TABLE OF CONTENTS
Introduction
I. Initial Coin Offerings Under Federal Law
II. Initial Coin Offerings Under State Law
INTRODUCTION
Over the years, prudent investors have been conditioned to approach claims that a market sector will experience paradigm shifts due to new technology with healthy skepticism. Like the introduction of personal computers to the trading floor, blockchain technology will cause a paradigm shift across most market sectors – particularly, in the financial industry. Despite blockchain’s promising future as a new platform, blockchain-based currency’s journey thus far can be summarized in two sentences: “Regulation breeds innovation; Innovation breeds regulation.”
As many entrepreneurs and venture capitalists try to innovate to take advantage of blockchain’s market opportunities, they should be prepared to enter regulatory grey areas, especially concerning early investments like seed and Series A rounds and the likelihood that a given blockchain investment would be considered a regulated “security.”
The most common method we’ve encountered that is used by blockchain startups today is conducting an “initial coin offering,” which we will call “Option One.” Option One involves a startup company using an ICO to solicit existing cryptocurrency or US currency, which then converts into new blockchain tokens (“Awesome Tokens”) for use on a later blockchain-based technology platform (“Awesome Tech”).
An alternative “membership-style” investment structure has also grown in popularity and has been deployed by some entrepreneurs in an attempt to “innovate” around federal securities regulations that govern the offering and sale of securities. “Option Two” involves soliciting a “fee” from investors in Bitcoin or US currency in exchange for a “membership” in Awesome Tech, which would operate like a private club.
With respect to Option Two, members would need to participate in growing the blockchain and would be required to mine Awesome Tokens, or give some other investment of labor and time, as a condition of membership. Mining is the process of solving algorithms and verifying transactions on the blockchain. As a reward for solving a given number of algorithms and verifying transactions on the blockchain, a user is rewarded with a unit of virtual currency – e.g., an “Awesome Token.”
This article discusses the general legal challenges associated with conducting an ICO or alternative blockchain-related fundraiser under Florida and federal law. This article is not, however, an opinion letter and is not to be relied on in connection with any securities offering or other fundraising activity. This article is simply an overview of general legal principles based on a general discussion of possible platforms for blockchain-related fundraisings, such as ICOs and membership-style fundraising activities. Developers and users should consult with an attorney who can give tailored advice based on the particular facts and circumstances of a given investment.
I. INITIAL COIN OFFERINGS UNDER FEDERAL LAW
Despite a large body of federal law interpreting securities generally, there is very limited federal case law directly interpreting blockchain technology. To the extent that existing case law and analogous legal precedents are available, we summarize and apply the key legal concepts that we anticipate are relevant. We conclude that Option One would be more likely to be subject to registration under federal law, and Option Two would be less likely to be subject to registration under federal law. Both options, however, contain a remote possibility of exposure to federal criminal law. If both options are subject to regulation under federal securities laws, Florida securities law will likely not apply. However, if not superseded by federal law, Florida or some other state law could apply where investors reside or the investment is sold.
A. Federal Securities Laws
Federal law regulates the offering, sale, and trading of “securities.” Under the 1933 Act, unless a registration statement is filed with respect to a security, it is unlawful to sell or distribute a prospectus (e.g., offering document, private placement memorandum, etc.) for the sale of the security. There are exceptions, however, to this Section 5 registration requirement.
A “security” is defined by federal law as “any note, stock, treasury stock, security future, security-based swap, bond, debenture . . . investment contract . . . [or any] interest or instrument commonly known as a ‘security’.” (emphasis added). The term “investment contract” has been interpreted very broadly. The U.S. Supreme Court’s decision in SEC v. W.J. Howey (“Howey”) is the benchmark test for determining whether a contract is an “investment contract,” and therefore a security.
A security exists if there is: (1) an investment of money; (2) in a common enterprise; (3) with an expectation of profits; (4) solely from the efforts of others, “regardless of whether the shares in the enterprise are evidenced by formal certificates or by a nominal interest in the physical assets used by an enterprise.” All four factors must be present to constitute a security. Each element is addressed in turn.
First Element: Investment of Money
Investment of money may include not only providing capital, assets, and cash, but also goods, services, or a promissory note. Both Option One and Option Two would require a person to contribute their existing assets, whether the assets are virtual currency, US currency, or simply their labor and services. Therefore, the first Howey factor is satisfied.
