Blockchain Tokens: From Utility to Equity (Podcast)
Summary: Blockchain cryptocurrencies are anticipated to change from utility tokens to equity tokens in order to comply with SEC guidance which apparently has worldwide reach. Equity tokens may assume an already developed form of security such as a Regulation D offering until possibly other forms are developed approved by the SEC for tokens.
The Blockchain Report – From Utility to Equity – How ICO’s Will Change for the SEC
Ian: [00:00:05] Welcome to The Blockchain Report sponsored by Sun Fund. I’m Ian McGrady [Director of Communications for Sun Fund] I’m here with Scott Licamele [Co-Founder of Sun Fund]. How are you doing?
Scott: [00:00:10] Very well, how are you today?
SEC Guidelines Affect The World
Ian: [00:00:11] We’re going to talk about security tokens and what type of security a token offer can become. We’ll start by looking at a statement that was made by the FCC Chairman Jay Clayton on December 11th of last year and he said by and “By and large the securities of initial coin offerings that I have seen promoted involve the offer and sale of securities and directly implicate the securities registration requirements and other investor protection provisions of our federal securities laws.” Now, what does that mean? Because some of these ICOs are located in other countries. Does the FCC have the ability to reach into other countries and make them do things that they think are right for the American public? The answer may be here: in an article published in the D & O Diary author Kevin Lacroix says “U.S. federal securities laws are oddly idiosyncratic and drafted as laws of inclusion rather than exclusion. In other words, the US Federal Securities Laws broadly apply to everyone in the world with exceptions being available to the extent the person or organization in question does not actually tend to act in the U.S. or with U.S. persons or companies. U.S. federal securities laws even define a person broadly not limiting the definition to US citizens.”
Ian: [00:01:47] So Scott that sets the stage for this discussion on the distinctions that the FCC is making in the ICO world: Basically a lot of ICOs sort of say “oh hey this is a utility token” and it seems that the opinion of the SEC is that for the most part (not all) but for the most part some of these tokens that are saying that they are utilities may actually be behaving as securities.
Blockchain Utility Token vs Blockchain Security Token
Ian: [00:02:15] So what’s the difference between these two types of tokens and then we’ll go into the security side.
Scott: [00:02:19] The principle difference is the concept “utility token” was devised by issuers doing/conducting Initial Coin Offerings specifically in my personal view to circumvent securities regulation. So basically it’s a new way to raise capital for a new tech space if you will which is blockchain technology or cryptocurrencies that are generally connected to blockchain technology applications. The goal of the ICO, the concept of the ICO, was to replace the IPO and essentially eliminate all regulation and allow for a global liquid flow of capital between investors and technology development teams looking to build these new blockchain technology platforms. The concept of utility token, the purpose of it as such is to basically argue that the token is not a security and therefore should not be regulated as such in whatever location or domicile that the issuer is located in. So I think that’s it. And so a security token would mean just it is defined usually by a regulator as a security — could be a bond, could be a stock — that’s not the point. The point is it needs to comply with some form of regulations depending on what type of security it is.
Ian: [00:03:33] …And there’s this thing called the Howey Test which we’ll post in the show notes…
Scott: [00:03:36] If an investor purchases a [blockchain] token with the expectation of either the token price going up so that they have a return on their investment or some kind of dividend or payment, you know, — cash flow stream, whatever it might be — then that’s an investment and therefore it is a security token.
Scott: [00:03:54] Now obviously anyone investing as far as I know in an ICO has the expectation that the token value will increase so that they can sell the token for profit which by definition makes it a security. And I think that was the whole point of the FCC guidance and I think that’s why US insurers are realizing OK we need to do these ICO’s as actual securities offerings that comply with existing rules because they have not yet devised new rules governing ICOs.
Ian: [00:04:21] Not all tokens are going to be considered security tokens but some of them may have to reinterpret their offering because some of them may actually be behaving as security tokens. But some there must be some utility tokens out there that are purely utility tokens and, good for them and they’ll they will not be affected by this force at work that we’re describing.
Scott: [00:04:45] I think that’s clearly the minority of [blockchain] tokens. You know, I think there are there are some that really are legitimately utility tokens but that’s a very very small number. And I think the guidance and all the main markets — I mean let’s just assume OECD countries, G8 countries, we’re looking at know they’re being defined as securities.
Ian: [00:05:02] Is that the plan to sort of shoehorn the tokens into one of these existing forms of security?
Scott: [00:05:10] Yeah I think absolutely that’s correct. And I think it can be looked at in a very basic way, you know, from an investor perspective. So if I’m if I’m looking at these things saying OK I’m going to buy I’m going to participate in an ICO. And let’s assume that the issuer like in our case is based in the United States is issuing a security to comply with FCC guidance and regulations or at least current guidance. Then the question is OK, what is it? Is it a stock or is it a bond? Is it equity or is it fixed think what is it and how do you define it? I can speak to that but I think that would be the first step is it is a security but obviously it’s quite … it could behave differently depending on whether it’s classified as a stock or a bond.
Ian: [00:05:51] OK, and I can throw in definitions from the internet for those things into the show notes. But what do you think will be the most likely category that these tokens will fall into?
Scott: [00:06:06] Sure I think the trend is going to be toward the registration of ICOs as either common or preferred equity shares until the S.E.C. comes out with guidelines that specifically govern tokens which they haven’t done and they are not really saying they’re doing anytime soon. So if that’s the case you kind of have to choose your lane so to speak and decide as an issuer.
Ian: [00:06:32] And what about preferred equity preferred shares usually pay some kind of a dividend. Can tokens pay dividends?
