Planning an ICO? Don't forget the Howey test and U.S. securities laws
In this four-part series, New York attorney Bryan Hollmann explains the multifaceted approach to the regulation of virtual currencies in the United States. This series is particularly useful for persons outside the United States who may be unfamiliar with U.S. law as applied to cryptocurrencies. The first part of this series covers U.S. federal securities law. Looking ahead, part two will cover bitcoin futures and the regulation of virtual currency derivatives in the United States. Part three will discuss anti-money laundering and know-your-customer compliance under the Bank Secrecy Act and FinCEN, and part four will provide an overview of virtual currency taxation by the U.S. Internal Revenue Service.
People are often surprised to learn that their initial coin offering (ICO) may be subject to U.S. federal securities laws. ICOs that sell digital tokens for the purpose of raising capital with the expectation that the tokens will appreciate in value generally are securities subject to U.S. law if they are offered or sold in the United States.
The applicability of U.S. federal securities law to offers and sales of digital tokens frequently turns on whether the token satisfies the Howey test. Digital tokens offered in ICOs almost always pass the test, meaning they are securities under U.S. law. In February 2018, Jay Clayton, the Chairman of the U.S. Securities and Exchange Commission (SEC), remarked that "every ICO I've seen is a security." Since then, the SEC has aggressively pursued enforcement actions against several ICO issuers for violations of the securities laws, including against some foreign companies and their directors.
The Howey test, named after the seminal 1946 Supreme Court case SEC v. W. J. Howey Co., consists of four elements: (1) an investment of money, (2) in a common enterprise, (3) with a reasonable expectation of profit, (4) to be derived from the efforts of others. Digital tokens that satisfy all four elements of the Howey test are securities and must comply with U.S. federal securities law.
Digital tokens offered in ICOs typically bear all the hallmarks of a security. Investors exchange money for tokens that can be used on a (sometimes yet-to-be developed) platform or traded on a cryptocurrency exchange, whose value is expected to rise as demand for the tokens increases. At its core, the Howey test is a flexible standard, designed to examine the economic substance of a transaction rather than its form. As the SEC's enforcement activity over the last two years has shown (e.g., the DAO Report, Munchee, Inc., Tomahawk Exploration LLC, Paragon Coin, Airfox), ICOs of all shapes and sizes—and varying complexity—can take the form of securities offerings.
ICOs that involve securities must be registered pursuant to the Securities Act of 1933 or qualify for an exemption from registration. Violations can result in civil or criminal penalties, or even in litigation by private plaintiffs. In the ICO space, issuers planning to offer tokens in the United States typically utilize the exemption under Rule 506(c) of Regulation D of the Securities Act, which generally permits issuers to raise an unlimited amount of capital from 'accredited investors.' However, tokens issued pursuant to Rule 506(c) are 'restricted,' meaning they generally cannot be resold for up to one year.
In an attempt to avoid the long jurisdictional reach of the SEC, many issuers seek to exclude the United States from their ICO entirely. This approach, however, must be implemented with care. Prominent disclaimers, geo-blocking and know-your-customer checks are standard practice and must be designed to prevent 'U.S. persons,' e.g., U.S. residents, from participating in the ICO. Moreover, issuers have an obligation to implement these exclusions in good faith.
As the SEC ramps up its enforcement of ICOs, the necessity of compliance with U.S. securities law is at an all-time high. Every ICO is different, and an offering strategy that works for one ICO may not work for another. If you plan to conduct an ICO, whether inside or outside the United States, you should consult a knowledgeable securities attorney to discuss the specifics of your project.
Disclaimer: This article does not constitute legal advice and does not establish an attorney-client relationship. If you need legal advice, please contact an attorney directly.