Second Element: Common Enterprise
There are three approaches to the “common enterprise” test: (1) horizontal; (2) narrow vertical; and (3) broad vertical. Our circuit (the Federal Appellate court that oversees Florida), the 11th Circuit Court of Appeals, has adopted the broad vertical concept of common enterprise. The Court held that a common enterprise exists where “the fortunes of the investor are interwoven with and dependent on the efforts and success of those seeking the investment or [dependent on the efforts and success] of third parties. Further, the requisite commonality “is evidenced by the fact that the fortunes of all investors are inextricably tied to the efficacy of the promotor.” In other words, “the thrust of the common enterprise test is that the investors have no desire to perform the chores necessary for a return.”
Under Option One, the likelihood of a common enterprise depends on how centralized the company’s control over creating, writing and maintaining the Awesome Tech platform would be. If the company gives a great deal of autonomy to Awesome Tech users to develop the blockchain on a day to day basis, rather than a core group of managers, a common enterprise may not exist. Conversely, if the company simply solicits investments, but does not allow investors to participate in autonomous blockchain mining or other operations, a common enterprise may exist. The less reliance an investor has on the issuer’s expertise, the less likely that Awesome Tech will be considered a common enterprise. However, regulators and courts (as well as investors and law enforcement) may interpret the facts and law differently.
Under Option Two, the investors would be considered “members,” and all would be expected to contribute to the operations of Awesome Tech. Therefore, it is less likely Awesome Tech would be considered a common enterprise under Option Two. The common enterprise element is more likely to be satisfied, however, if the Awesome Tech platform is not fully developed technologically when the company first solicit investments, or the creation of the Awesome Tech platform is contingent on the company’s ability to raise investment money successfully as Awesome Tech’s promotor. Again, regulators and courts (as well as investors and law enforcement) may interpret the facts and law differently.
We also note that there is a “circuit split” (i.e., the Federal Appellate courts disagree) on the common enterprise test in a way that has not yet been resolved by the United States Supreme Court. In the event that the U.S. Supreme Court adopts a different view, such as the horizontal common enterprise test that focuses on pooling funds and sharing profits, a future Awesome Tech platform could very likely be considered a “common enterprise.”
Third and Fourth Elements: Expectation of Profits Solely From the Efforts of Others
The third and fourth elements are considered in conjunction with each other. Naturally, most investors expect some return on their investment. The question is whether the investor’s expectation of profit is based solely on the efforts of others. The legal test looks to “the economic reality, focusing on the dependency of the investor on the entrepreneurial or managerial skills of a promotor or other party.” Therefore, “[a]n investor who has the ability to control the profitability of his investment, either by his own efforts of by majority vote in the group ventures, is not dependent upon the managerial skills of others.”
Like the first two prongs, the investor’s autonomy to manage Awesome Tech is critical. If the financial return comes in the form of Awesome Token mined by the investor’s own efforts, or having the ability to trade Awesome Token in a secondary market, then the investment may not meet the third and fourth prongs.
Conversely, if the return is generated from pooled profits, having a repayment interest, having an ownership interest in the legal entity, or a similar investment return that exists primarily by virtue of the company’s, or company’s agent’s, management over the corporation with no other effort on behalf of the investor, the third and fourth prongs are likely met.
Accordingly, pursuing Option One would likely result in meeting the third and fourth prongs because the company would likely be soliciting capital and using the proceeds to build Awesome Tech. There would be an expectation of profit contingent on Awesome Tech’s success under the company’s (or company’s employees’) management. Under Option Two, the company would be selling memberships that have an expectation of profit, but each investor only receives a return based on their own efforts. Option Two likely would be less likely to satisfy the fourth prong.
CONCLUSION
In conclusion, Option One likely meets all four prongs under Howey, and would likely be considered a security. Option Two meets the first and third Howey prongs, but is less likely to meet the second and fourth. Therefore, Option Two may be less likely to be considered a security, on the strict condition that investors are granted significant autonomy and will only generate profit based on their individual participation in Awesome Tech.
B. FEDERAL CRIMINAL LAW
We cannot rule out the possibility that operating a blockchain-related business may trigger federal criminal exposure. Our interpretations of criminal law are for general legal information purposes only and readers should not consider the following information as sanctioning, authorizing, or ratifying any course of conduct the reader undertakes.
