If you’re thinking about issuing a token, you’re entering uncharted territory. You should start with the default position that any arrangement you use to raise funds for their project is itself a security. Almost every form of project launch starts with a founder coming up with a great idea that needs funding to implement. Regardless of the type of asset being created, an arrangement, contract or plan between an active builder and a passive investor (the passive investor contributing money to the project with the expectation of a financial return) is an investment contract and is a security under U.S. law .
Financing will result in a default position of some form of security and you should consider whether to register the security or raise funds under an exemption. The first thing to do before you enter the market to raise capital is to have an attorney help you think about the near- and long-term goals of your project, to consider how and when a planned token offering fits into the broader plan. Together with an experienced securities attorney, you should consider whether a waiver is best for your long-term plans.
In most cases, founders will choose to raise funds from private sources through Regulation D (Private Placement). Some founders may want access to public market capital raised by Reg A+ (small IPO); Reg S (offshore offering) offering offshore offering, disconnected from the U.S.; Reg CF (crowdfunding) offering intermediary benefits ; Generally speaking, Reg D can raise funds quickly and can raise funds for the project indefinitely.
Typically, the founders will raise equity capital for the legacy business through a SAFF (SAFF stands for Services and Financial Framework) agreement, and as part of the financing, they will have a token warrant that allows SAFF investors to later purchase the legacy company’s issued any token. Warrants usually contain an explicit statement clarifying that there is no guarantee that the company will issue tokens. The warrant stipulates that if the token offering does occur, investors will have the ability to participate in predefined terms. Certified equity, like SAFF agreements, is generally considered a security.
Following the funding round, the founders and capitalization firm developed a strong and favorable plan for the token under the continued supervision of lawyers. When the plan is complete, the company creates the network that will generate the tokens. The token generation event mints tokens locked in a smart contract that restricts the token’s transferability for an authorized period (usually one year). After the grant period, investors may be able to transfer their tokens, either because the tokens are not securities (which takes an incorrect risk), or through an exemption for the sale of restricted securities (as in Article 1972, the SEC issued 144, which regulates the transfer of existing shares).
Founders have to ask: are tokens a security when they are issued? This is a profound fact-based consideration that depends on how judges and juries will examine the facts in light of the Supreme Court’s SEC v. Howey case. The Howey case analysis considers whether the launch of the token is an arrangement, contract or plan that “involves the investment of capital in an ordinary enterprise with profits derived solely from the efforts of others”. The claim that a token represents a security is very convincing if it purely represents an investor betting on the founding team and creating capital appreciation for investors sitting on the sidelines. However, if the token represents a utility, voting rights or access rights, then the token may not be a security and the law remains uncertain.
If a token is a security at launch, is it always a security? This is a controversial issue. Proponents of classifying tokens as securities or not generally see decentralization as a way to change the classification. Decentralization would render the “efforts of others” consideration of the Howey test moot, since a decentralized network does not depend on the specific efforts of identifiable people. Unlike its dedicated attorneys, the entire SEC neither accepts nor rejects this theory.
As part of your web design, you should consider specific points for taking the Howey test with your attorney. If you and your attorney determine that your initial offering creates a security, your attorney may recommend that you set a strict lock-up period during which investors cannot transfer their tokens. Depending on your facts and circumstances, your lawyer may decide that implementing a decentralization plan during lockdown may be the best way forward.
As a founder, you need to know enough about securities law to understand how to structure it with the advice of an informed attorney. Too often, founders turn to lawyers who are not sufficiently competent in securities analysis; and, since founders know nothing about securities law issues, they are unaware that their lawyers lack relevant knowledge. Lack of knowledge leads to legal inaction. “Do nothing” is the safest answer. In order to obtain sound legal advice and act in accordance with the law, it is worth taking the time to familiarize yourself with the basics of securities considerations.
The remainder of this discussion includes a summary of issues founders may face when designing tokens in the United States, as well as references for more in-depth discussions with their lawyers.
