sale of such restricted securities in the US is governed under these rules.

Rule 144 exemption

The Rule 144 exemption is a safe harbor provision. This allows nonaffiliate public resales of a private company's restricted securities after a one-year holding period by the security holder.

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Securities laws development in blockchain and digital cryptocurrencies

After an overview of the US securities laws and regulations, we now turn to how the SEC gradually became involved in regulating digital tokens offerings and trading. We will review the SEC's analysis of how the current securities regulations apply to this regime as new issues emerge.

Some of the early warnings and guideline on investments in digital tokens are as follows.

SEC alerts

Let's look at the following few alerts:

• Alert on the use of Bitcoin as a Ponzi scheme in July 2013 – SEC versus Shavers:

This early alert made by the SEC involving digital tokens was based on the Shavers case in 2013.

In that case, the organizer of an alleged...

Real cases

The following real cases will show how the organizations in question violated federal securities laws under the SEC's reviews and the failure to file registration for the offering of digital tokens with the SEC.

Munchee Inc. (Munchee order, December 11, 2017)

In the Munchee case, the SEC applied the analysis from the DAO report.

The facts of the case are as follows:

• Munchee has its place of business in California. It created an iPhone application (the Munchee app) in the US for the public to post pictures, review meals, and rate restaurants. Munchee's staff maintained and upgraded the Munchee app.
• Munchee and its agents had control of the content on multiple web pages, which included a Twitter account...

STO launch and legal considerations

To comply with the legal requirements of US securities laws, an issuer needs to consider the following:

• White paper—whether the content shows that this is an offering for digital tokens that would be considered as an investment contract under the Howey test
• Issuance of tokens—the number of tokens, the price, whether they are backed by assets/profits, and so on
• How the issuer markets the tokens
• Purchasers of the tokens
• Purchasers' expectations
• Use of tokens
• Whether there is a secondary market for the digital tokens

Summary

To issue an STO, issuers need to follow requirements under the Securities Act of 1933 and be monitored by the SEC and FinCEN. For state issuance, issuers are subject to the state's blue sky laws and state regulators. The main issue is that the federal and state governments' goals are to protect the general public and investors against fraud and ensure that the investors are informed so they can make informed investment decisions.

However, whether an STO is subject to US securities laws is very fact specific. As you can see from the preceding real cases, the SEC's analysis emphasizes the economic reality of the transaction and the way the creators of the tokens market the STO. The SEC will look at substance rather than form. A token being called a utility token will not preclude the SEC from reclassifying such a token as a security.

Other than securities...