We advise entrepreneurs and investors in capital raising transactions using a tool box of new legal strategies, technology and business practices.
This article is based on the summary of major events of 2018 in the Coins/Token/Blockchain world that Jim Verdonik and Benji Jones did for a continuing legal education class for the University of North Carolina Law School on February 8, 2019
2018 was a wild year for Coins, Tokens and other Digital Assets
The substantial drops in Coin prices accomplished what the SEC was not able to do – decrease the speculative fever that was causing investors to overpay for ICOs.
Lower Coin prices means there are fewer dollars chasing ICOs and the early “Whales” are looking to diversify their investments before they become minnows.
Like in most bubbles:
- The early smart money got out with profits
- The true believers and late comers suffered substantial losses
As the market was re-balancing itself, the SEC stopped acting crazy and began to take a more thoughtful position. We saw five main phases to this shift in the SEC’s tactics:
- Yelling and Scaring – The SEC shut down obvious fraud rings, warned investors about risks, threatened a major enforcement effort against issuers and promoters and (in what we think is an over the top move) threatened securities lawyers who disagreed with the SEC’s legal position with losing their ability to practice securities law.
- Enforcement – The SEC launched dozens of investigations; moving beyond fraud to enforcement against issuers that conducted public offerings without an exemption. (See the Airfox and Paragon Coin settlements in November 2018) that included civil fines, rescission offers and requirements that the issuers file 1934 Act periodic reports as if they had conducted an IPO. The SEC also brought enforcement actions against Coin exchanges that were violating 1934 Act rule governing broker-dealers and securities exchanges. Click here for a list of SEC Cyber Enforcement Actions.
- Coordinate with Foreign Regulators – The US and Canada are in substantial agreement, the EU is beginning to focus on the dangers of fraud, countries like Japan and Singapore that want to be trading centers understand that some regulation is necessary to maintain market confidence. China bans whatever the government can’t control. The offshore tax havens (Cayman Islands and the like) remain the primary unregulated countries.
- Too Big to Fail – The SEC did not want to be blamed for causing the losses in big Coins. So, the SEC announced that Bitcoin and Ethereum were no longer securities – proving to some securities law geeks that an orange really can transform into a banana. (Ask a securities lawyer what that means.)
- Normalization – “Digital Assets” is the new buzz term. From the SEC perspective, Digital Assets represent “innovation” that that must be facilitated like any other technology as long as issuers obey long standing securities offering rules when they raise capital. The SEC staff is helping issuers understand how the rules apply to Coins, Tokens and other Digital Assets
Where does this evolution leave us now?
- Companies are fulfilling their disclosure obligations and are complying with requirements to have exemptions from registration.
- The days of free money are over.
- Investors are conducting due diligence.
- Valuations are becoming more reasonable in light of risks.
- Transfer restrictions after offerings have become the primary securities law problem that is still a work in progress. Issuers and their lawyers are refining various strategies (including the SAFT concept) to ensure that Tokens can be used in the marketplace. The crux of the problem is that we need the “Utility Tokens” never to be considered “restricted securities” whose transfer is restricted, which would decrease their immediate usefulness in any marketplace, because marketplaces thrive on transfers. Some structures to solve this problem involve:
- Creating a second investment decision that allows investors to choose to have their rights to receive Tokens redeemed after the Token gains utility.
- Creating two Tokens. One Token is purchased by investors and is and remains a security because it includes economic rights. The second token is sold to users of services (once the distributed network is built). Its only function is to cause software to work and is never a security. Look for the SEC to address this issue later this year by providing guidance about what attributes make a digital asset a “utility token.”
- Other approaches involve structuring the Token as a true currency and embracing FinCEN and money transfer regulations.
- Tokenizing normal securities (like common stock or preferred stock) is creating trading markets for private companies.
- Tax issues may replace securities laws as the primary reason for issuers to incorporate outside the US. Currently, the IRS treats Tokens as “property.” The IRS taxes gains on all sales of “property.” Section 1032(a) of the Internal Revenue Code exempts from income tax sales by an issuer of its capital stock. If a Token is not capital stock, Section 1032(a) does not protect the issuer from being taxed when it sells Tokens. This creates an incentive for American software developers to utilize off-shore companies to mint their tokens. (This does not apply to capital stock that has been “tokenized.” Simply using a token to evidence ownership of stock instead of using a stock certificate should not affect the tax outcome.)
- Employee compensation taxes on Tokens are a big issue for employees who receive token allocations. S. employees will be taxed even if the issuer is located offshore. Section 83(b) applies only if a Token constitutes capital stock (which often is not the case), but there is no equivalent to a stock option for Tokens allocated to employees.
In summary, raising capital by selling Tokens, Coins, SAFTs and other Digital Assets remains a viable capital raising tool, but requires substantially more planning than does selling traditional capital stock or debt securities.
Let us know how we can help you decide whether Digital Assets are for you and how to plan your offering.
|Jim Verdonik||Benji Jones|
© 2019 Innovate Capital Law (Verdonik & Jones, PLLC) For further information regarding the issues described above, please contact us.
This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.