United States: Securities And Tax Classifications Of Cryptocurrency Relating To ICOs

Bitcoin's recent rise to fame and the growing role played by virtual currencies (i.e., "cryptocurrencies") and distributed ledger technology (e.g., the Blockchain) in a variety of areas, including global finance and e-commerce, have piqued legal and regulatory interest in these topics, which has given rise to a variety of legal issues. This Stroock Special Bulletin discusses the classification of cryptocurrencies for purposes of federal securities laws and U.S. federal income tax, particularly in the context of Initial Coin Offerings ("ICOs").

Cryptocurrencies and Securities Laws

Nascent companies looking to raise vital growth capital can find themselves stuck between a rock and a hard place. On the one hand, the complexity of and costs of compliance with securities laws can make traditional equity capital markets an unviable fundraising platform for small, start-up enterprises. On the other hand, the competition for venture capital backing can be fierce and, even if obtained, often delivers financing with significant "strings" attached (including loss of significant economics), which some start-ups may shy away from. Start-ups may attempt to raise funds in crowdfunding campaigns, such as Kickstarter, but these are subject to limited terms and are not conducive to raising significant amounts of capital.

ICOs could be the digital crowdfunding solution to the challenges facing start-ups in their fundraising endeavors. In basic terms, an ICO involves the issuance, by a company, organization, person or group, of a cryptocurrency (i.e., digital "tokens" or "coins") to investors in exchange for cash or other cryptocurrencies. Since securities laws apply to offers and sales of "securities," such as shares and bonds, and a digital token is, at least on its face, neither a share nor a bond, but rather a standalone, new type of asset class, early proponents of ICOs assumed that the offer and sale of digital token would fall outside the purview of the securities regime.

If this assumption were correct, ICOs could present a way for a start-up to fundraise on a widespread scale without having to comply with costly and burdensome securities laws and regulations, and, from the start-up's perspective, could become a viable alternative to traditional capital markets and venture capital financing. From an investor's perspective, the advent of ICOs would mean that smaller, non-institutional investors could finally see the types of returns that the start-up industry has been famed for but which have thus far been reserved for venture capitalistsand large institutional investors. While this sounds promising, the Securities and Exchange Commission's ("SEC") approach to ICOs to date is a strong indication that it may be too good to be true, at least with U.S. investors or a U.S. issuer. For a discussion of Bermuda as an alternative ICO jurisdiction, see https://www.stroock.com/siteFiles/Publications/Bermu daJurisdictionOfChoiceDigitalAssets.pdf.

With its 2017 enforcement action against The Dao, involving one of the earliest ICOs in the U.S., the SEC indicated that, "depending on the facts and circumstances of each individual ICO, the virtual coins or tokens that are offered or sold may be securities"1 and that offers and sales of digital assets by "virtual" organizations may be subject to the requirements of the federal securities laws. The SEC's analysis dealt a severe blow to ICOs, potentially undermining their appeal as simpler, cheaper alternatives to traditional securities offerings, and has given rise to significant debate over the last 12 months.

According to the SEC, a determination of whether digital tokens issued as part of an ICO constitute "securities" under Section 2(a)(1) of the Securities Act of 1933 and Section 3(a)(10) of the Securities Exchange Act of 1934 requires establishing whether the tokens display the hallmarks of an "investment contract." According to the Supreme Court's decision in SEC v. W.J. Howey Co., an investment contract is "an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others."2

In The Dao, an unincorporated, "decentralized" organization sold digital "Dao Tokens" to investors in return for the cryptocurrency Ethereum, which was then used by The Dao to finance projects sanctioned by a vote of Dao Token holders, who in turn stood to receive a portion of the profits from those projects. Holders of DAO Tokens had certain voting and ownership rights in The Dao, as well as a right to receive a return based on The Dao's performance. Applying the Howey test, the SEC concluded that Dao Tokens bore the hallmarks of an "investment contract" and, as such, The Dao's failure to comply with federal securities laws in selling Dao Tokens made its activities an illegal offering of securities.

