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Initial Coin Offerings (ICOs) are a new method of crowdfunding used by blockchain companies to raise funds. ICOs are making growth in the cryptocurrency world possible by allowing money to flow into the digital coin market. Though many of ICOs have been successful, there have been some that failed, which leaves many questions regarding legality are up in the air.
ICOs hold considerable power in the expansion of financial inclusion in the generation of built-in user networks and open source development. However, for any ICO, to meet its goal, it is important that the involved companies know the regulations and the legal ties surrounding them, to avoid any civil and criminal liabilities that might be charged in the future. Many of the companies that are interested in ICOs have a number of common misconceptions about the legal implications of ICOs.
Here are a few common misconceptions surrounding the laws related to ICOs. Adhering to these laws would help blockchain companies avoid legal implications.
Misconception #1: A Utility Token Is Not A Security
Often, companies think their token cannot be considered a security because it is a utility token. This belief can be attributed to the fact that a utility token is a gift card and simply provides access to a platform and hence, cannot be a security. In 2017, this mindset, plus the creation of the SAFT (Simple Agreement for Future Tokens), had many companies believing they were not subject to regulated securities laws.
To discuss this misconception, we must understand the different types of tokens.
What is a Utility Token?
Utility tokens, also referred to as app coins, are tokens used to gain access to a product or service. They are not made to be investments which are a big reason why many ICOs felt they would not be securities.
Utility Tokens can be put to many uses; its value can be judged by how it is consumed. If a token holds a good deal of utility, it is most unlikely that it would pass as a security.
The law was also clarified in order for a utility token to not be a security, it must have actual utility and an already built platform at the time of token issuance.
What is a Security Token?
A security token is a token based on a hard asset, equity in a company or shares in a fund. It can also be any token that raises capital under existing regulated securities laws. Any deviation from these regulations can lead to penalties and legal issues.
The generalized belief that utility tokens are not securities is not accurate. The mere existence of utility cannot be used in determining whether a token can be taken as security or not. If this were the case, any ICO could easily defraud the laws, merely by enlisting any utility to the token. It would have made it possible for a token to be just a utility token for any small reason.
Giving a company the “Howey test” is a good way to determine whether or not a token can be classified as a security. It is important to note that the largest difference between a utility and security token is in the way funds were raised, the type of language used to attract investors, and the legal structure under which it was filed.
Misconception #2: If My Tokens Are Not A Security Subject To The Law, They Cannot Be Considered Securities
There are a number of laws which must be taken into account for the selling of the tokens, in addition to the requirements of the country where it operates.
Prominent among them are laws that govern taxes, consumer protection, consumer rights and laws against money laundering.
Laws Which Might Affect Token Sale
1. Taxation Laws
Tax laws are never simple, and they differ by county. Most of the tax laws view tokens as commodities making them liable to commodities tax laws. The dilemma comes because most of the governments have two ideas about tokens. On one hand, regulators of securities say that tokens are indeed securities, on the other, the tax authorities are more inclined towards taxing them like they would an investment. Thus, if a token is not considered a security, it becomes taxable.
2. AML and KYC Laws
Cryptocurrencies are digitized versions of real-world assets. Simply put, when cryptocurrencies are transferred from one digital wallet to another, or they are exchanged from one crypto to another, their values get aligned in proportion with the asset value in the real world. It makes the laundering of significant amounts of money possible.
AML anti-money laundering) and KYC (Know Your Customer) laws become vital to keep criminal elements at bay. AML regulations determine the difference between actual investors and frauds. KYC processes enable a company to confirm a customer’s real identity by using a data verification system. This helps them to keep the criminal clients at bay.
3. Consumer Protection and Consumer Rights Laws
Every country has its own consumer protection and consumer rights laws. These laws ensure that consumers are not beguiled and defrauded by the token issuers who give false, equivocal and misleading statements. The authorities can take action against them for contract perfidies and giving false and luring advertisements. These authorities have the full right to investigate a company, individual and organization for any of these charges.
4. Laws Across the Borders
Every token issuer has to consider the legal implications of the dealings and businesses of taxes, the consumer protection laws and anti-money laundering laws globally.
Apart from the laws of the country they are operating in, the token issuer is subject to the rules and regulations of some countries in which the token holders live and is answerable to all of them. Different countries have different laws for taxes, securities, and consumer protection.
Misconception #3. If A Token Fails To Meet The Definition of Securities Under Any of the Accepted Tests, It Is Not A Security
This is the most common misconception of all. Several tests like Howey’s test, family resemblance test, and risk capital test are used to analyze and decide if a token is to be considered security or not. It is here that this misconception is rooted. Most of the times, it is taken that if a token fails these, it will not be considered a security token. To clear this, one needs to know how is security defined by the concerned legal authority, what is a security token, how the tests decide if a token is a security or not and what are the loopholes involved.
The most important thing to understand is how a token as security is defined and hence determined. This is a very critical matter because this answers if a particular token will be regulated by the respective authority or not.
Particularly in the case of the customers from the United States, any token is considered a security when it is in the same organization where the investor is investing money, and expecting profit out of it; the profit whose source lies in the management endeavors of others.
Three major tests act as determinants for a token to be a security.
Howey’s Test is used to find out if a transaction qualifies as ‘investment contract.’ If a particular transaction does qualify as an investment contract, then that transaction is supposed to be security.
According to the Howey’s Test, a certain transaction qualifies as security when:
- It is a monetary investment
- Profits are expected from the investment
- The financial investment is done in a common enterprise
- Profit is derived from the endeavors of the third parties involved
Utility tokens fail the fourth factor of this test because in a number of cases, profit is expected from the token’s consumptive value and not from the endeavors of the third party involved.
While he Howey Test is a very trusted determinant of whether an arrangement is an investment contract or not, it cannot be relied upon totally to judge if a token is a security or not. This is because a court of law may choose another test to decide upon it.
Family Resemblance Test
Family resemblance test is another four-factor test. According to this test, a note would be taken as security when the investors involved are interested in the profit derived from the given note, or the note is to be used for general trading for investment, or when the public takes it to be a security.
If a token is not considered security as a contract under the Howey’s Test, it can be regarded as a security under the Family Resemblance judgment.
Considering this, anybody who is issuing a token must keep in mind how the Howey’s and Family resemblance tests will apply to it.
Risk Capital Test
Risk capital test is different across different US states.
The risk capital test is applicable in many circumstances because a large number of token issuers are raising funds through the general public for risky business projects.
However, the risk capital test might be used alongside the Howey’s Test. A transaction which passes either of the two tests is considered a security.
The legal issues involved with the sale of tokens is a very complicated and difficult area which requires many considerations.
It is crucial to know the reality of the various misconceptions surrounding the laws related to the sale of tokens and ICOs.
Legal expertise is required to analyze how legal framework applies to the needs of an organization and its functioning, operations, and needs. A knowledgeable lawyer will know the legal risks involved and hence, frame an excellent strategy to deal with these matters.
The entire philosophy of the blockchain technology and of ICOs is built around creating a democratic and self-regulated system that does not need any third party trust or regulation. If the philosophy is adhered to by all those involved – platform developers and investors – the need for third-party regulation can be negated. After all, the blockchain phenomena was created to do exactly that. But if investors interests are jeopardized, regulatory authorities will clamp down on ICOs, this will have a severe impact on innovation and this will go against the grain of the philosophy. It is thus, paramount for the crypto community to come together to forge a strong self-regulatory mechanism to keep governmental regulations away from the equation.