Companies and projects have increasingly relied on the sale of digital assets, or tokens, as a means of fundraising. These tokens generally do not grant the holders an ownership interest in the issuing company or project, but may provide governance rights, access rights or other utility. This has been conducted through public sales known as initial coin offerings (ICOs), proliferation through token generation events (TGEs) or private sales, among other mechanisms. While showing characteristics of traditional methods of fundraising, there are a range of unanswered questions related to the legal classifications of such products. As ICOs and TGEs will usually be distributed online and internationally, there is usually no single legal framework applying to such transaction, and the legal framework of each market in which the tokens may be offered or sold needs to be considered.
Attitude of the country towards ICOs/token sales
Regulators in the United States, particularly the SEC, have taken the view that most ICO token sales are offers and sales and securities that must be registered with the SEC or offered and sold pursuant to an exemption. The first major communication in this regard was in 2017 when the SEC issued an Investigative Report Concluding “DAO Tokens, a Digital Asset, Were Securities”. Under the report, the SEC utilised the Howey test to determine that the DAO tokens were investment contracts that were securities because the instrument involved an investment of money into a “common enterprise” with an expectation of profits from the efforts of others. This report was followed up by numerous enforcement actions by the SEC and state regulators, including the blocking of the Telegram token, the “gram”. Litigation is still ongoing against the XRP tokens issued by Ripple Labs.
The SEC has issued a few “no-action letters” stating that certain very simple ICO tokens with no real trading or profit potential are not securities. There also was a speech and statement on the framework for investment contract analysis pertaining to digital assets, each of which indicated that a token might not be a security if there is sufficient decentralisation. That said, the SEC has yet to deem any token other than Bitcoin and Ethereum to be sufficiently decentralised, and there has been little to no meaningful guidance on how to sell a token that is not a security. Recent statements by regulators have only led to more uncertainty and the almost complete inability to do a registered ICO.
This regulatory situation has led to most ICOs and TGEs taking place outside of the United States with Americans blocked from participating. Where tokens are sold within the United States, such sales generally are pursuant to private placement exemptions that restrict the transferability of the token through lockups and other mechanisms.
Presence of any explicit regulation on ICOs and the issuance of token/coins
As mentioned above, there are no specific Untied States federal laws that relate specially to ICOs or the sale of tokens. The laws applicable to a sale of a digital asset will depend on whether the asset is classified as a security, a commodity, or something else that is unregulated.
United States regulators have thus far attempted to place ICOs and token sales into long-existing laws that were designed to be used for physical assets or traditional securities. However, the limitations of the securities laws make it nearly impossible to register a token sale. As such, there are not any currency type tokens which are trading as a security in compliance with the securities laws. See “Classification of token/coins in the jurisdiction” below for additional information on the determination of the regulatory schemes to which a particular token may be subject.
Presence of any explicit restrictions on ICOs or the issuance, distribution and/or transfer of token/coins
The distribution and resale of digital assets would also depend on whether they are classified as a security by the SEC and other regulators. If an ICO token or transaction would be classified as a security, then it would be subject to all SEC restrictions on securities, particularly if sold under an exemption from registration where there are significant restrictions on who can purchase as well as resale restrictions. As a general matter, all offers, and sales of securities must either be registered at both the federal and state level or be exempt from registration.
To determine whether the offer and sale of a token is an offer or sale of a security, the SEC typically has looked at whether the sale was for capital raising purposes. This effectively means that the SEC deems all ICOs to be offers and sales of securities. Subsequent redistribution of a security could also result in underwriter liability to the redistributor. Platforms that facilitate the trading of securities are also governed by broker-dealer and exchange laws, as described in “Financial advisory and brokerage services including robo-advisory and auto-trading”. While many tokens originally offered and sold in ICOs trade on exchanges that comply with MSB laws, the SEC has publicly questioned whether those exchanges should also be registered as securities exchanges.
Non-fungible tokens (NFTs) that only have the characteristics of a certificate of authenticity (e.g. those representing art or collectibles) generally are not thought to be securities and thus may be issued or transferred without an exemption from securities law registration. That said, they may be subject to a host of other laws including money transmission, depending on how an NFT platform is operated. Further, NFTs that have other characteristics, such as an interest in profits, could still be viewed as securities.
There is also a limited number of alternative trading platforms that facilitate the offer, sale and trading of tokens that clearly are securities, such as those representing tokenised stock or fractionalised assets. The offer and sale of those security tokens typically are conducted through private placement exemptions.
