2017 was the year of the Initial Coin Offering or “ICO”. I believe 2018 will be the year of the Security Token Offering or “STO”. What does this even mean, and why should you care?
THE ICO’s LATENT DEFECT – ITS A SECURITIES OFFERING
Prior to 2017, the ICO was rare. There was the Ethereum ICO in 2014, which raised the equivalent of about $18 million. The Ethereum ICO spawned the DAO in 2016, a decentralized corporation intended to have decision making baked into a smart contract. The idea was novel, but it crashed and burned terribly. The DAO ICO raised the equivalent of $150 million in minutes.
The market took notice. The ICO appeared to be an exciting new fundraising tool that allowed entrepreneurs to raise money without all the hassle of regulation.
There were over 700 ICOs in 2017, which raised the dollar equivalent of approximately $5 billion. Most projects were pretty scammy. Crypto after all, is the wild west of capitalism. All an entrepreneur needed to do was attach a “blockchain” feature to a project, no matter how tangential, and integrate a crypto token. Voila! Instant riches.
For entrepreneurs, the ICO was the holy grail. It had the potential to raise millions – or hundreds of millions – based on little more than a website and a white paper. It was fast, and because everyone thought it was unregulated, entrepreneurs could raise funds no strings attached.
Investors love ICOs too. Lured by the prospect of making hundreds or thousands of percent returns, ICO offerings were scooped up with both hands.
The problem was that, at least in the US, ICOs fall squarely within the ambit of federal and state securities laws. Basically any fundraising tool, where investors expect to receive profits from the efforts of others, constitutes an offering of securities. And those securities cannot be sold or traded without registering the offering with the SEC, or unless the offering is limited to “accredited investors.” This is a gross oversimplification, but you get the idea.
Lawyers advising their ICO clients knew this. But because the SEC had not yet made a pronouncement, and no court had considered the issue, entrepreneurs didn’t care.
So to make sure ICOs were “compliant,” the lawyers got creative. ICOs started disclaiming that their tokens were securities or that investors were seeking a profit. They described their offerings as “donations” and token allocations as gifts. Reciprocal gifts… yeah right. ICO projects set up various entities in jurisdictions such as Estonia, Switzerland, and Singapore. The thought was, if you can keep the fundraising aspect of the ICO somewhere outside the US, the securities laws wouldn’t apply.
Some lawyers came up with a creative work around called the Simple Agreement for Future Tokens or SAFT. The SAFT is an investment contract whereby accredited investors fund developers to built out a token project. Once the project is complete, the accredited investors receive their tokens, and the SAFT agreement is extinguished. Now, assuming the token doesn’t contain a profit generating component akin to dividends, it may not look like a security anymore. It’s just a “utility token” that founders and SAFT investors can later resell.
The thought was to separate enterprise risk (e.g., developers won’t complete the token launch) from the product risk (e.g., the risk that no one wants to use the token). Enterprise risk is the type normally undertaken when you invest in the regular stock market and is the province of securities regulators. You give your money to someone else who hopefully turns it into something more valuable. But once the decentralized network is launched, investors aren’t relying on the founders anymore.
There are huge factual and legal limitations of the SAFT that will be the focus of a future post. But in essence, the SAFT attempts to create a Rube Goldberg model of compliance that may not hold water if (when?) tested in the courts.
Then in July 2017, in the heart of the ICO boom, the SEC issued its Report concluding that the DAO constituted an illegal offering of securities. After some ICOs crashed and burned, the investor class action lawsuits came. By January 2018, SEC Director Jay Clayton told Congress that “I believe every ICO I’ve seen is a security.”
This creates a tremendous amount of uncertainty in the ICO space. It’s a problem for token issuers because the Securities Act of 1933 allows investors to rescind their investment and get their contributed funds back. And unregistered securities cannot be listed on US based crypto exchanges, forcing investors overseas.
So to keep the money flowing, investors can attempt a SAFT-type ICO, or simply block contributions from US based IP addresses. There has to be a better solution.
THE SECURITIES TOKEN OFFERING (STO)
The entrepreneurs who solve the problem of effectively tokenizing securities will be fantastically wealthy. If you think about it, ICOs were attempting to bring the capital markets to the blockchain. We saw a small taste of this with the ICO boom, flawed as that model is. But there is an ocean of capital that is ready for the move.
The solution will have to work with existing securities laws, not against them. It has been coined the Securities Token Offering (STO). One project, called Polymath, may have the answer. They are developing a project to tokenize securities. This includes traditional offerings such as stocks and bonds. How are they doing it? By using Ethereum based smart contracts to bake compliance into the token itself. I wrote a post on it here.
This isn’t an advertisement for Polymath (I have no affiliation). But the project is gaining a lot of traction. They currently have more than 50,000 investors cleared to purchase securities issued on the platform. And even more impressive, at the end of January 2018, Polymath had a cue of more than 17,000 companies waiting list their shares.
I’m excited to see how it all plays out.
SOME STATES MAY CONSIDER THIS AN ATTORNEY ADVERTISEMENT.
I am not your attorney and this is not legal or investment advice.