The problem with established crowdfunding companies is that they are centralised bodies, charging high fees and also influencing the projects. Blockchain-based crowdfunding is set to be a game changer because it decentralises the funding model.
Crowdfunding provides an excellent way for creative projects to find cash. Many small or obscure projects lay outside of the scope of traditional investment. This makes it very difficult for them to get their ideas off the ground. Kickstarter, Indiegogo, and others changed that, by allowing startups to connect directly with potential consumers in order to seek funding.
How crowdfunding works; Most crowdfunding websites allow individuals or companies to present an idea to others, who donate money with no expectation of anything (other than a small token gift) in return. One of the largest crowdfunding sites, Kickstarter, sets itself as a middleman between creative types, who are given approval to present their creative projects on the site to others, who give small amounts of money as donations. For example, an author might give copies of the book to donors, or someone creating a product might give one of the products to those who contribute a specific amount.
Peer-to-peer lending as crowdfunding; Another type of crowdfunding is peer-to-peer lending (P2P), which is basically a way for individuals to get loans from other individuals, at specific interest rates, through an online intermediary. P2P services like Prosper.com must comply with state and federal laws.
The problem with established crowdfunding companies is that they are centralized bodies, charging high fees and also influencing the projects. Blockchain-based crowdfunding is set to be a game changer because it decentralizes the funding model. Blockchain crowdfunding works by allowing startups to create their own digital currencies and sell them. This allows them to raise funds from early investors, while the investors also have the potential to make money if the value of their cryptographic shares increases. Some advocates consider this a more pure form of crowdfunding, because it removes any intermediaries standing between the backers and the startup. It also has the potential to boost new blockchain platforms, because it will give the blockchain community a new way to fund its own projects. It appeals to the more anarchistic blockchain enthusiasts as well, because it allows them to avoid traditional funding methods.
But how does Blockchain Work? Blockchain is a distributed ledger system that maintains a continuously growing record of transactions, or blocks, where each block is linked to a previous block and cannot be altered or reversed once it is added to the chain, and which does not require a central administrator to guarantee the veracity of any transaction. It is essentially a technological solution to the issue of trust in a record or transaction. Blockchain is the underlying technology behind bitcoin, which is a digital token that allows one party to pay another anywhere in the world for goods and services, in some ways like cash. Just like a dollar bill, a bitcoin, once used, permanently passes to another person and cannot be reused or unilaterally withdrawn. With a dollar bill, this is because the bill physically passes to another party; with a bitcoin, this is because the transaction is etched in the public ledger and cannot be undone. Blockchain technology eliminates situations akin to receiving a blank check where there is no value in the underlying account or paying a seller for land that he does not own. Furthermore, because the transaction itself is secure, the cost of the transaction can be significantly lower when compared to traditional payment methods such as credit card payments, international remittances, or any situation where there is a third party guarantor.
What are Smart Contracts? A smart contract is a computer protocol intended to digitally facilitate, verify, or enforce the negotiation or performance of a contract. Smart contracts allow the performance of credible transactions without third parties. These transactions are trackable and irreversible. Smart contracts were first proposed by Nick Szabo, who coined the term, in 1994. Proponents of smart contracts claim that many kinds of contractual clauses may be made partially or fully self-executing, self-enforcing, or both. The aim of smart contracts is to provide security that is superior to traditional contract law and to reduce other transaction costs associated with contracting. Various cryptocurrencies have implemented types of smart contracts.
