The Legal Requirements For A Compliant ICO In The US Are Unclear – Dror Futter

Bitcoin, Blockchain and the Law, Blockchain, ICO News, Investing, Regulation | April 13, 2018 By:

Rimon Law partner Dror Futter runs The Blockchain Patent Chronicle, a blog which provides timely summaries of developments in blockchain/distributed ledger technology patents. The patents are the earliest public indication of research and development in the blockchain ecosystem.

Naturally, that bully pulpit provides a vehicle for some strong opinions on the state of blockchain and cryptocurrency.

“Unfortunately, 95% (or more) of ICOs give the rest a bad name,” says Futter. “The ICO market needs to overcome two problems. First, outright fraud is pervasive. Much of the fraud is not particularly sophisticated and with limited diligence, investors should see red flags.  Second, the legal requirements for a compliant ICO in the US and many other jurisidictions are unclear and as a result, there is a high likelihood that many existing ICOs, including ICOs that involved reputable counsel, were completed in violation of securities laws.  The SEC has a powerful arsenal of enforcement tools and whether and how it utilizes these tools against non-compliant ICOs is the $6 billion question.”

Futter talked with Block Tribune about where the blockchain and ICO sectors appear to be heading.

BLOCK TRIBUNE: There’s a statement from you claiming 95% of ICOs give the rest a bad name. How is that? Is fraud that massive?

DROR FUTTER: I think 95% is a bit tongue in cheek, but probably not by much. I think you have two main sources of the problems when it comes to ICOs. The first is just right up front, and, you know, there has been a lot of people just launching tokens being in no position to deliver on any of their promises and, in extreme cases, vanishing. Or making outlandish promises that they can’t keep. And then there’s a second category. Most of the enforcement until now has gone after those actors. And even there, the number of enforcement actions is kind of the tip of the iceberg, given what’s out there.

And then there’s a whole second category of ICOs, and I can’t give you a sense of dollar value of one category versus the other, but it’s a large category of ICOs that were issued as, quote: “utility tokens,” which the SEC has made pretty clear it views as securities. And as a result, anybody who issued tokens as a utility token and that the SEC has a different view of it, they have now issued registered securities. And that opens up the issuers and their advisers and promoters to a whole range of potential and enforcement actions by the SEC, not the least of which is an investor right, what’s called rescission. 

BLOCK TRIBUNE: So, when will we start to see the fruits of that?  We’ve seen a few, but what do you expect later this year? Is there going to be a massive wave of SEC prosecutions?

DROR FUTTER: The SEC has been kind of been very incremental and cautious in terms of how it’s preceded. So, for example, last month, we got word that they issued a number of subpoenas. They’re gathering a large amount of facts. In cases of rights fraud, as the SEC establishes the factual precedents they need to prosecute, you’ll see more and more of these cases.

Among the quote legit ICOs, the ones who went out of utility token. When I say legit, I don’t mean that they are legitimate. But the ones that aren’t fraud, but just went out as utilities when they should have been securities. That’s the multi-billion dollar question. What will SEC enforcement look like? That could be a range of anything from not prosecuting to the other extreme, which would be treating them as unregistered securities and enforcing the range of options of what it has in forms of enforcement actions. Or they might pick a middle path and say, “We will allow you to remediate your offering if you do XYZ for investors.”

So, for example, there was one shop that actually approached to SEC and published the letter, where they basically said, “Okay, a lot of people issued tokens in an uncertain regulatory environment. We now understand that the SEC views these as securities. Can we create a path of remediation where after-the-fact issuers will be allowed to classify them as securities as long as they appropriate necessary steps to issue them as securities and essentially offer investors the ability to op-out if don’t like what that does to the offering?”

BLOCK TRIBUNE: Most ICOs are based on white papers and a lot of promises. How can you tell whether something is a good ICO or a bad ICO?

DROR FUTTER: I would say there are a couple of levels. On one hand, there is no difference in diligencing an ICO from a lot of early stage investments. My background is in the venture space. And, so, I routinely deal with companies that don’t have long track records and long histories. And that doesn’t mean that they’re going to perpetrate a fraud. And basically, you look for the backgrounds of the team leaders, preferably you want to see people who have done this before. And if not, people who clearly have backgrounds that qualify what they’re supposedly doing. You look to see who their advisers are and if they’re reputable and to the extent they’ve taken financing. You look to see who it’s coming from. And then you look to the white papers. How much of it is really buzzwords and how much of it describes a viable business model.

The one thing I would question is on the legal end. And the chairmen of the SEC has said this on more than one occasion. There has been a lot of, for lack of a better term, bad lawyering. When you actually read a lot white papers and ICO-issuers websites, if you read them carefully, there’s a lot of misrepresentation of what the lawyers have and haven’t said. And there you have to do the homework and find out as much information about exactly what legal input they’ve got. It is very difficult for a US-based attorney to issue a legal opinion as legal opinions are traditionally understood. It says, “Token X is not a security.” If an Ikea is going out as a utility token in the current environment, you need to a lot of diligence in terms of how they’re getting the legal clearance to do that. The chairman of the SEC has made it very clear that he has yet to see one that isn’t the security.

