How to Launch an Unregulated Token

Confusion has arisen in the American markets about whether launching a #token on a decentralized exchange (#DEX) removes the token issuer from regulatory oversight. The short answer is - it doesn't. No matter the platform, if the token issuer is an enterprise with identifiable decision-makers who the government can name in a lawsuit, then the token will be regulated by either the Securities and Exchange Commission (#SEC), the Commodity Futures Trading Commission (#CFTC), the Financial Crimes Enforcement Network (#FinCEN), or the Federal Trade Commission (#FTC). So how can a business launch an unregulated token? Read on to learn more.


WHEN TOKENS ARE REGULATED BY THE SEC

In 2016, the SEC issued a landmark decision about “The DAO Attack”[1] which subsequently fueled aggressive enforcement actions against unregistered initial coin offerings (ICOs) and the successful prosecution of dozens of cyber enforcement actions in the past several years. [2] In a speech delivered in 2018, former SEC Director William Hinman explained that labeling an investment opportunity as a coin or token does not, without more, remove the transaction from securities laws. [3] Rather, the analysis of “… whether a transaction in a coin or token on the secondary market amounts to an offer or sale of a security requires a careful and fact-sensitive legal analysis … [involving] how it is being sold and the reasonable expectations of the purchasers.” [4] Issuers, promoters, and other market participants, like securities brokers and lawyers, should understand whether transactions involving a particular digital asset are really the sale of a security disguised.

While the definition of a #security is located in 15 U.S.C. § 77b(a)(1), the landmark case of SEC v. W.J. Howey Co., established a more commonly used four-part test to determine whether variable documents traded for speculation or investment, such as a pledge or loan against a security, or even a contract to sell, can also be regulated as securities. [5] The test to determine whether an investment contract is a security is whether the scheme involves (a) an investment of money (b) into a common enterprise (c) with an expectation of profits (d) derived from the efforts of others; and, if that test be satisfied, it is immaterial whether the enterprise is speculative or non-speculative, or whether there is a sale of property with or without intrinsic value. [6] In other words, even airdrops have been found to be securities.


When the leadership of an enterprise offers a token for sale, and the purchasers expect the value of the token to increase over time, the token is likely a security. So why do folks think these tokens are somehow exempt from securities treatment? I think it's because when tokens are offered on unregulated #blockchains like #Ethereum, or unregulated decentralized exchanges like #Uniswap, that somehow this lack of regulation benefits tokens launched on these platforms. However, although the exchange one uses to launch their token may be #decentralized and consequently outside the regulation of the SEC, that doesn’t make the issuer decentralized and outside the regulation of the SEC. Neither does launching activities from outside the United States. Issuers of #assets are regulated based on the location of the #issuer AND the location of the #investor. So, if an issuer is targeting investors in France, they will also have to comply with the laws of France. U.S. securities regulations are the most stringent, so generally speaking, if issuers comply with SEC regulations, it’s likely they are compliant with global securities regulations.


WHEN TOKENS ARE REGULATED BY FINCEN AND THE CFTC

If the token is not a security and therefore not regulated by the SEC, then the issuer may be a money transmitter subject to compliance with the Bank Secrecy Act (#BSA) enforced by FinCEN – and FinCEN don’t play. Quite frankly, FinCEN makes the SEC look like a kindergarten teacher. I’d much prefer issuers to be in violation of securities laws than the Bank Secrecy Act because the former most often results in rescission while the latter results in jail time. FIN-2019-G001 is the latest authoritative federal regulatory guidance on The Application of FinCEN’s Regulations to Certain Business Models Involving Convertible Virtual Currencies. It explains that whether a business is a money transmitter is a matter of facts and circumstances under 31 CFR § 1010.100(ff)(5)(ii). Money transmission may occur when a business issues physical or digital tokens evidencing ownership of commodities, securities, or futures contracts that serve as value that substitutes for currency in money transmission transactions. “The Commodity Exchange Act (CEA) defines ‘commodity' broadly to include all ‘goods and articles, . . . and all services, rights, and interest . . . in which contracts for future delivery are presently or in the future dealt in.’” 7 U.S.C. § 1a(9). [7] Notably, this definition does not limit the meaning of commodity to only tangibles; so, depending on their structure and use, digital assets may be regulated by the CFTC as a commodity, swap, or other derivative. [8] As early as December 2014, the U.S. Commodities Futures Trading Commission (CFTC) declared #cryptocurrencies are commodities subject to oversight under its authority granted pursuant to the Commodity Exchange Act (#CEA). [9] Since then, the CFTC has taken action against unregistered #Bitcoin futures exchanges, prohibited illicit activity on derivatives platforms, issued guidance and warnings in the context of cryptocurrencies, and addressed cryptocurrency Ponzi schemes. [10]


WHEN TOKENS ARE REGULATED BY THE FTC

If the token performs a function that does not involve issuing a security or a commodity, then it may be the rare jackalope that is a utility token. Fundamentally, a utility token provides a function, or represents a right, to its holder, that may be traded for goods or services within a participant network, and that has no value outside that participant network. For example, when you use your credit card you may be awarded points, represented as tokens, that can be exchanged for goods or services in the credit card’s participant network – like for car rentals or airline miles. If the purchaser of a utility token has an expectation that the purchasing power of the token is going to rise over time, then it’s not a utility token. Utility tokens exist within a closed network, and they are not publicly traded, because if they were, they’d be regulated by either the SEC or the CFTC and/or FinCEN.