What is an ICO? Initial Coin Offering (ICO)’s are an increasingly popular method of start-up and other companies to raise capital. Investors participate in the fundraising by transferring fiat currencies, such as US dollar, Euro or cryptocurrencies, such as Bitcoin or Ether, to the issuer in exchange for digital tokens (“Tokens”). Tokens represent a holder’s right of benefit or performance vis-à-vis the issuer. Tokens may also be used (exclusively) for payment to the issuing company for its services or products. Contrary to a traditional initial public offering (“IPO”), Tokens typically do not represent an ownership interest or dividend right in an entity. ICO investors seek to directly benefit from the issuing company’s future business, while investors in IPOs tend to pursue a long-term interest in the value-creation of the IPO entity. The underlying technology of the Tokens is based on blockchain (an electronic distributed and therefore in general fraud-resistant ledger, in which transactions are protocolled in a documented and reproducible way without a central authority) which is maintained by a network of participants and computers. Utilising cryptography to record transactions, blockchains such as Bitcoin and Ethereum process, verify and track the trade of the relevant virtual currency (Bitcoin or Ether) securely across independent network components.
Current legal status of crowdfunding
Under current U.S. federal law, the sale of securities to the public as an investment is regulated by the Securities and Exchange Commission (SEC), and it is illegal to receive a payback on an investment unless the company is approved by the SEC. We are in a situation where it is clear that there are regulations, and these regulations need to be met. Those regulations were designed for an environment that is completely different than the ICO environment. However if you get it wrong you could end up being sued.
But isn’t this just crowdfunding? We ask the community for money and build a piece of software, and if those people like my piece of software, they give us money which will help us to develop it and maybe get a product for themselves?
The fact is, many ICOs are using crowdfunding to raise funding for their companies, and it is a product or service with the ability to trade, however it’s the ability to trade, that makes this whole thing completely different than a physical product like the Pebble watch.
When do securities law apply? The underlying legal question is whether tokens issued by an ICO constitute securities. If they do, complex financial regulations may apply — and many regulators have indicated that they intend to enforce them. If they do not constitute securities, then ICO issuers may fall outside the scope of more complex financial regulations. The answer to that question is likely to depend on the character of the tokens and the relevant jurisdictions’ laws.
On July 25, 2017, the SEC issued an investigative report warning that digital tokens may be securities under the Securities Act of 1933 (the Securities Act) and the Securities Exchange Act of 1934 (the Exchange Act) and, therefore, subject to regulation under the federal securities laws. See Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, SEC Release No. 81207 (July 25, 2017) (the Report). The Report presents significant legal ramifications for certain issuers of ICOs and their intermediaries, which threatens to frustrate some of the motivating rationales for the use of ICOs, namely, the ease of fundraising and the flexible resale of tokens on a secondary basis.
Securities and Exchange Commission v. W. J. Howey Co., was a case in which the Supreme Court of the United States held that the offer of a land sales and service contract was an “investment contract” within the meaning of the Securities Act and that the use of the mails and interstate commerce in the offer and sale of these securities was a violation of the Act. It was an important case in determining the general applicability of the federal securities laws. The case resulted in a test, known as the Howey test, to determine whether an instrument qualifies as an “investment contract” for the purposes of the Securities Act:
“a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”
There are several different Supreme Court cases that tell you if its a security or not, and there are many cases from the lower courts that interpret those further.
Can you call the SEC and ask if you have a security or not? The SEC’s responses would most likely be, that you should analysis your circumstances and consult with your lawyer is he would be in a much better position to determine whether your company does have a security or not.
Can I go to the SEC and request a ‘no action letter’? It’s probably going to take a long time, and you most likely will be less successful and cost more to get a no action letter from the SEC on whether your product is a security or not and if you simply comply with the security laws in the first place.
Bear in mind that the SEC is not the only regulator even though state securities regulators very frequently follow the same definition of whether something is a security or not, but not all of State follow the same view of risk capital.
Another important point to consider is the SEC is not the only plaintiff who can sue you. The people who have invested in the ICO can sue you and they will sue you if something goes wrong. Plaintiff lawyers around the country are collecting lists of ICO’s and they are going to see those investors, in order to convince them to sue the ICO holders.
Why should I care? Now its important to note that, they can sue the ICO Holders for any unregistered offences of the securities act. For example, if your token was a security, which wasn’t registered or made in accordance with an available exemptions, then they can sue the ICO holders to get their money back…with interest…and you can be assured that there are lawyers out there who are planning that right now.