Securities Law Summary
Securities laws are the subject of intense debate in the United States. Securities are regulated in the United States by the Securities and Exchange Commission (SEC). Securities need to be registered with the U.S. Securities and Exchange Commission (SEC), which administers a set of rules that require issuers of securities to report information to investors and/or the public. The SEC also oversees securities offerings to protect the public from fraud, misinformation and wrongdoing.
For founders considering issuing a token, there are three questions to ask:
(1) Am I issuing securities?
(2) If yes, is it within the scope of the exemption?
(3) Do I need to register?
Step 1 (Securities):
The first question that arises when founders consider issuing a tokenized product is whether any protocol related to the tokenized offering creates securities that require registration with the SEC. Often, the nature of the agreement needs to be analyzed in order to understand whether the issuer has entered into a part of the “investment contract” with the investor as a token offering. Investment contracts are marketable securities, and what creates investment contracts can be seen from the Supreme Court’s analysis in the Howey case.
The Howey involved a hotel that sold land containing orange groves to tourists, and at the same time entered into a contract to lease the land to the hotel and give the buyer a share of the net profit from harvesting the oranges, which is entirely the product of the hotelier’s efforts . The court determined through a four-part test that the arrangement created a security. The conclusion is that the underlying assets (oranges, trees, tokens) do not determine what creates the investment contract; what matters is the actions of the parties involved and the nature of their agreement.
Following the ICO boom, SEC staff publicly commented that, in the Commission’s view, the 2017-18 offerings were almost all securities. As a notable contrast, in 2018, William Hinman, director of corporate finance at the SEC, gave a speech in which he argued that ethereum is not a security because it has reached a point of “sufficient decentralization.” The SEC emphasizes that Hinman’s remarks are not binding on committee policy and are not legally binding; however, Hinman’s discussion of decentralization has led to a legal theory that many attorneys believe supports the path for issuers to create decentralized networks , where tokens are not securities, SEC Commissioner Pierce acknowledged the theory:
“The underlying network cannot mature into a functional or decentralized network that does not rely on a single person or group for the necessary administrative or entrepreneurial work, unless tokens are distributed to potential users, developers and participants of the network, and among them Securities laws cannot be ignored, but neither can we, as securities regulators, ignore the conundrum created by our laws.”
Commissioner Pierce also advocates for a safe harbor for token issuers to create a decentralized network without the onerous reporting standards that apply to public companies. To date, the question of whether decentralization will change securities analysis remains unanswered, and the specific criteria used to assess what constitutes decentralization remain controversial.
A major difficulty in achieving transparency is the current SEC’s enforcement-based approach to securities regulation. This approach means that instead of clarifying the standards that apply to token offerings, the SEC announces which actions it believes require registration by launching enforcement actions against those it deems to be in violation. The current chairman said that enforcement is “a fundamental pillar of the SEC’s mission.” Unfortunately, enforcement is an opaque way to communicate the regulatory market because enforcement actions focus on specific facts that cannot be easily generalized, and enforcement actions can be worked out before there is a solution.
Step 2 (Exemption):
If an arrangement related to a token offering creates a security, the next question is whether the token-related contract needs to be registered with the SEC. All securities require registration unless they are exempt. Typically, token issuers consider the following four exemptions:
- Regulation D (Private Placement)
- Regulation S (Offshore Issuance)
- Regulation A+ (Small IPO/Small IPO)
- Regulation CF (Crowdfunding)
Each of these exemptions is listed in the references below.
Many founders raise funds under Regulation D (eg Uniswap and Filecoin). Entrepreneurs generally consider Regulation D to be the most flexible path; however, the method of issuance of Regulation D is private and subject to resale restrictions. Another advantage of Regulation D is that certain provisions enable founders to raise an unlimited amount of capital.
