April 6, 2018
The Current State of U.S. ICO Compliance
Posted by Jeremy Nau
As the SEC has yet to make an official ruling or create a governance entity to oversee ICOs (initial coin offerings) or TGEs (token generating events) and related processes, the current U.S. compliance landscape surrounding ICOs and related cryptocurrencies is quite ambiguous. Along with this regulatory uncertainty, future compliance may be costly and limit projects’ access to funds during the ICO process.
This gives project teams wishing to utilize an ICO funding strategy two main options: 1) launching their entity in a more ICO-mature (i.e. Switzerland) or ICO-friendly environment (i.e. Mauritius, Gibraltar, Isle of Man), with the hope of escaping the invisible hand of the SEC, or 2) launching in the U.S. landscape and “hoping for the best” by utilizing an existing (albeit not government-backed) ICO framework.
This post focuses on those projects selecting option 2 (and thus, looking to potentially comply with the SEC).
The SAFT Framework
The SAFT (Simple Agreement for Future Tokens) has been the most widely adopted framework in the current landscape. It was created by Protocol Labs in conjunction with their platform, CoinList, to allow easier access to ICOs for accredited investors within the U.S., while still theoretically adhering to the SEC’s wishes (or as much as possible, since there has been no formal SEC guidance).
Protocol Labs’ SAFT whitepaper notes that the framework is intended to initiate a conversation within the community, to lead to collaboration and eventual maturation of a “compliant ICO environment.” The SAFT mirrors the SAFE (Simple Agreement for Future Entity) framework utilized by accelerator Y Combinator to fund traditional startups.
Direct Token Pre-Sales
Most ICOs are direct token pre-sales (see sidebar ICO Token Terminology, below), as developers attempt to fund the project prior to having a functioning network. For utility tokens, funds received for tokens prior to a “use” on a network are likely to be deemed an investment contract (i.e. security) utilizing the 4-prong Howey Test, and thus governed by the SEC.
The Howey Test and its relation to tokens demands its own analysis and is outside the scope of this post, but basically, the SAFT says that utility tokens disbursed and sold prior to the development of an “essentially complete” functioning network will be deemed as securities, as investors will rely on the “efforts of others” (among other Howey prongs). These tokens will be governed by the SEC, and thus can only be sold to accredited investors prior to launch.
Utility tokens disbursed after the creation of the network will most likely be deemed not to be an investment contract (security), and thus governed by the Bureau of Consumer Protections, which opens up sales to all types of investors (including individual/casual investors) and is a lot less costly to comply with. Most projects will likely want this latter situation, to give them access to the most potential capital and limit up-front costs.
The SAFT attempts to tip-toe the line of security (and non-security) inherent within the direct token pre-sale model by utilizing a “SAFT instrument,” which (in theory) accentuates the positives and minimizes the negatives of securities and consumer protection guidelines.
A SAFT agreement states that tokens are only disbursed to the investors once a token is deemed functional (and, in theory, the underlying network). Like preferred stock in Y Combinator’s SAFE agreement, the SAFT instrument uses the tokens as a vehicle to obtain the “right of something in the future with value,” very much like a forward contact. Since the agreement relies on the “effort of others” and “the expectation of profits” Howey prongs as the clear driving factors for investment, the SAFT (while in this stage) is most likely going to be considered an investment contract, and therefore governed by the SEC, limiting investment participation to accredited investors prior to regulatory filings with the SEC.
However, upon the creation of a “functional token” (and most likely an “accompanying network”), the SAFT instrument will have been fulfilled, the “security” portion of the transaction is complete upon delivery of the tokens, and the accredited investors who purchased in the pre-sale and all other stakeholders in the ICO can sell “now functional” tokens to any and all investors.
An important delineation to note is that a SAFT is an agreement only up to the point of a “functional token.” Past this threshold, a SAFT will have no bearing or necessity, as the tokens will have “utility” (in theory) and be able to satisfy the Howey test.
This is Just the Beginning
As the SAFT whitepaper outlines, this is truly the start of the conversation on ICOs and related compliance mechanisms. As subsequent scrutiny leads to eventual iterations of ICO compliance standards, we can thank the SAFT model for catalyzing thoughts and considerations for a tool that has the potential to revolutionize how we think about traditional funding.
ICO Token Terminology
Security tokens represent a stake of ownership (blockchain benefits this type of token as it records transaction history, an undeniable chain of title, with nearly instant settlement times). An example is the DAO token.
Utility tokens are designed to offer intrinsic utility on a blockchain platform, not necessarily to replace existing financial products. Often these types of tokens are offered prior to the point of utility (the point at which the token can be used on a functional network/blockchain) to fund the development of the decentralized application (dApp) or platform via “direct token presale.” Examples include Ethereum and NEO.
Direct token pre-sale is the direct sale of a utility token to the public prior to the token being “usable” on a blockchain or network.
Jeremy is a manager in Armanino’s Blockchain practice, with more than 4 years of experience performing compliance, internal and blockchain-technical audits. He has experience leading and participating in cryptocurrency/blockchain engagements for exchanges, crypto-startups, and stablecoins. Jeremy authors Armanino’s blockchain audit memos, and he has helped develop proprietary procedures to test digital assets for reliance during an audit.
A Certified Blockchain Professional and member of the Cryptocurrency Certification Consortium, Jeremy is also a Certified Public Accountant (CPA) and Certified Management Accoutant (CMA). He holds a Bachelor of Business Administration, Accounting from California State University, Chico.