Legal Framework for a Tokenized Business - Lawyer Commentary
With all the speculation about how the SEC will treat ICOs and tokens, here is the take from a few lawyers. **Everything here is paraphrased. Additionally, it should not be taken as legal advice.**
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Are Tokens Securities?
The DAO token is a security and relied on the Howey Test. The SEC may use the family resemblance test to determine - "if it looks like a security, it probably is a security". There are no clear guidelines yet, except that some tokens will be considered securities.
Federal Analysis AND State Analysis
In addition to federal law, each state has their own analysis. Some states, like California, have a risk capital test and therefore a lot of ICOs and token sales would be considered a security.
Many foreign countries have followed the lead of the US with regards to regulations in the space.
How To Safeguard Against Being Categorized as Security
Since securities are subject to all manner of regulation, it is in the interest of many an ICO issuer to ensure their tokens are not considered securities. While there are no guarantees, there are certain safeguard precautions that may be taken.
- Get a No Action letter from the SEC
- Write a letter to explain to the SEC why your token is not a security.
- They can write back or not. The best outcome is they write back and say they won’t take action.
- You have the option of sending an email to the SEC, but then that’s informal guidance. Also emailing them puts you on their radar, for better or for worse.
- Either register as a security or get an exemption
- Reg D allows you to sell to accredited investors.
- 506B means you can sell to 35 non-accredited but they have to be sophisticated, no advertising.
- 506C means you can advertise but only accredited.
- Regulation crowdfunding – allows $1.7mm to accredited and non-accredited and employees/founders/insiders.
- Legitimate US non-profits are exempt from the SEC but have to abide by state law.
- Consider overlaying Jobs Act Crowdfunding, to allow $25mm in assets.
- Suggestion : Raise from accredited
- Once you allow unaccredited, the disclosure levels almost reach IPO levels.
- For what it's worth, in California, most Kickstarters are securities due to the Risk Capital Test.
Worst Case Scenario if Going with Utility Strategy
What is the reasonable worst case scenario for going “utility” and then the SEC decides your tokens are securities? If you are not a bad actor doing criminal activities, it might not be that bad. If people you sold tokens to try to get their money back, you could be liable for that. The SEC could also ban you from industry - this means you can’t be a top level officer at a startup and your company also can’t sell/issue securities.
The key differentiator between selling a product and selling a security is that with a product, you can get a refund so your capital isn’t at risk. The closer you are to having something live (versus just a whitepaper for instance), the more it looks like a product and less like a security.
What About Tax Implications?
If you are selling a product, it’s considered income. If raising money as investment, the IRS would tax capital gains.