Pre-sales are still Sales. We have been seeing a lot pre-sale and people believe its not a sale of securities. Yes, if your service is taking money and giving people a right, then that’s a sale.
Simple Agreement for Future Tokens (SAFTS) is an agreement between the ICO holders and the buyers for future tokensand those future tokens hold a huge amount of uncertainty. When you compare it to its cousin the Simple agreement for future equity (SAFE) agreements, in a SAFE; you know what you can get in the future, and you know that there’s going to be an investor, and the investors can put together an offering, and its can be of preferred shares and they have certain rights with respect to dividends and voting and anti dilution, while with respect to the SAFTS, there is a huge amount of uncertainty.
Now, lets assume that your ICO is now compliant, regulation CF for crowdfunding has some restrictions on transfer of funds by regs CF securities which means that when you build your smart contract you build it in some way so that it can only be transferred within the first year to the people to whom it’s allowed to be transferred too…and this creates a problem with the whole anonymity issue.
There there’s also the problem that in regulation CF, the funds must be held by a qualified third party or a bank. Smart contracts are not qualified third parties, and this must be clarified when structuring the deal.
Two more regulations that you might comply with in trying to stay compliant;
Regulation D is when you sell to accredited investors only. Those securities are restricted, and using a smart contract, ICO Holders have to find a way of monitoring the identities of the persons to whom the securities are to be transferred too. With respect to reg S, ICO holders are selling securities to people outside the United States.
Section 12 G of the exchange act says that if you have a certain number of shareholders and 10 million in assets then you have to register and become a fully reporting company with the SEC.
In conclusion, securities regulators globally appear to be coalescing on the securities implications for certain digital token issuers and the intermediaries for such offerings. Because of the market’s evolving nature and the distinct possibility of disruptive enforcement action, participants in this burgeoning market should carefully analyze existing and contemplated ICOs under applicable securities laws.
- The Monetary Authority of Singapore (MAS) issued clarification that it views certain tokens as securities under Singapore law. See MAS Clarifies Regulatory Position on the Offer of Digital Tokens in Singapore, Monetary Authority of Singapore (Aug. 1, 2017). The MAS’ guidance should disabuse the market of the perception that the MAS would not deem tokens to be securities.
- The Canadian Securities Administrators issued a notice that stated that many cryptocurrency offerings involve sales of securities under Canadian law. SeeCryptocurrency Offerings, CSA Staff Notice 46-307 (Aug. 24, 2017).
- On September 3, 2017, South Korea’s Financial Supervision Commission, in conjunction with the Korea Fair Trade Commission and the National Tax Service, announced plans to introduce regulations on the trading of digital currencies in South Korea and indicated that “punishments” could be assessed against international ICOs involving the sale of “securities.”
- On September 4, 2017, the People’s Bank of China (PBOC) and other Chinese financial regulators went further than regulators in other countries, calling ICOs an illegal public financing activity and outright banning ICOs in China. (The Chinese language edict may be found here. An unofficial translation may be found here.) As a result of this pronouncement, sponsors should analyze whether they must unwind transactions with Chinese investors and return investor funds. Given the crucial role that Chinese investors have played in the growth of the ICO market and the recent rise in valuations, this sweeping ban may have a chilling impact on the ICO market.
- Also on September 4, 2017, the Central Bank of the Russian Federation warned about the risks of exchanging cryptocurrencies and participating in ICOs. (The Russian language version may be found here. A summary news article may be found here.) The bank stated that, at the present time, it would not allow tokens to be used on official exchanges in Russia.
- The day after the PBOC’s edict, the Hong Kong Securities and Futures Commission (SFC) cautioned that digital tokens in ICOs may involve the sale of securities and therefore would need to comply with the Hong Kong securities laws. See SFC, Statement on Initial Coin Offerings (Sept. 5, 2017).