If you’re going against the grain and saying, “No, my token is utility,” you really need to do a lot of homework in terms of how the lawyers got comfortable with that conclusion. And I routinely, when I’m talking to potential clients, I’ll say, “Well, so-and-so says they’re compliant. And then, when you go to their website and you really look closely on how the legal section is phrased, it’s more in the case of we’re getting advice from a really good law firm, but it’s not like that law firm has come out and blessed what they’re planning to do yet.”

BLOCK TRIBUNE: That leads into my next question. There were a number of companies out there that are offering to instantly create a compliant token for you and make it a turn-key operation. What do you think of them?

DROR FUTTER: This has been an evolving space. At this point in time, unless they’re planning to do…if you treat a token offering…I’ll get to kind of the short answer in a second. If you treat the tokens as securities, there’s still ways you can get them out to market. There’s Reg CF, which is the crowdfunding. There’s paths on Reg D506B and 506C where you’re limited to accredited investors. And then there’s Reg A+, which is kind of a mini IPO. There are some technical issues with goin the Reg A+ route, but big picture, those are the ways you can go out as a security. Each one of them has significant issues when it comes to your garden variety ICO. If you’re selling to accredited investors, there would be questions about how you legally handle the subsequent resales. If you’re gonna do a Reg CF, you’re limited to a million dollars. Reg A+ has a number of issues because you’ve got, for example, [inaudible 00:09:52] two years of limited financials, which if you’re really a start-up, is not something that you have lying around.

Each one of these paths to a compliant securities issuance is difficult and not a perfect fit. If somebody is saying that they have a turn-key solution for a utility offering in the united states, I think you have to be very skeptical. Based on the guidance of the SEC, I don’t know how somebody makes that statement today. For all I know, they’ve consulted with the SEC, received assurances from them that their offering will be one of the first. But that’s the kind of thing that I’d want to hear because these promises of turn-key solutions just aren’t there.


DROR FUTTER: And, oh! Just one other thing that’s really important. A lot of ICO issuers, for example, the question I received today was about–again, this is a potential client we we’re working through, and in their case, we may actually be considering a Reg A+ offering; and they forwarded me an article about these guys in Japan who just did a 15-million dollar pre-sale. Now they’re going to be doing a global sale, including the US. The message from my potential client was, “How are they doing this?” And then when you actually kind of focus on the exact words of their press release, they say they have actually hired US counsel to explore how to do it. At the end of the day, everybody is kind of working in the same sandbox. People thought there were paths to do this. And the SCC kind of incrementally recalibrated peoples’ expectations. Are you familiar with a SAFT?


DROR FUTTER: So the SAFT was this almost magical cure to the problem because out like a security and you sold it only to accredited investors under Reg D. And then when you had up in the [inaudible 00:12:41] platform, the amounts you put in the SAFT converted into tokens. The authors kind of really focused on one of the factors of the Howey test, but didn’t solve the overall problem. And I think one of the big changes in the last two months is everybody that I know conceived the SAFT as not likely to pass SEC muster. For a while, you had lots of people broadcasting that they had SEC compliant ICOs because they were using a SAFT, and SAFT was promoted by fairly weighty law firms. But that path most people would say this was as big changer over the last two months or so. Most people understand that this is not the magic answer. And parenthetically, raises significant issues about what the SEC will do with all those tokens that were issued under SAFT. That one’s tough to call.

BLOCK TRIBUNE: Now, what is a reverse ICO? It was mentioned in one of your statements.  

DROR FUTTER: A reverse ICO is a short-hand that some consultants use that hasn’t really gotten great legs, but it’s essentially designed to describe a situation where a company that’s already taken venture capital funding, then does an ICO for additional fundraising. What you have is in an interesting dynamic because you have invested money. They’ve bought stock. And then you’ve got this pool of tokens out there with a lot of question marks around it.

The article that I wrote was really triggered–I’m a member of the Committee of the National Venture Capital Association that maintains model forms for series-A financings. About, I don’t know, 3, 4, 5, months ago, somebody raised the question, “Hey, in investment documents, investors typically have a whole bunch of veto rights when they address an ICO.” And not surprisingly, the answer came back, “No.” The newest edition of those forms that came out in February, actually have a vision that gives investors a blocking vote on an ICO.

When I start thinking about it, I realize that was just kind of the tip of the iceberg in terms of questions. So, for example, in the capital grill, if you will, investors typically get referred rights of return. Which basically means that if the company sold and there’s not enough to ensure everyone’s return, the investors get their money back. Sometimes they get it back with a preferred return on top of it or some other rights. But kind of a general rule of[inaudible 00:16:19]is people who put in cash are usually the ones who get it out first.