Unlicensed Money Transmitting
Potential investors and venture capitalists should aware of a few federal criminal cases that alleged certain virtual currency exchanges are “unlicensed money transmitting businesses” under 18 U.S.C. § 1960.
18 U.S.C. § 1960 reads: “Whoever knowingly conducts, controls, manages, supervises, directs, or owns all or part of an unlicensed money transmitting business, shall be fined in accordance with this title or imprisoned not more than 5 years, or both.” Money transmitting “includes transferring funds on behalf of the public by any and all means including but not limited to transfers within this country or to locations abroad by wire, check, draft, facsimile, or courier.”
Defining “money transmitting” has proven problematic in the context of virtual currency. For illustration, in US v. Murgio, the government alleged that Murgio and his co-conspirators attempted to shield the true nature of their Bitcoin exchange business by operating through several front companies, including one known as “Collectable Club,” to convince financial institutions that Coin.mx – the company in question – was “just a members-only association of individuals interested in collectable items, like stamps and sports memorabilia.”
On the Defendant’s Motion to Dismiss, the Court ruled that allowing the free exchange of cryptocurrency on the platform equates to “transmitting funds” because the cryptocurrency “can be used directly to pay for things or can act as a medium of exchange and be converted into a currency which can pay for things.”
Under Option One or Option Two, the company should not allow Awesome Tech to be used as a “medium of exchange.” The money transmitted via Awesome Tech could be converted into Awesome Token to pay for goods or services exchanged on the Awesome Tech platform, and profit in Awesome Tech could be driven by fees charged on transactions. But, users should not be able to exchange Bitcoin or US dollars for Awesome Token with the ability to instantaneously re-convert the Awesome Token back into Bitcoin or US dollars. (This limitation would not extend to the ability to sell Awesome Token on a secondary market).
While criminal prosecutions relating to cryptocurrency exchanges seem to be limited to secondary charges in cases of money laundering, we would recommend either obtaining appropriate money transmitting licenses, or restricting the ability of users to re-convert Awesome Token back into US currency.
Obtaining a Money Transmitting License
Obtaining a money transmitting license is a somewhat burdensome process. Licensing is controlled by state law. A brief overview of Florida’s licensing requirements is explained in Section II.
Awesome Tech’s parent company may potentially need to register as a money transmitter in multiple states. At the federal level, money transmitters must register with the Financial Crimes Enforcement Network (FinCEN) of the U.S. Department of Treasury. Registration is valid for two years. Once registered, the company would be required to file various currency transaction reports, suspicious activity reports, and other regulatory reports. As Awesome Tech’s business model would involve internet technology, the company would likely need to keep detailed logs to complete cybersecurity-related suspicious activity reports adequately.
Finally, potential investors should consult with a tax professional to assess any potential tax implications connected with operating blockchain technology business.
II. INITIAL COIN OFFERINGS UNDER STATE LAW
Generally, Florida securities law has largely been preempted by federal securities laws. As in federal securities law, there is an absence of Florida case law interpreting blockchain technology. The relevant points that are available are summarized and applied below.
A. Florida Securities Laws (“Blue Sky” Laws)
Florida law defines “security” by statute. Florida has adopted the Howey test, and therefore, the federal law analysis presented in Section A is essentially the same under Florida securities laws. Option One is more likely a security and Option two is less likely a security.
Under Florida law, it is unlawful for any person to sell or offer to sell an unregistered security unless an exemption applies. There are two classes of exemption – exempt securities, based on the nature of security being offered, and exempt transactions, based on the nature of the transaction in which the security is being offered. A security also does not need to be registered if the security is a federal covered security. If the ICO is covered by federal law (“preemption”), such as Rule 506 of Regulation D, then the security offering does not need to be registered under Florida law. Like federal law, exemptions to registration apply. The most common exemption is the private placement exemption, where an issue can sell securities to no more than 35 purchasers in a 12-month period. But, in order to sell securities, the dealer, associated person, or issuer usually must be registered with the Florida Division of Securities.
Based on our research, we could find no cases of Florida Department of Banking and Finance enforcement actions relating to blockchain technology. The closest case we found was an administrative petition seeking an advisory opinion regarding whether a money transmitter license is required to act as a “bitcoin administrator.” The Department denied the request for an advisory opinion on the grounds that the petition lacked specificity without commenting on the substance of the petition.