Obligations and requirements to issue token/coins
As mentioned above, this would depend on if the token is considered a security, in which case all SEC rules would apply, including possible regulation as an investment company under the Investment Company Act of 1940. If the token is not a security the only registration on issuance and trading would be a state money transmission license. As noted, there is no clarity as to what is a true currency that is not a security, and the SEC has stated that it believes most tokens are securities.
Classification of token/coins in the jurisdiction
Unlike Switzerland and some other countries, the United States does not have formal classifications of tokens such as securities tokens, digital payment tokens or utility tokens. Rather, regulators are utilising common law tests established decades ago, before digital assets even existed, to make a case-by-case fact-based determination as to whether a token is classified as a security, a commodity or anything else. The most famous of these tests is from the 1946 United States Supreme Court case SEC v. WJ Howey Co., wherein the court found that the sale of plots of an orange grove with a promise to sell the oranges was an investment contract that constitutes a security. Under the test more generally, an instrument may be a security if there is an investment of money into a “common enterprise” with an expectation of profits from the efforts of others. Another important case is Reves v. Ernst & Young, a 1990 United States Supreme Court case that uses a “family resemblance” test to determine whether a debt instrument might be a security. Practically, these tests can only be used as guidance since the SEC has made it clear that it views most if not all ICO tokens as securities.
Presence of a duty to publish a prospectus bevor offering token/coins to investors
In the extremely rare instance that a token issuance would be pursuant to a registered offering, then the issuer and its underwriters would need to provide investors with a prospectus prior to offering and selling the tokens. Offers and sales pursuant to certain exemptions, such as Regulation A+, may also require presentation of mandated offering materials to investors.
Even when there is no legal duty to provide a prospectus it is generally good practise to provide purchasers some form of legally vetted risk disclosers to limit the risk of claims from a private legal action for fraud or misstatements and to help ensure that valid private placement exemptions have been established.
Presence of AML/KYC requirements that are needed to be fulfilled regarding (i) the initial issuance of token/coins and (ii) any following transfer of token/coins to third parties
There are no formal AML/KYC requirements regarding the initial issuance of tokens or the transfer of tokens. That said, most tokens that are traded in the United States are traded on exchanges that are licensed as banks or MSBs. These banks and MSBs are required to abide by AML/KYC requirements as further described in KYC requirements section below. Platforms for the trading of securities tokens must be operated by registered broker-dealers that are also subject to significant AML/KYC requirements.
Additional comments regarding (i) the legal situation for ICOs/token/coins and (ii) any following transfer of token/coins to third parties
As discussed above, the legal situation for the issuance of ICO tokens in the United States is difficult due to the lack of legal classification of tokens or any regulatory clarity.
Issuers that sell tokens in ICOs or TGEs outside of the United States should take reasonable care to ensure that the tokens do not flow back into the United States and should not facilitate any marketplace or means for Americans to obtain the tokens. Even an offering and sale of securities that is entirely outside of the United States should attempt to rely on the registration safe harbour contained in Regulation S under the Securities Act which provides, among other things, that offers, and sales must be in an offshore transaction and that there must be no directed selling efforts towards persons located in the United States.
In addition, the issuance of a token through a decentralised autonomous organisation (DAO) does not obviate the need to otherwise follow legal requirements. While level of decentralisation may be a factor in determining whether a token is a security for purposes of the Howey test, it is not a factor for many other regulatory purposes, such as whether the issuer might be an investment company that would need to register under the Investment Company Act of 1940. Further, there have been no instances where a DAO has formally been determined sufficiently decentralised to be issuing a token that is not a security.
The IRS has also issued guidance reflecting that “convertible virtual currencies”, including tokens, may be subject to income and payroll tax if they are issued to individuals in exchange for services. The IRS notes that such exchanges may be treated as compensation.
Market size for ICOs/token sales and existence of any previous regulated ICO/token sales in the jurisdiction
Due to the lack of an established regulatory structure for ICOs in the United States as well as the fact that the established regulatory framework does not mesh well with token frameworks, there have hardly been any regulated ICOs in the United States.
The vast majority of ICOs and token sales from the United States, particularly over the last few years, have taken place through private placements as securities exempt from registration under the securities laws. Due to the private placement nature of these offerings, there is little to no available market data.
Additional comments regarding the economic situation for ICOs/token sales or what companies must be aware of in this business area
As mentioned above, because of the lack of regulatory clarity, there is significant risk associated with conducting any offering or sale of tokens where there are purchasers located in the United States or members of the issuing team are located in the United States.