As is the case with all consumer goods and services, utility tokens and their issuers are regulated by the FTC whose job it is to stop unfair, deceptive, or fradulent business practices. As the nation's consumer protection agency, the FTC investigates reports and brings lawsuits against businesses that cheat people out of money, or if the goods and businesses sold to consumers don't live up to the advertising. The FTC also works with law enforcement to bring criminal charges if necessary.


HOW TO LAUNCH AN UNREGULATED TOKEN

In summary of the above, “[f]inancial products that are linked to underlying digital assets may be structured as securities products subject to the federal securities laws even if the underlying cryptocurrencies [or tokens] are not themselves securities.” [11] As in the case of The DAO, enterprises that offer digital assets labeled as a coin or token to investors in exchange for currency (such as U.S. dollars or other cryptocurrencies) are securities offerings. [12] Although many market professionals have tried to highlight the utility or voucher-like characteristics of their proposed #ICOs (or token offerings), these assertions elevate form over substance which the SEC has found to be a disturbing trend, especially when the promoters of these offerings emphasize the secondary market trading potential of these tokens. [13] Consequently, adding a utility to that which is a security does not deprive it of its status as a security, nor does it deprive a commodity from such status and corresponding regulation by the CFTC or FinCEN. The trick, then, to launching an unregulated token is the very thing that most #startups cannot do - they have to be #Satoshi. If the regulators can see you - if they can do an investigation and identify who you are as the organizer, the developer, the decision maker, or the influencer, of the token, then they can subpoena you, which means they can regulate you. Because blockchain and digital assets are now on the radar of every regulator worldwide, this is a lot harder to accomplish these days than ever before, especially given the expansion of available tools to track and trace blockchain transactions. Consequently, even if an unregulated token could be launched under today's enhanced surveillance, enjoying any financial benefit from this effort would be extremely unlikely to go unnoticed. In fact, one might even be tempted to suggest that regulatory #compliance would be easier.


EndNotes

[1] Siegel, D., 2016. The DAO Attack: Understanding What Happened – CoinDesk. [online] CoinDesk. Available at: https://www.coindesk.com/understanding-dao-hack-journalists [Accessed 10 February 2021].


[2] Sec.gov. 2021. SEC.gov | Cyber Enforcement Actions. [online] Available at: <https://www.sec.gov/spotlight/cybersecurity-enforcement-actions> [Accessed 14 February 2021].


[3] Hinman, W., 2018. SEC.gov | Digital Asset Transactions: When Howey Met Gary (Plastic). [online] Sec.gov. Available at: <https://www.sec.gov/news/speech/speech-hinman-061418> [Accessed 14 February 2021].


[4] Id.


[5] SEC v. W.J. Howey Co., 328 U.S. 293 (1946).


[6] Id. at 51.


[7] 2020. Digital Assets Primer. [ebook] Commodity Futures Trading Commission. Available at: <https://www.cftc.gov/LabCFTC/Primers/index.htm> [Accessed 23 March 2021].


[8] Id.


[9] U.S. CFTC, 2018. CFTC Backgrounder on Oversight of and Approach to Virtual Currency Futures Markets. Washington, D.C.: CFTC Office of Public Affairs.Cftc.gov. 2014. (Citing, Testimony of Chairman Timothy Massad before the U.S. Senate Committee on Agriculture, Nutrition & Forestry | CFTC. [online] Available at: <https://www.cftc.gov/PressRoom/SpeechesTestimony/opamassad-6 > [Accessed 8 March 2021].


[10] CFTC v. McDonnell, 287 F.Supp.3d 213, 228 (E.D.N.Y. 2018) (holding that Bitcoin and other cryptocurrencies qualify as commodities because they “are ‘goods’ exchanged in a market for a uniform quality and value.”)


[11] Chairman’s Testimony on Virtual Currencies: The Roles of the SEC and CFTC, Sec.gov (2018), https://www.sec.gov/news/testimony/testimony-virtual-currencies-oversight-role-us-securities-and-exchange-commission (last visited Aug 26, 2021).


[12] Id.


[13] Id.

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