Although The Dao was not a traditional corporation, and the tokens were not traditional shares or membership interests, it is not too difficult to draw parallels between The Dao's actions and those of a corporation issuing shares, with shareholders using their voting rights to influence the corporation's activities and reaping the profits of those activities through dividends declared on those shares.

The SEC's approach in The Dao clarifies that the uniqueness and novelty of cryptocurrencies and ICOs does not render them immune from traditional securities laws. When determining whether a particular ICO triggers the application of securities laws, the SEC may look beyond labels and focus instead on whether "the economic substance" of the transaction is akin to that of "a conventional securities offering," which will typically be the case where the token is being sold as part of an investment to develop a particular enterprise, "represents a set of rights that gives the holder a financial interest in [the] enterprise," and where the primary motivation for purchasing the digital asset is the potential investment return rather than the intent to use the digital asset to obtain goods or services.3 Therefore, the absence of labels traditionally associated with securities offerings, such as "shares" or "Initial Public Offering/IPO," is not enough to take a transaction that otherwise bears the hallmarks of a securitiestransaction "out of the purview of the U.S. securities laws."4

According to a recent speech by William Hinman, Director of the SEC's Division of Corporate Finance, the token itself is "simply code" and not a security in and of itself; however, the manner in which the token is being sold and the reasonable expectations of its purchasers are central to the SEC's analysis, and "there are contractual or technical ways to structure digital assets so they function more like a consumer item and less like a security."5

Since The Dao case, the SEC has been fleshing out its position on cryptocurrencies and its approach to analyzing transactions involving digital assets, with Hinman recognizing that "there are numerous implications under the federal securities laws of a particular asset being considered a security"6 and SEC Chairman, Jay Clayton, indicating that the SEC seeks to "foster innovative and beneficial ways to raise capital, while ensuring – first and foremost – that investors and our markets are protected"7 and that investors are able to make properly informed investment decisions. One important nuance articulated by Hinman, which may inform the SEC's thinking, is that "the analysis of whether something is a security is not static and does not strictly inhere to the instrument."8 This suggests that the classification of a token as a security at the time of the token's initial offering in an ICO need not permanently seal its fate, and that the use and characteristics of that token may evolve in such a way as to take it outside of the realm of an investment contract at a future point in time, for example, because it no longer reflects the profits or "entrepreneurial efforts" of a particular group or person. These discussions imply that the SEC may be willing to recognize different types of tokens and that the application of securities laws may depend on that classification.

At one end of the token spectrum lie "equity" tokens, such as the Dao Token, which are typically issued by a single person, entity or a centralized group and whose value is linked to the activities of that person, entity or group and which are purchased with the goal of delivering performance-based returns, rather than a particular product, goods or services. At the other end of the spectrum lie "utility" tokens, which are typically issued on a decentralized network (e.g. the blockchain), whose value does not depend on the efforts or performance of a single or centralized entity, person or group and which can be exchanged for specific goods or services, or potentially used as a currency (e.g., the Bitcoin).

Hinman's recognition that "digital assets can represent an efficient way to reach a global audience"9 and that the classification of tokens as securities is fluid may be an indication that the SEC may be leaving the door open for those wishing to build a blockchain-based enterprise, though insisting that the investor protections brought about by the securities regime be respected. In that vein, the SEC may be signaling a willingness to help companies analyze the regulatory landscape by providing "more formal interpretive or no-action guidance about the proper characterization of a digital asset in a proposed use."10

Footnote

1 See SEC Investor Bulletin: Initial Coin Offerings, July 25, 2017.

2 328 U.S. 293, 301 (1946).

3Digital Asset Transactions: When Howey Met Gary (Plastic), speech by William Hinman, Director of the SEC's Division of Corporate Finance, June 14, 2018.

4 Id.

5 Id.

6 Id.

7 See SEC press release 2017-131 "SEC Issues Investigative Report Concluding DAO Tokens, a Digital Asset, Were Securities."

8 Digital Asset Transactions: When Howey Met Gary (Plastic), speech by William Hinman, Director of the SEC's Division of Corporate Finance, June 14, 2018.

9 Id.

10 Id.

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