This is a statement made by Jay Clayton, the Chairman of U.S. Securities and Exchange Commission, before the United States Senate on February 6, 2018. He makes it clear that the US securities laws apply to almost every ICOs and that the entrepreneurs who raise funds with an ICO are required to comply with regulations set by the SEC. In his speech, Clayton revealed that he instructed the SEC staff to be on high alert for ICOs that may be contrary to the nation’s Securities Law.
SEC has now made it crystal clear that virtually all ICOs are securities and they want to define a path forward for the industry through rigorous enforcement. Simply put, the commission wants all ICOs conducted for fundraising in the U.S. to be brought into immediate compliance with securities laws. SEC proposes a way to do that with a Reg D-compliant private sale, combined with a new token permissioning technology (the “R-Token”) that makes it possible for issuers and investors to abide by existing rules and regulations. This approach shall be called as Private Placement ICO or “PICO”. Before exploring the PICO, let’s take a deeper look at the journey ICO founders have travelled to reach the PICO policy.
Initially, no one thought of applying compliances to the ICOs. Especially since those ICOs were small and launched with little public awareness. However, by March 2017, ICOs had raised a total of $330 million and in six months later in September 2017, total raised funds was over $2 billion. This explosive growth of ICOs resulted in SEC publishing a report (DAO report) in June 2017, which mentions that digital assets could be securities, applying traditional securities law doctrine (the Howey test). After this2 Report, Protocol Labs and the law firm of Cooley LLP introduced a conceptual framework for how securities laws might apply to token sales in a white paper entitled “The SAFT Project” (October 2017). The paper argued that tokens designed for use as payment in blockchain protocols were likely not securities when the protocol was functional and the token had true utility. At the same time, the white paper expressed concern over ICOs of utility tokens before they were functional, warning that most such tokens would likely be deemed securities subject to the federal securities regime.
SAFT project outline a model in which, instead of issuing pre-functional utility tokens, the company would enter into a forward contract with accredited investors. The accredited investors would provide the company with immediate capital, and in exchange, would be promised rights to receive functional utility tokens once the protocol was working. While the SAFT itself was a security, the tokens themselves would not be securities because they were functional. Thus there would be no restrictions on the further sale of these utility tokens. Since October 2017, many companies have followed this process. However, the recent series of escalating comments from the SEC shows that the simple binary functionality distinction in the SAFT white paper is not sufficient to exclude ICOs from the SEC compliances.
ICO fundraising hasn’t slowed even with SEC’s enforcement but has accelerated with a record of around $2B raised in 2018 already. However, the Commission’s action has resulted with public crowd sales being replaced by private ICOs that limits token sales to accredited retail investors and institutions. Nearly 84% of the ICO fundraising in 2018 was from private ICOs. The Private ICO uses the Reg D, specifically Rule 506(c) to comply with the securities laws. A significant restriction in the Form D security issuance is that only authorized investors with more than 1 million USD in net worth may buy it. Reg D securities can be issued more easily than public securities though its trading is restricted in the first year. Many private ICOs have a drawback of not enforcing restrictions in secondary trading. The problem of secondary trading during the restricted period can be solved by selling tokens to an authorized investor subject to a one-year lock up so that investors don’t receive their tokens for at least one year.
Even though Reg D securities are easier to issue than public securities, their trading is restricted in the first year after issuance. To comply with this, ICOs started selling tokens to accredited investors with a token lockup of one year so that the investors don’t receive their tokens for at least one year. This solved the problem of secondary trading during the restricted period, but it created a practical issue where, the protocol could not function in the first year due to the unavailability of tokens.
To address this problem, ICOs started giving away free tokens in name of “airdrops” to the investors under assumption that securities laws do not apply for tokens which are given away rather than sold. However, this practice also turned out to be not acceptable for the SEC since the company has already received or will receive “any value” from the recipients of the airdrop in exchange for the tokens. This makes the securities laws apply to the airdrop as well. In light of the recent comments and actions of SEC, we can expect stronger policies from the them against the approach of “lockup + airdrop” for token distribution.
The objective of a Reg D-compliant private sale needs to
Solution : A combination of Reg D, Section 4(a)(7), and Rule 144 can achieve the objective of a private ICO as pointed above. Under Section 4(a)(7), the private resale exemption, accredited investors may generally resell to other accredited investors after a 90-day post-issuance lockup period. One year after the initial issuance, the public may generally buy and trade the tokens under Rule 144.
In this scenario, the company raises initial funds on a SAFT from accredited investors, then issues the tokens to those accredited investors. After a relatively short 90-day lockup, those initial accredited investors are free to trade with any other accredited investors. This allows the protocol to begin functioning. Nine months after that, all investors, not just accredited, are free to own the token.
A new technology called R-Token enforces the secondary trading requirements under Section 4(a)(7) and Rule 144. An R-Token is a permissioned token based on the Regulated Token Standard. The Regulated Token Standard is based on the ERC-20 standard but contains additional code to check an on-chain Regulator Service before it trades. The Regulator Service can be configured to meet relevant securities regulations, Know Your Customer (KYC) policies, Anti-Money Laundering (AML) requirements, tax laws, and more.
When a trade is requested, the R-Token checks with the Regulator Service to make sure that the investor and the trade are compliant; otherwise the token throws off an error message and will not transfer. In the case of Section 4(a)(7), for example, R-token will ensure that a token is being transferred to an accredited investor after the initial 90-day period. The R-Token can also be implemented to ensure that the tokens trade only on approved trading platforms.
The PICO’s protocol allows for multiple jurisdictions for true international compliant use. For example, Reg S provides an exemption under U.S. securities laws for international offerings sold to non-U.S. persons. Issuers wanting to do a Reg S token sale could permission R-Token to exclude U.S. persons altogether. Alternately, R-Token could facilitate the combination of a Reg D offering to accredited U.S. investors and a Reg S offering to non-U.S. persons to achieve the widest possible compliant token distribution.
The SEC has a 3-part mission: (i) protect investors, (ii) maintain fair, orderly, and efficient markets, and (iii) facilitate capital formation. The Reg D-compliant PICO serves all three interests, providing a common, reliable, and efficient way to raise funds with slowly expanding liquidity as the risks to investors lessen and become better known:
In the first year after the token issuance, the company will have a limited pool of engaged, and fault-tolerant users which can add value to the company and after an year from the token issuance, there should be much more information for all investors on whether the protocol is working, the use and valuation of the token, etc., Moreover, after a year the functionality of the protocol may have advanced sufficiently such that the tokens have truly become utility tokens. R-Token ensures that every token holder is a known party who passes KYC/AML and other tests.
ICO fundraising has impacted innovation across the industry, democratizing global capital access and allowing passion-driven developers to accomplish their visions. Investors have to quickly ensure that their ICOs are compliant with securities and other laws to prevent it from getting shut down by regulators and private litigation. It is the need of ICO issuers and issuing platforms to embrace the Regulated Token Standard, and to that end, they should execute the necessary restrictions on issuance and secondary trading. Despite the growing demand for ICO fundraising, many investors don’t comply with the securities laws. It is high time the industry protect their ICOs and token sales from strangled by law enforcement, private litigation, and new regulations. PICO with the proper implementation of permissioned tokens will allow this new financial system to flourish.