So, over the weekend I received an inquiry regarding the pros and cons of traditional fundraising versus creating and offering a token for purchase. The benefits of conducting a token offering are apparent: people are incentivized to buy tokens that they believe will increase in value and as more and more exchanges pop up, it is becoming easier than ever to trade and sell these tokens. However, it’s not so simple. If you are planning to raise capital in this manner, it is important to realize now your token will likely be viewed by the SEC as a security. Therefore, if the token does not comport with an exemption to SEC registration requirements, your company will find itself in major trouble. Fear not though. I did a deep dive on the rules and exemptions provided by both Regulation A and D, and even state laws that you’ll have to look out for (yes, you have to worry about those, too), so you don’t have to.
First, what makes a token a security. If you’ve been following along with my writings, you know that a token is basically just a representation of an asset. It resides on a blockchain. When you sell that token for the purposes of raising capital, it may be considered a security, which includes an “investment contract,” as well as other instruments such as stocks, bonds, and transferable shares. The Howey test applies in considering whether a digital asset is a security subject to SEC regulation.
The prongs of the Howey test are as follows:
- The Investment of Money
The first prong of the Howey test is typically satisfied in an offer and sale of a digital asset because the digital asset is purchased or otherwise acquired in exchange for value, whether in the form of real (or fiat) currency, another digital asset, or other type of consideration.
2. Common Enterprise
Courts generally have analyzed a “common enterprise” as a distinct element of an investment contract.10 In evaluating digital assets, we have found that a “common enterprise” typically exists.
3. Reasonable Expectation of Profits Derived from Efforts of Others
Usually, the main issue in analyzing a digital asset under the Howey test is whether a purchaser has a reasonable expectation of profits (or other financial returns) derived from the efforts of others. A purchaser may expect to realize a return through participating in distributions or through other methods of realizing appreciation on the asset, such as selling at a gain in a secondary market.
As you can see, most tokens offerings fall squarely within the purview of the Howey test and will thus be considered securities. So what? What’s the big deal about a token being considered a security?
Well, SEC regulations are very restrictive, most notably because of the distinction made between accredited and non-accredited investors. (See here Rule 501(a)). Many of these restrictions make fundraising inaccessible to the investors most likely to take a chance on them (i.e. non-rich people). So instead, companies looking to fundraise with token offerings should try to fit into an exemption, and the two main exemptions that companies take advantage of are called Regulation A and Regulation D. To date, Regulation D is the most widely-adopted, but the number of companies using Regulation A are increasing. In a nutshell, I will give you the pros and cons of both:
As you can see, I limited my comparison to Tier 1 of Regulation A and Rule 504 of Regulation D because I believe these are the two exceptions that would be most relevant to the general crypto community and accessible to the greatest number of people. Both regulations come with a major caveat, however, and that’s state securities law, a.k.a. “Blue Sky Laws.” If you are planning to sell a token within a state, you are subject to the regulations of that state and that state may impose stricter rules. For example, despite the limit being $20 million for Regulation A Tier 1 and $10 million for Regulation D Rule 504, the state of Delaware requires that all offerings of over $1 million must be registered as securities. So if your plan is to launch a token offering, not only will you have to make sure that the offering is exempt under federal law, but also the law of every state in which you desire to sell the token.
This is not legal advice, only legal information.