Scott: [00:06:39] I think in some cases you’ll see preferred shares being or other [blockchain] tokens registered as preferred equity shares are described as such.
[00:06:47] Not so much because of the dividend that would be guaranteed or not guaranteed but paid out as a percentage of net income or whatever the calculation would be. But instead, it has to do with legally defining the token holder or preferred token holders rights related to things like liquidation.
[00:07:07] So for example if you invest in an ICO that is defined as a utility token meaning that it is not registered as a security anywhere, and let’s say for example that issuer says hey we’re developing an asset backed token or maybe a commodity backed token like gold or real estate or whatever — If there’s no definition of the token, in other words, there’s no legal definition then the investor technically has no rights like no liquidation rights in the case of dissolution of the entity or what-have-you. So that’s where a preferred token or a preferred equity share masquerading as a token if you will…
Ian: [00:07:45] So Scott, there are preferred equity shares and preferred equity shares pay a dividend. Can a token behave like that?
Scott: [00:07:50] There can be [blockchain] tokens that theoretically could target a particular return. In the case of a dividend it’s not a guaranteed payment but it defines things like liquidation rights for investors so I think it’s important to understand that if you have if you’re looking at a token specifically a utility token that for example claims to be an asset-backed [blockchain] token the investors should note that assuming it’s a utility token by that I mean specifically that it is not registered anywhere as a security in any market in the world which is probably about 90 9 or 98 percent of the tokens that are out there in terms of the total float then the investor has zero legal rights to the assets backing the token because if it’s not if there’s no like legally defining offering document or what have you then it’s impossible to know what your rights are or what your liquidation rights are. You know where I mean where you are in line in the case of the entity being dissolved and you do actually have a claim on the assets that backed token or is it just all hypothetical white paper which is not a legally binding document.
Questions to Ask About Blockchain Tokens
Scott: [00:08:56] If I were looking from an investor perspective the first question I would ask is OK I own a utility token however utility tokens meaning tokens that are not registered as securities in any market whether it be the United States or some other country. The question is — is my investment potentially at risk because of that? And my personal view is: yes your investment is at risk, because the SEC can indeed engage in enforcement actions beyond U.S. borders. They specifically focus on entities that issued there that conducted an ICAO where U.S. investors purchased the initial offering. And that’s why you’ve seen a lot of ICOs prohibit U.S. investors from participating because they’re trying to avoid that.
Scott: [00:09:41] The problem with that strategy is that even if an American investor does not participate in the initial coin offering if they subsequently begin to trade the token on an unregulated exchange then it is equally relevant to the SEC from an enforcement perspective to go after the issuer to say wait a minute maybe they didn’t buy it at the initial coin offering but they’re trading now and it’s an unregistered security. So you’re in violation. And what does that mean? Why should I care as an investor?
[00:10:12] Well if you raise 10 or 20 million dollars in an ICO and you’re sitting in I don’t know… Eastern Europe somewhere. And then let’s assume that a bunch of U.S. investors begin trading your token and then let’s assume that the FCC subpoenas that team in some respective country outside the United States the potential of millions of dollars that would need to spend on the legal and other measures would — to mention the time and effort of the team to have to address such a complex issue — would be I think detrimental to the development of the technology if you will for the team. And so I would be very concerned about that because I think what you’re going to see is because there are no rules or regulations governing really anything. And frankly when NYCO an issue or raises capital there are effectively no rights that the investors have because technically it’s not a security if suddenly they’re hit with large you know legal or other actions. It’s really difficult to say what the outcome would be.
How the Blockchain Token Market is Changing
[00:11:15] The market’s evolving. There was a crescendo of activity in 2017. The market was completely unregulated. You had huge amounts of capital flowing in and out of all these tokens. And I think that will continue to be the case. But what you’re seeing now is regulators stepping up saying hey you need to have some compliant behaviour issue in accordance with the spirit of our regulations in each respective country at least the major developed countries that we’re talking about. And you can conduct your ICO in a responsible manner.
[00:11:46] Investors know that their rights are protected and that the issuer has complied to the best of their ability with SEC guidance that’s reasonable. And frankly if I were looking from an investor perspective I always would want to know that. I would want to understand what exactly am I’m buying, what am my purchasing?
[00:12:05] In this gap between missing regulations for ICOs and what ICOs can do in order to meet the FCC halfway at least until these things become officially regulated maybe on an official exchange or something like that — the offerers can register an offer with the SEC at the very least. Is that right?
[00:12:33] Yeah. In other words, let’s assume that you’re an issue in the United States — or really anywhere — wishes to engage U.S. investors, they can register their offering as a Reg A Plus, as a Reg D, as a Title crowdfund. I mean there are there are multiple multiple options available that are you know compliant enough based on sort of the limited guidance.
[00:12:55] It’s very important to distinguish between registering the offering and where that token is trading. Because in other words, tokens trade on unregulated exchanges. Now there are a number of U.S. entities that are developing platforms known as alternative trading systems that will basically allow tokens to be listed in an online marketplace that is compliant with U.S. securities rules or regulations. So just imagine eventually you know a year from now or whatever it might be that you’ll log into your eTrade or Schwab account and you’ll see a bunch of registered security tokens that reissued in the United States. Trading on a specific platform just like a regular stock ticker. That’s that’s how they’re going to trade.
Ian: [00:13:38] A lot to think about for token holders today. Scott thank you very much for joining us this morning on The Sun Fund Blockchain report.
Scott: [00:13:46] Thank you. Have a good one.