B. Florida Criminal Law
As we explained in Section I.B., our interpretations of criminal law are for general legal information purposes only and the reader should not consider the following information as sanctioning, authorizing, or ratifying any course of conduct the reader decides to undertake.
One well-publicized case in Miami, State of Florida v. Michell Abner Espinoza, outlines the uncertainty surrounding certain blockchain transactions. In Espinoza, the Defendant was charged with violating § 560.125(5)(a), Fla. Stat. Section 560.125(1), (5)(a), and (5)(b) states in pertinent part:
(1) A person may not engage in the business of a money services business or deferred presentment provider in this state unless the person is licensed or exempted from licensure under this chapter . . . (5) A person who violates this section, if the violation involves: (a) Currency or payment instruments exceeding $300 but less than $20,000 in any 12-month period, commits a felony of the third degree . . . (b) Currency or payment instruments totaling or exceeding $20,000 but less than $100,000 in any 12-month period, commits a felony of the second degree. (emphasis added).
A “payment instrument” means “a check, draft, warrant, money order, travelers check, electronic instrument, or other instrument, payment of money, or monetary value whether or not negotiable. The term does not include an instrument that is redeemable by the issuer in merchandise or service, a credit card voucher, or a letter of credit.”
The Florida criminal law invoked by the Espinoza case is similar to the federal criminal law outlined in Section I.B. above. The judge here dismissed the criminal complaint, however, holding that Bitcoin is not money, and does not fall within the statutory definition of a “payment instrument.”
Under different factual and legal circumstances, such as a shift in federal law that begins treating bitcoin more like currency, a company’s potential exposure to criminal sanctions could increase.
Even in the absence of a shift in the law, a judge or law enforcement official may disagree with the holding in Espinoza, which was not “binding” precedent (i.e., the ruling did not come from an appeals court and a different trial court would be free to disregard the Espinoza holding).
Obtaining A Money Transmitting License
Under Florida law, the company must complete a comprehensive application. The company’s main office must maintain a $100,000 minimum net worth at all times and post a surety bond ranging from $50,000 to $2,000,000. Each additional location must maintain a $10,000 net worth, up to a maximum of $2,000,000. Due to the decentralized structure of blockchain technology, each server that is mining Awesome Token (or even each wallet that contains Awesome Token) could, hypothetically, be considered an “additional location” if enough centralized control exists over the technological vehicle used to mine Awesome Token. In such a case, each location could be subject to the minimum net worth requirements.
Once registered, licensees must submit quarterly reports, an annual audited financial statement, a yearly security device calculator form, in addition to complying with all federal reporting obligations as a condition of maintaining a Florida license.
III. CONCLUSIONS
The analysis of whether an investment is a “security” is largely based on relative degrees of likelihood. At face value, Option Two appears less likely to be a security. If the goal is to avoid registration, Option Two is more likely than Option One to be exempt. Our conclusions, however, are based on our understanding of current securities laws. Given the uncertainty of blockchain technology’s treatment under existing federal law generally, any slight change in a federal law could dramatically change a new blockchain venture’s legal status.
Given the above considerations, venture capitalists and investors should consider conducting a traditional private placement. By conducting a traditional private placement, the investor may be able to avoid the uncertainties outlined in this article. The two most common options are a Regulation D offering conducted under Section 505 or Section 506. As outlined above, conducting a federal Section 506 private placement would likely exclude a company from registration under Florida law as well. This process is very expensive, however, and doing so would not wholly insulate the company from legal claims should the project not turn out as investors hope.
Finally, we also suggest that any potential investor conducts a thorough background review of all persons with whom the investor plans to use or work within their fundraising efforts.
ABOUT VERNON LITIGATION GROUP
Vernon Litigation Group is based in Naples, Florida, with additional offices in Orlando, Florida, and Atlanta, Georgia. Vernon Litigation Group handles all types of financial litigation, including financial disputes involving investment, business, and cyber issues. The lawyers at Vernon Litigation Group have collectively represented thousands of investors in investment disputes and recovered many millions of dollars from purported financial professionals and financial institutions, both large and small. Vernon Litigation Group’s representation related to cyber issues is focused on representing businesses and professionals who have suffered data breaches and representing individuals and businesses in disputes involving emerging technologies, identity theft, negligence, financial fraud, misappropriation of identity, unauthorized transactions, and civil regulatory penalties.
For more information, contact:
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