Regulatory Insights for ICO Creation
Our financial legislation experts try here to answer questions about ICOs and their legal status in various jurisdictions.
This document include answers to the key questions every company considering an ICO needs to ask.
- United States Regulatory Analysis
- China Regulatory Analysis
- Canada Regulatory Analysis
- Other Jurisdictions: What are Regulators around the World doing about ICOs?
- The core difference between the Utility Token model and Securities
United States Regulatory Analysis
What is a Security?
The Howey Test was created by The Supreme Court for determining whether certain transactions qualify as investment contracts – and thus
subject to security requirements.
Securities include notes, stocks, bonds, debentures, and any other instrument that can be characterized as an investment contract.
Under the Howey Test, a transaction is an investment if:
- It is an investment of money
- There is an expectation of profits from the investment
- The investment of money is in a common enterprise
- Any profits comes from the efforts of a promoter of third party
If an investor's own actions largely dictate whether an investment will be profitable, then that investment is probably not a security
Courts will look at the economic realities (substance) of an investment scheme -> Investment SUBSTANCE -> Investment FORM
Getting Familiar with The Howey Test
Requirements If You Are A Security
In general, all securities offered in the US must be registered with the SEC (there are some exceptions).
The registration process involves the disclosure of certain information, including:
- Description of the company’s properties and business purpose
- A description of the security being offered
- Information about the company’s management
- Financial statements about the company, certified by independent accountants
1. Is it worth launching a ICO if you’re a security? Or should you consider other funding mechanisms?
- Some business models may not be a good fit for tokens, so consider the function of the token itself (security or utility) to answer this question
- Reg D or Reg A+, which allow smaller companies to raise capital without registering with the SEC, are also options
- Speak to an experienced lawyer as early as possible, as they can advise on the market demand for the token in the given regulatory constraints
2. If you are possibly a security, do you block the US?
- Whether the ICO is targeted at the US or not, it is almost certain that the resulting activity will enter US jurisdiction.
- Blocking the US is unlikely to exempt most ICOs from regulatory obligations.
- The US is also a very large market, so blocking the US may make it challenging for any given ICO to gain enough contributors.
3. If you are security and you don't block the US: What could happen?
For example, you're in Switzerland and you're a security accepting US customers.
The possible consequences of violating US law are:
- Losing the value of the investment
- Being financially liable as an individual
- A jail sentence
These are all possibilities, but significant monetary penalties are more probable.
4. If you’re not a security, which US Government Agencies have jurisdiction? Who should you be most concerned about?
- If a token is administrating or exchanging virtual currencies, FinCEN could deem the the ICO issuer a money transmitter, which would require them to be registered under the federal BSA guidelines.
- If the token has a utility it may be exempt from these guidelines.
5. If you're not a security, what kind of compliance do you have to do?
- If a token is not a security or a virtual currency, it is categorized as income.
- This means that the IRS will be paying attention to the token sale.
- More broadly, the underlying service offered in the ICO should guide the compliance process.
- For example, data storage, healthcare record management, or financial services all pose their own regulatory considerations.
6. Who's scarier: the SEC or Class Action Lawyers?
If there is an ICO which knows it classifies as a security but is trying to fly under the a radar, the SEC will pose a bigger threat.
As time goes on, class action lawyers or private lawsuits can become more common and costly. This could be due to a data breach, an ICO never developing a product, or if there is fraud present.
China Regulatory Analysis
7. The Essential Attributes of Fundraising Through Coin Offering
- Characterized ICOs as unauthorized and illegal public fundraising suspected of involving criminal activities.
- No Organizations or Individuals Shall Engage in Illegal Fundraising through Coin Offering.
- Bans fundraising through ICOs or token sales, and orders individuals and organizations who have raised funds using these mechanisms to refund them to the investors.
8. What did the recent Public Notice from The People’s Bank of China actually say?
- Management of Related Platforms Shall be Strengthened.
- Platforms and virtual currency exchanges are not to engage in any sort of trading activities that involves tokens or coins proceeding from ICOs.
- Financial Institutions and Non-Bank Payment Institutions Shall Not Conduct Businesses Related to Coin Offering Fundraising and Trading.
- Financial Institutions and Non-Bank Payment Institutions cannot directly or indirectly provide products or services for fundraising through ICOs, or insure businesses related to these activities, or include these tokens or coins in insurance coverage.
9. What did the recent Public Notice from The People’s Bank of China actually say?
- There has been pressure to protect less experienced investors from Ponzi Scheme ICOs, and market sentiment is that this ban is not permanent, but a temporary measure until more robust regulations are in place.
10. If you're a Non-Chinese firm, do you have to block Chinese individuals?
- If you are hoping to do business with China in future, the safest option would be to abide by the existing rules.
- Otherwise, assess which jurisdictions you care about in the long term and the risk you are willing to take on.
11. If you're an Non-Chinese exchange, what do you do with Chinese tokens from previous ICOs?
- The answer to this is less clear. It is possible that Chinese regulators will mandate a return of tokens and money.
- This could pose problems for a US-based exchange as the token would need to be assessed as a security or otherwise.
- It is helpful to consider the regulations in the jurisdiction the exchange is operating in.
12. The Chinese Government revealed a list that named 60 different companies and ICO platforms slated for investigation.
- The list shows they were reviewing a Canadian company. What could they do?