And if the company doesn’t sell for enough money, that may mean that founders and employees don’t get anything or are reduced amounts. If you actually get an ICO that is a utility, what you’re doing, essentially, is a prepayment. In other words, you say, “I’m selling you these tokens today, and you can use them to buy product or services in the future.” If that’s the case, then the token holders are essentially creditors of the company. If the company has a liquidation, then, by law, creditors come before equity owners, which means that the holders of the tokens come before the investors in the company. And that’s very scary.

BLOCK TRIBUNE: What do you think is the balance going forward between ICOs and IPOs or venture money? Do you see one or the other holding sway or going up or going down?

DROR FUTTER: I think the entire view of the ICO venture is a bit premature. I think that right now, there’s too much regulatory uncertainty around ICOs to really predict kind of what their steady state is going to look like. And that’s not just because of uncertainty in terms of where the SEC is gonna bottom out on a lot of this. But you also kind of have a global patchwork of countries with different views. For example, Gibraltar has gotten a reputation for being very ICO friendly. So if you do an Gibraltar ICO, and you try to sell outside of Gibraltar, you run up against the national laws of a whole bunch of countries, including the United States. You can try to avoid the United States, which some ICO issuers do, but you still have every other countries’ laws to deal with.

So, it’s a little hard to say, “Okay. This is what the ICO market it going to look like.” High likelihood that there will be an ICO market out there. And it will be a fundraising tool for at early stage companies. In some cases, it will make sense because companies use business models that really are blockchain dependent. The issuance of tokens fits really nicely with their business model. But there is still a whole bunch of ventures out there for whom blockchain is either irrelevant or is something that gets kind of latched on as a means of fundraising.

For the serious ventures, not the one’s trying to take advantage of the hype, they’re not gonna be appealing ICO candidates. They can still be very solid venture capital candidates. The market will fragment with the going to those for whom tokens and ICOs make sense and can be done in a legally compliant way. And for the rest of the market, venture’s not going away.

Let me add just on the last thing I said — I actually have developed might be of interest to you. I get phone calls pretty routinely looking to do ICOs–several times a week, sometimes several times a day. In my own mind, I’ve kind of categorized them in four categories.


DROR FUTTER: At the bottom, you have fraud. And that’s plain and simple. I was talking to somebody yesterday, and by the time we were done digging through their buzzwords, it was like, “It sounds a lot like you’re structuring a Ponzi Scheme.” And his best defense was, “How are we different from XYZ?” And I’m like, “First of all, XYZ doesn’t require you to put in additional money to keep the game going, but I’m not sure XYZ is okay either.” So you have that. We talked about this earlier in the phone call, you smell out fraud from them like you would do any other diligence in the early stage investment.

The second category is what I call “blockchain bolt-on,” which basically means that the business model doesn’t really require blockchain, but you bolt-on blockchain to take advantage of the hype. For most investors, that’s only slightly less scary than flat-out fraud. I’ve seen different reports, but there are staggeringly high numbers in terms of the number of these ICOs that are [inaudible 00:21:47]. Even if you don’t have outright fraud, if you’ve basically just glommed blockchain onto a business that doesn’t need it, you’re gonna fail fast.

The third category up the ladder is what I call “incremental blockchain,” where blockchain delivers value to the business model. It’s note life-changing value change, but it helps the business model work better.

Sitting at the top of the heap is what I call “blockchain but for.” Your things, but for blockchain, could not exist. The reason I got excited about the field is a presentation I heard a few years ago. A guy from Dell was giving the presentation. He said “Listen. You go into an office building, there are all these thermostats. Every thermostat has a processor that basically sits unused most of the day. What if we could create an exchange where the owner could of the building could put all of his processing power online with a smart contract that said, ‘Okay. I’m willing to offer it for these hours at this cost.’ And it would be pennies per processor. And have an exchange where Google, instead of building it’s next data center, could launch it’s smart contracts, and say, ‘If you’re willing to deliver me processing power X for unit cost of Y or below, we’re a buyer.'”

You use blockchain technology to match up the smart contracts and form a contract. And then you used some cryptocurrency to move the payments across, so you didn’t have bank transfer fees because the dollar-value-ready transaction here is too small it would be wiped out by bank transfer fees. Now Google can avoid building its next data center, and the guy who owns the building found a new revenue stream. And that’s what I call a blockchain but for. It’s the kind of thing that, without blockchain, couldn’t exist. And those are some really neat things.

And unfortunately, you don’t see many of those. But when you see one of those, that’s what investors should be looking for–at least my level three where blockchain delivers some incremental value. But the best case scenario: I’ve seen some of it in some different applications where it’s really creating a difference–that you just couldn’t run it without blockchain.