(Disclaimer: I am not a lawyer, and this is not legal advice. Please check with your attorney for legal advice on how to design your cryptocurrency project)
Why ICOs are doomed in the US
Initial Coin Offerings have sucked the air out of tech investing in 2017. Many startups and teams saw the opportunity to raise money easily from investors for their startups, using the same process that Ethereum foundation followed. For people who have been in a coma in 2017, here is how it worked.
- A team announces a project, which includes a product or a network
- The network has not been built yet
- The purported network will use a token either as an internal currency or as a way to reward participants for actions within the network
- The supply of tokens is limited
- The team premines some or all of the tokens, and sells them to people who will purchase them to, presumably, use them in the network.
- The money will be used to create the network.
But this has created legal and regulatory problems for the teams that sold these tokens in the US, because, many of these tokens were deemed securities by the SEC.
The sale of securities in the US is governed by The Securities Act of 1933, which regulates initial offerings of securities while the Securities Exchange Act of 1934 governs the subsequent exchange of those securities.
In making the determination that many of these token sales were unregistered securities sales, the SEC used the Howey test, in addition to several other criteria set forth by both the 1933 & 1934 securities acts (which include, but are not limited to all pre-sale communications by the team, the sale mechanics, as well as post sale actions such as enabling secondary markets for tokens, promising returns to investors, etc).
However, the primary determinant of whether a sale involves a security is called the “Howey test”, which refers to a test developed by the Supreme Court in a 1946 case, the SEC vs W.J.Howey & Co, for determining whether certain transaction qualifies as an “investment contract (aka a security)”.
Under the Howey Test, a transaction is a security, if:
- It is an investment of money
- In a common enterprise
- With an expectation of profits
- Which solely come from the efforts of the promoter or a third party
If a transaction does not meet any of the four “prongs” of the Howey test (aka, it “fails the howey test”), it is not a security.
Why many token sales were deemed securities
Most token sales clearly are investments of money in common enterprises, so the first two criteria are met. Also, some token selling teams were explicit in their marketing as to why their token value will increase, which strengthens the argument that the buyers/investors bought them, expecting to profit from them and not to use those tokens for the utility of the network. This passes the third part of the Howey test. If, the network is designed in such a way that the value of tokens will appreciate predominantly due to the efforts of others and not the buyers themselves, you pass all 4 parts of the Howey test, and the token is clearly a security.
However, if you design your network and your company the right way, you can potentially avoid passing the last two parts of the Howey test.
Lets see how this is possible.
Failing Part 3. of the Howey test: “With the expectation of profits”:
If users buy your token with an expectation of profits, you’ve passed prong 3. If, however, they buy it with an intent to use it in the network to derive utility, you fail the howey test. Though it is hard to divine the intent a user has before he purchases a token, having a functioning network before the tokens are sold makes a strong argument that the users value the utility of the network, and therefore they bought it. Making the same argument for a non-existent network is much harder.
Failing Part 4. of the Howey test: “Profits which solely come from the efforts of the promoter or a third party”:
If your token becomes more valuable to users because of the actions the team or company that sold the tokens takes, it passes the 4th prong of the Howey test. However, if, to receive a token, the user has to perform an action that strengthens the network and therefore increases the value of the network, it fails the 4th prong of Howey test. In the Bitcoin network, every bitcoin is mined by performing POW mining, which increases the network hash rate, and acts as a security barrier against attacks, thus increasing the value of the Bitcoin network. This is independent of what Satoshi did then or what bitcoin core team does now. This is a perfect model to emulate, in designing your network and your token mechanics.
Other factors that can tip your token into being a security:
Helping the tokens get traded in secondary markets: This definitely makes a security out of a token, if the team that sold the token in any way, shape or form enables the tradability of the token (by helping list the token on an exchange, for example).
An alternative, fully compliant cryptocurrency issuance framework:
The mechanism by which cryptocurrencies can help build new and important decentralized networks has been explored in detail here.
The important question that needs answering is how one can create a decentralized network that has increasing value, and be able to bootstrap the building of the network.
- Create a network that is truly decentralized, meaning as the network grows, the founding team is not in control of the nettwork governance. Follow the example set forth by Satoshi.
- To bootstrap the creation of the network, and to reward early contributors, form a corporation that consists of early contributors (both founders and investors can be shareholders of this corporation).
- As a for profit corporation, you are free to get rewarded for creating, seeding and strengthening the network that you are creating. The corporation can mine the currency just as anyone else could, but being the creators, they have an early advantage in accumulating the network cryptocurrency. [REMEMBER, THIS DOES NOT GIVE THE CORPORATION ANY RESIDUAL CONTROL OF THE NETWORK. THE NETWORK SHOULD BE TRULY DECENTRALIZED.]
- Since the cryptocurrency that the corporation has mined is a property of the company, the company is free to distribute it to it’s shareholders in anyway that it’s board and bylaws allow
- A good way to distribute the cryptocurrency to founders and investors is through a dividend mechanism.
Simple steps that can be taken to distribute the token:
- The company sells equity in the corporation, to accredited investors, and raises money
- Company creates and seeds the network
- Company gets to mine the cryptocurrency for a limited time, before anyone else starts competing to mine
- The cryptocurrency that the company has mined becomes the property of the company and can be distributed to all it’s shareholders as a dividend. Note that the investors need to be given the option of receiving the dividend in cash or cryptocurrency, at the time the dividend is offered.
- Since the cryptocurrency was never sold to anyone, and can be mined by anyone inside or outside the company, there cannot be a “securities sale” and therefore no unregistered sale of securities.
- The equity holders benefit from the success of the startup, whose primary product is selling ancillary services that can make the network more valuable. This is the time tested silicon valley model.
Why this hybrid model matters
If done right, we believe that this hybrid structure allows teams to be able to monetarily benefit from their contributions in building a network, while not compromising the decentralization of the network. Teams will be able to build networks of great importance, without being hamstrung by the fear of securities laws violations. And, though the network appears centralized at first, this is no different from Satoshi hashing the first million BTC.
PS: Thanks to Ryan Singer or Chia.network for first alerting us to this strategy and Rick Levin of the Polsinelli law firm for further educating us on the minutiae of securities laws.