Some tokens have been issued through intermediaries such as Republic and Coinlist (financing platforms), relying on Regulation A+ and Regulation CF (for example, the Stacks public chain project). Regulation A+ offers a more direct route to a public offering; however, as Stacks’ IPO demonstrated, the process of creating an offering circular for Regulation A+ can be difficult and costly, and as founders seek larger sums, Regulation CF becomes more onerous.
Some founders choose to issue tokens offshore, relying on Regulation S. The key advantage of Regulation S is that there are few restrictions on offshore issuance. The restrictions applicable to Regulation S offerings are designed to ensure that offshore offerings remain offshore. The downside of Regulation S is that the issuer forgoes raising capital in the U.S. market and needs to ensure that the purchaser is not a U.S. person and agrees to abide by the terms of Regulation S, an offering under Regulation S (like any other offering) does not preclude the application of non-U.S. law .
Step 3 (Registration):
It is very rare for founders to seek SEC registration, and two stories illustrate the difficulty of registering token offerings. First, in 2021, INX (Ethereum-based Information Services Protocol) became the first token issuer to successfully register a token sale and conduct an IPO. As part of the public offering, INX disclosed the burden of legal and regulatory fees required to start and operate a public filing platform:
“We intend to use $1.1 million to $3.2 million for regulatory and legal expenses, including legal counsel fees and expenses, filing and authorization fees, consulting fees, and related legal and regulatory support.”
Ultimately, INX paid the $5.8 million offering costs associated with the offering. INX’s general counsel was interviewed after the public offering, expressing concerns about the founders.
My biggest worry is that companies, projects and founders will send out invitations to the SEC or other regulators, “Come and talk to us”, what are their thoughts, if you can get that before doing this Permission and you’ll be fine.
But you’ve (spent) a lot of money in order to get to the point of submitting a proposal to the SEC. You have to build the team, you have to build the technology, you have incurred legal fees, audit fees. (perhaps) the SEC will make a good-faith effort to try and help you find a solution, but it could take 18 months. If you’re a no-revenue company, how are you going to survive the 18 months waiting for the SEC to settle?
Another attempt at public filing led to the SEC taking enforcement action against potential filers. After obtaining the first Wyoming DAO LLC (DAO LLC) filing, Cryptofed, an EOS-based decentralized organization, attempted to register an offering with the SEC. Contrary to the issuer’s hopes, the SEC filed a lawsuit against Cryptofed, which recently withdrew its registration request in the United States, for material misstatements in its offering documents.
If an offering is considered a security but not covered by the exemption, founders should think deeply about whether to continue or change their product plans.
the way forward
Congress has joined the securities debate with the release of a draft bill sponsored by Senators Lummis and Gillibrand. The bill seeks to balance the need for token buyers to obtain adequate disclosure about early token network governance efforts and the need to stimulate innovation in blockchain development. The bill strikes this balance by creating securities law exemptions for certain types of tokens, known as subassemblies, that do not have certain equity-like features, such as the right to receive dividends. The draft bill could mean that governance tokens would be commodities, not securities. Nonetheless, issuers will be required to report certain details of these tokens to the SEC until the value of the tokens is no longer primarily determined by the management efforts of the large holders of the issuing entity. Notably, the bill is not law and could take years to pass.
The progress of the SEC’s action against Ripple may clarify whether decentralized tokens become a key factor in considering securities in the near term. Recently, Ripple won a motion to force the SEC to disclose internal legal analysis that informs Hinman’s theory of decentralization. While the SEC’s internal legal opinion will not be conclusive, it can provide information to courts as to whether a token can transition from an issued security to one that ceases to be a security when fully decentralized. Determining securities offerings and resale restrictions is important for a particular token offering.
Founders shouldn’t expect much clarity on the issues posed by securities in the short term. At the time of issuance, founders should work closely with securities advisors to determine if they are creating investment contracts, and if so, lawyers should help them consider how to issue securities under exemptions, and how to consider decentralizing securities for any subsequent token offerings or the effect of non-security status.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/web3-founders-guide-legal-risks-to-know-about-token-design/
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