Initial coin offering, security token offering, or initial token sale –
whatever you call it, there are important legal issues to consider when
selling digital assets or digital coins
Initial coin offerings are all the rage for companies looking to raise
capital for projects. According to Coindesk there were almost 350 ICOs
in 2017, and as of April 2018, there have been 200 ICOs [ Link to
https://www.coindesk.com/6-3-billion-2018-ico-funding-already-outpaced-2017/ ]. The success of these offerings (and their underlying projects) has
The Securities and Exchange Commission (SEC) has taken an interest in ICOs.
According to the Chairman of the SEC [ Link tohttps://www.coindesk.com/sec-chief-clayton-every-ico-ive-seen-security/ ], coins or tokens sold in ICOs are securities that should either be registered
with the SEC or must be sold pursuant to an applicable exemption from
Here are a few considerations if you are planning on conducting an ICO
for your company:
- Is the coin a security? – A coin is subject to same securities law
analysis as any other instrument. The SEC has set forth the following
criteria in determining whether an instrument is a security: (1) an expectation
of profits arising from (2) a common enterprise that (3) depends upon
the efforts of others.
In practical terms, this means that if the ICO is to be used to finance
the completion of a project, then it will be considered a security, which
means that the offering of the coins must either be registered with the
SEC or sold pursuant to an applicable exemption.
Even if the coin’s underlying asset is an already completed project
(for instance, real estate), then it could still be considered a security,
because the purpose of the coin is to vest ownership in or pass on returns
from the underlying asset.
- What other legal requirements apply to the company’s business? –
Depending on the business plan of the company issuing the coin, additional
non-securities law legal requirements may apply. For instance, if the
company issuing the coin is intending to make loans which will be represented
by the coins, then state lending laws may apply. These laws often require
registration with state authorities and state interest law caps may apply.
- How will the coins be sold? – The ICO itself is a public affair,
with the coin issuer advertising the offering. That means the manner in
which the coins are offered must fit into one of the following categories:
- Rule 506(c) – With this exemption, there is no limit on how many
coins can be sold or how much capital can be raised. However, all investors
purchasing the coins must be accredited investors, and the accredited
investor status of each investor must be verified. Self-certification
by the investor (i.e. checking a box) is not sufficient. Coins sold under
Rule 506(c) are considered restricted securities, which means that they
must be held for at least one year before being resold. In order to sell
coins under a Rule 506(c) exemption, a private placement memorandum is
advisable in order to describe the issuer’s business, management,
project, and risk factors.
- Regulation A+ – Regulation A+ offerings go through a process similar
to SEC registration. The issuer must prepare and file with the SEC an
offering circular (similar to a prospectus) that describes the issuer’s
business, management, and risk factors. In addition, audited financial
statements are required. Once the offering circular is declared effective
by the SEC, then there are certain ongoing compliance requirements, such
as filing semi-annual and annual reports with the SEC, as well as current
reports for certain extraordinary corporate events. Coins sold to investors
in a Regulation A+ offering can be freely resold, which makes Regulation
A+ an ideal process for most ICOs. ICOs conducted pursuant to Regulation
A+ are limited to $50 million.
- Fully registered offering – In a fully registered offering, a full
registration statement (that includes a prospectus) is filed with the
SEC. Audited financial statements are also required. In this sense, it
is similar to a Regulation A+ offering. However, once the SEC has declared
the registration statement effective, the issuer is required to file annual,
quarterly, and current reports with the SEC on an ongoing basis. In addition,
registration is also required at the state level for securities sold in
a fully registered offering. The benefits of a fully registered offering
are that the coins can be freely resold by non-affiliates and there is
no limit on the amount that can be raised.
- Regulation S – This exemption allows coins to be sold to non-U.S.
investors only. The coins may be freely resold outside the U.S.; however,
they may not be resold to U.S. investors for one year. Investors purchasing
in a Regulation S offering are required to certify to the issuer that
they are not a U.S. person.
If the goal of the offering is to have the coins trading so that initial
investors can sell the coins, then Regulation A+, a fully registered offering,
or Regulation S are the only available options. As noted earlier, coins
sold under Regulation S cannot be resold in the U.S. for a year; however,
they can be resold to investors outside the U.S., subject to compliance
with any applicable non-U.S. securities laws.
Often, coin issuers planning an ICO will undertake a pre-ICO raise from
established angel investors or venture capital investors in order to raise
capital for the expenses associated with the ICO. These offerings can
be conducted in reliance upon a different and more permissive offering
exemption if the offering is not advertised. If the issuer and its principals
have pre-existing relationships with these investors, then the pre-ICO
raise can be accomplished fairly easy with no SEC registration of the
offering required. However, these coins will be considered restricted
securities with a one year holding period unless they are registered for
resale under a Regulation A+ offering or fully registered offering, or
resold in a compliant Regulation S offering. In addition, depending on
the structure of the ICO, there may be a waiting period required between
the pre-ICO raise and the ICO.
- Who will the coins be sold to? – This factor harkens back to the
available offering methods described above. If the coins are to be sold
to non-accredited investors in the U.S., then the ICO will have to be
conducted under Regulation A+ or fully registered with the SEC. If the
offering is limited solely to accredited investors in the U.S., and the
issuer verifies the accredited investor status of the investors purchasing
coins in the offering, then the offering can be conducted under Rule 506(c).
If the offering will be limited to non-U.S. investors, then Regulation
S will apply. In certain cases, it is possible to “mix and match”
these offering methods to permit sales to different types of investors.
Additional requirements may apply to the offering methods described above.
In addition, this is not an exhaustive list of all requirements that may
be applicable to a particular ICO or ICO issuer. For instance, non-U.S.
securities laws and other non-U.S. legal requirements may apply if the
coin issuer sells coins to non-U.S. investors or has business operations
in other countries.
The final thing to keep in mind is that conducting a legally compliant
ICO costs money, and the necessary advisors don’t take coins or
agree to be paid contingent upon a successful offering. As a result, you
will need to have funds available before starting the ICO process.
If you are ready to conduct your ICO, STO, or ITS after taking into account
the above considerations, contact Whitley LLP Attorneys at Law. Our corporate
finance and securities law expertise will help you conduct your offering
in compliance with applicable laws.