Demystifying Securities Laws: A Comprehensive Guide to Initial Coin Offerings
In a complex regulatory landscape, founders need to master U.S. securities laws and collaborate closely with legal advisors before launching their ICO journey.
Cryptocurrencies and initial coin offerings (ICOs) have become a popular way for startups to raise money. Until mid-2017, ICOs operated in a regulatory grey area. Some companies raised hundreds of millions of dollars quickly, while others failed just as fast. This changed when the Securities and Exchange Commission (SEC) stepped in, asserting its authority over ICOs. The SEC's involvement was necessary, however, the laws around ICOs and digital token financing are still unclear, leaving startups to navigate a complex landscape with limited guidance.
While some would argue that cryptocurrencies are a new asset class that doesn’t fit neatly into existing laws, this article assumes that digital tokens are securities and must follow all applicable securities laws (both in the U.S. and internationally).
How we got here?
Different countries have various approaches to ICO regulation. China has banned ICOs, the British Virgin Islands and the Isle of Man have light regulations, and the U.S. uses a case-by-case method, causing confusion for startup founders.
Until 2017, U.S. ICOs operated without oversight, leading to scams, fraud, cyberthefts, and price crashes. However in July 2017, the SEC released the "Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO" (generally known as the “DAO Report”). This report declared that most tokens sold in ICOs are securities and warned companies to comply with federal securities laws when offering and selling such tokens. Since then, there have been a number of court cases that further clarified the government’s position. But to keep it simple, as SEC Chairman Jay Clayton stated, tokens and offerings that promise potential profits based on the entrepreneurial or managerial efforts of others are likely to be considered securities under U.S. law.
Since then, the ICO market has been in a constant state of flux. Many issuers now avoid the U.S. entirely, targeting other jurisdictions and excluding U.S. investors. Others rely on various securities law exemptions, such as Reg D or Reg A+, while some choose to register their offerings, following a process similar to a standard IPO.
What does this mean for you?
Unless you plan to register your ICO under U.S. securities laws, which is a similar process to an IPO, you need to decide whether to (i) target U.S. investors using one of the exemptions to the U.S. Securities Laws, or (ii) avoid the U.S. market entirely. This decision involves significant complexities, and each situation is unique. We strongly recommend consulting with a securities attorney before proceeding.
Offering in the U.S. market using a securities exemption (Reg D or Reg A+)
The Securities Act provides several registration exemptions, the most relevant for token sales being: Reg D or Reg A+.
Sales within the U.S. to Accredited Investors (Regulation D) - Reg D is an exemption from the registration requirements. It allows the sale of tokens in the U.S. to certain pre-determined groups or limits the amount that could be sold or how the offering could be advertised. Which of Reg D rules would best fit your transaction needs to be determined based on your specific facts. All Reg D ICOs impose strict transfer restrictions on the sold tokens, sometimes requiring up to twelve-month holding period. Additionally, offerings must comply with anti-fraud rules under the U.S. Securities Exchange Act of 1934, ensuring that offering materials are accurate and provide essential information for investors.
Rule 504 under Reg D allows a company to offer and sell virtual tokens through an ICO to an unlimited number of investors, but the total amount raised cannot exceed $5 million in any 12-month period.
Rule 506(b) under Reg D permits a company to offer and sell an unlimited number of virtual tokens to “Accredited Investors” and up to 35 non-accredited investors but prohibits general marketing.
Rule 506(c) requires all investors to be Accredited Investors and allows general solicitation, but the company is liable for verifying each investor's accredited status.
Issuers must file a Form D notice within 15 days of the first sale.
Issuers can switch from a 506(b) to a 506(c) offering to start advertising, but not vice versa once advertising has begun.
Sales within the U.S. through Crowdfunding Campaigns (Regulation A+) - Introduced in 2012, Regulation A+ transformed crowdfunding by enabling ICOs to offer tokens to U.S. investors in two tiers: $20 million or $50 million over 12 months. Reg A+ offers streamlined processes and reduced disclosure requirements compared to traditional IPOs. In addition, tokens sold under Reg A+ face no resale restrictions, unlike those under Reg D. While Reg D doesn't require SEC clearance like Reg A+ and is therefore a much faster process, tokens qualified under Reg A+ can be sold to both accredited and non-accredited investors and could be marketed widely. Undertaking a Reg A+ offering is a significant undertaking for most founders, but it provides a middle ground between a limited Reg D offering and a full IPO.
Offerings outside the U.S. market (Reg S)
Reg S provides a safe harbor for token issuers to sell tokens exclusively to non-U.S. investors, prohibiting any marketing within the U.S. or to the U.S. market. Some issuers may target both U.S. and non-U.S. investors by conducting simultaneous offerings under both Reg D and Reg S. This structure can minimize exposure and liability for the issuer while offering maximum flexibility.
Reg S Required Compliance Measures:
Implement IP address restrictions to block U.S. purchasers.
Reject buyers using technology that obscures their IP addresses (e.g., TOR, proxy servers, VPNs).
Avoid marketing the tokens in the U.S.
Prevent sales to purchasers registered or residing in the U.S., even if they are outside the U.S. at the time of purchase.
Use smart contracts or other mechanisms to restrict token sales into the U.S. for one year after issuance.
List tokens on exchanges that do not accept U.S. accounts or can segregate U.S. accounts.
Conclusion
Understanding and complying with U.S. securities regulations is crucial for token issuers navigating the complex legal environment. While the regulatory uncertainties surrounding ICOs have led to challenges like scams and fraud, these issues are not unique to ICOs but are common in new markets. Looking ahead, companies planning an ICO should expect SEC oversight and treat it as a security offering. Despite recent SEC guidance, ICO issuers still face difficult decisions. They must weigh the challenging process of SEC registration against alternative financing options like Reg A+ and Reg D exemptions. As the law develops and the SEC provides further guidance, these decisions will likely remain challenging for ICO issuers and their legal advisors.