- There is a penalty for violating Chinese securities laws, but they don’t seem to be enforced widely outside of China.
- Violating the laws while operating within the country is more of a concern.
13. If you're in Switzerland and your ICO accepts Chinese customers, what could happen?
- This may be problematic as the activity would not be lawful in China.
- One should check if Swiss law has any rules against this, and perform a risk-based evaluation, weighing up whether you are willing to get on the bad side of Chinese regulators, and if access to a good customer base is worth the risk.
- Also remember: the ban is likely temporary, and you won’t want to be on regulators’ bad side when it lifts and you seek to do business in China.
Canada Regulatory Analysis
What Is A Security?
- Section 1 of Ontario’s Securities Act defines securities at length, in a fashion similar to that found in US Securities Regulation.
- In this definition, an “investment contract” is also included.
- The definition of investment contract may capture a purchase of coins or tokens where the value of such coins or tokens are dependent upon the future profits or success of a particular business.
- To determine whether an investment contract exists in Canada, we refer to the Supreme Court of Canada's decision in Pacific Coast Coin Exchange v. Ontario Securities Commission.
Investment SUBSTANCE - > Investment FORM
14. According to this ruling, an investment contract exists when there is:
- An investment of money.
- In a common enterprise.
- With the expectation of profit.
- That comes significantly from the efforts of others.
Requirements If You Are A Security
15. Create a Prospectus Or rely on a prospectus exemption.
If the token/coin seller meets the business triggers tests by trading in securities for a business purpose, the seller must then register as a dealer or rely on a dealer registration exemption
A prospectus consists of:
- Objective of the business
- What the funds are being raised for
- Projected value of the funds
- Information on the owner(s)
Canada is not one jurisdiction, and rules change province by province.
For example, dealer registration would need to be done for each of the provinces you operate and plan to offer tokens in.
- A white paper does not qualify as a prospectus.
- Do some due diligence on your prospective lawyer as well, as many lawyers may not have experience with ICOs.
- Even if you are exempt from the two above requirements, making a white paper available is good practice.
Requirements If You Are A Security
16. Regulatory Sandbox and How This Approach Can Help
- The Sandbox that was set-up by the Autorite des marches financiers is seeking to better understand ICOs and other blockchain use cases.
- The Sandbox was put together to help jumpstart FinTech projects that don’t easily fit within the confines of a legacy regulatory framework.
- ICO fundraising fits this definition.
Canada’s Strict KYC Regulations
The Canadian KYC Process for non-face-to-face transactions is very strict, and has to include one of the following:
- Credit File: Canadian credit file in existence for at least three years, Name, address and date of birth, Client identification information, Source of credit file, Reference number, Date of verification.
- Dual Process: Two original, valid and current documents or information from independent and reliable sources, Name, address and date of birth, Client identification information, The name of the two different sources used to identify your client, The type of information, Account or reference number, Date of verification.
17. If you’re not a security, which government agencies have jurisdiction?
- If you’re not a security but operating a virtual currency, similar to the US, you will be subject to FINTRAC (Financial Transactions and Reports Analysis Centre of Canada) regulation.”
Other Jurisdictions Regulatory Analysis:
18. ICO Regulation in the UK
- The UK has been on the quiet side in terms of taking a position on ICOs.
- However, the FCA have set up an email address to contact for those conducting token sales.
- The information that has been put up suggests a line of thinking similar to US and Canadian regulators: that ICOs can fall under a regulated line of business and be subject to securities laws.
19. Do we assume that securities regulation in the United States and Canada applies to rest of the world?
- It’s useful to decide which jurisdictions matter to you over the long term.
- Consider where you want to operate, travel to, have customers etc.
- Even if you are in the US entity and create a Swiss entity to operate from, US regulators will still keep an eye on you.
20. What kind of compliance do you need to do?
- Most countries have securities regulations, and some have already made statements about ICO fundraising.
- Find out whether you are a security or not.
- Plan your taxes, as bad practices cannot be fixed retroactively.
- Look at sanctions issues. Token sales are attractive to those on OFAC lists who want to transfer funds without leaving a paper trail.
21. Could you conduct an ICO from an offshore location?
- Just because the location of incorporation for a company doing an ICO doesn't have regulation, doesn't mean that they can ignore the regulation of their buyers.
- For example, if in the US you can sell machine guns online, doesn't mean you can sell those same machine guns to someone in the UK where they're illegal.
22: What degree of protection does a "carve-out" - asking the user to confirm that he/she does not come from a jurisdiction where the token contribution could be a regulated or prohibited activity - provide? Is IP blocking more effective?
- It's recommended that both occur; companies with regulatory compliance should be both asking contributors for their address and validating by confirming their IP address, including checking if they're using a proxy or other methods to mask their IP address.
23: For IRS purposes, do you believe that the utility token will be more analogous to a tangible property sale or an advance payment for services?
- This is a complex question. ICOs aren't included in tax law, so we look to existing law and see what's relevant.
- This varies by where the company is headquartered AND who controls the company.
- For example, if a company outside the US is more than 50% owned or controlled by US shareholders it becomes a “controlled foreign corporation” (“CFC”) which has one set of obligations while if it's less than 50% it can be a “passive foreign investment company” or PFIC which has different obligations.