As blockchain technology continues to mature, issuers today can launch a security token more efficiently than ever. However, while there are many tools on the market that can help you issue a token as a security, most of these tools fall short, leaving issuers to handle the liability and token compliance on their own once the asset has been sold.

This article should not be considered legal advice, but will hopefully shed light on a few important questions as well as examine seven key myths that we see persist among management teams planning to issue a token.  

1. Securities Legislation Targets Issuers

Securities legislation doesn’t exist to make the life of an issuer difficult—tokenized security or otherwise. Regulators have a duty to ensure market stability and, more importantly, investor protection. This means that what matters to regulators is not whether the issuing business is headquartered in the U.S., Singapore, Switzerland or anywhere else, but rather whether a U.S. citizen is able to own the asset. The responsibility falls on the issuer, as well as their advisors, to ensure that their tokens are not held by U.S. investors.

2. Compliance Continues After The Sale

Compliance is not about checking off boxes—it isn’t a form or application that can be filled out, submitted, and later tossed into the trash never to be seen again. Compliance is an active and stringent regulatory mechanism that is favourable to both issuers and investors.

This is easier to manage when assets are controlled by broker-dealers or other centralized entities but becomes increasingly difficult to manage when these assets are decentralized, moving peer-to-peer or being exchanged on one of dozens of crypto exchanges. Research shows that $2.5 billion of dirty Bitcoin alone has been laundered through these platforms.

The token launch market has had an especially hard time with this concept, as many ICO and STO platforms claim to help you with launching your token or coin, often brazenly plastering “compliant” across their sites and messaging without following these regulations themselves. Once your project has created and issued a digital asset, it is your responsibility and liability to ensure it stays compliant with regulations in perpetuity.

iComply offers compliance solutions for token issuers, including KYC/AML,
audited smart contracts, and access to leading legal, tax, and
business development support for over 150 countries.

3. The Reach of A Regulator Stops at the Border

While issuers have free rein on where they plan to launch their token, even more critical is where the investor is located and whether or not the token is considered a security by the standards of the regulatory bodies in question. (It is not based on whether the issuer decides to name it an ICO, TGE, STO, or otherwise.)

If the SEC determines the token is indeed a security, very likely action will be taken sooner or later to protect U.S. investors. Potential steps towards remediation may include rescission offers, forking or burning problematic tokens, and self-reporting to the SEC. The tokens created in traditional coin offerings are simply not capable of meeting these requirements and may need to be replaced or rehabilitated before they can continue to be traded without regulatory action.

Did you launch a token that is now facing regulatory action?
iComply offers compliance rehabilitation software to transform previously issued tokens into compliant security tokens.

Interestingly, the SEC’s very first investigation into blockchain finance was of The DAO, an entity situated outside U.S. borders. As such, issuers should have a strong understanding of jurisdictional boundaries and the movement of tokens on peer-to-peer networks (including secondary trading); once a token has been issued to an investor, the responsibility of that token remains with the issuer.

4. I Have a Legal Opinion Letter

The Howey Test, developed in 1948, is the standard the SEC uses to determine what is considered a security and what is not. Certain metrics of the Howey Test, such as ‘the expectation of profit’, are centered on the expectations of investors rather than those of the issuers. Some of the critical factors with the potential to create an expectation of profit are:

• selling the token at a discount (i.e.: during the presale),
• using a fungible token, such as an ERC20, versus the non-fungible ERC721, and
• listing the token on an exchange for secondary trading.

The hard reality is that a simple opinion letter stating why your lawyer thinks your token is not a security bears little weight when (not if) your token or coin is audited by regulators. While regulators in various markets may use slightly different tests, the fundamentals are often quite similar. It doesn’t matter what you call it . . . as the saying goes, if it looks like a duck and quacks like a duck, it just might be a security token.

5. The Best Advisors are Credentialed Experts, Gurus, and Influencers

While experts, gurus, influencers, and advisors abound in the blockchain industry, many of the best resources available tread much more carefully. Top securities lawyers have struggled with the nuances of structuring sound offerings, and experienced accountants have only recently begun to achieve clarification on FIFO vs LIFO (First In First Out vs Last In First Out).

In a market this young, there are few players who can provide the extensive legal knowledge required to navigate the space. This does not mean consultants aren’t available, but rather that due diligence is critical, and it is imperative that the team you build around your offering have the resources and experience to make your token offering successful.

Despite this uncertainty, many of these service providers have been taking on clients in droves, not because they have the expertise but because of a booming market and the opportunity to make good money. Unfortunately, an opinion letter from your lawyer will not protect you; issuers are still liable, and a lawyer will (often) be more than willing to continue collecting legal fees in order to represent that same client, should things go awry. 

6. We Can Wait for the Regulators to Catch Up

As we saw when Mark Zuckerberg, in his testimony to Congress, explained some of the most basic elements of Facebook to a perplexed room of lawmakers, technology clearly has the ability to advance far faster than the laws that govern it. So it is unsurprising that new laws and regulations have not yet been created to solve these problems. Lawmakers and regulators must navigate this uncharted territory with caution.

There have been countless demands for regulators to define a new global framework for tokens—alas, it seems unlikely that a consensus will be reached anytime soon. Fortunately, technology can be used today to achieve the same result by enabling decentralized assets to adhere to current regulations.

We created the iComplyICO platform and Prefacto™ technology to meet this need, to automate and decentralize these processes, providing efficiency and a global reach of decentralized finance while maintaining the compliance standards of traditional finance. If you are looking to launch a token, you can use the iComply platform to manage an unlimited number of offerings, access professional advisors, and connect with investment partners.

7. If It is Not a Security, It is Not Regulated

This may be one of the most prevalent myths about token offerings today. The truth is that the SEC’s jurisdiction is securities. If it is not a security, then what is it? A smart contract could represent rights—or be the actual asset itself—to a security, commodity, or consumer good. Each of these comes with their own regulatory restrictions.

However, regulatory oversight and legislation are only a small piece of the legal puzzle. In the U.S., multiple law firms have filed class action lawsuits on behalf of investors for violations of the Securities Act, and the SEC has begun taking action on those issuers selling unregistered securities, committing fraud, false advertising, and more. While companies that issued their tokens in the early days of the craze did not have decentralized compliance solutions available to them, issuers today do.

Looking Forward

While this list is far from exhaustive — and should not be construed as legal opinion or advice — it details some of the aspects of token issuance that you should be mindful of as you consider this exciting new technology as a way to raise capital, engage your community, and reach new markets.

For these new and future issuers, we are likely to see more and more tokens issued in compliance with current regulations, unlocking the doors to institutional investment, larger raises, and more innovative ideas reaching fruition worldwide. Onwards!

Looking for an end-to-end token management studio?

iComply’s token compliance platform, Prefacto enables issuers to capture the value of blockchain asset management with multi-jurisdictional compliance automation for over 150 countries.

Book a demo with one of our specialists to learn more.

“Due to the precision of software and mathematics, cryptocurrencies are some of the most fungible assets in the world.” – World Crypto Index

A dollar is a dollar is a dollar
In today’s world of digital currencies, attention has been heavily placed on security tokens because they are subject to regulation and typically tied to assets with real-life value (real estate, companies etc.). These tokens appeal to investors because real-life assets provide a means to measure the actual value of the tokens, making their value more tangible and potentially more akin to fiat currencies. Ironically, fiat money was once itself backed by gold  – the gold standard meant that banks accepted these notes for gold; however, in 1971 this was terminated and money was no longer backed by anything of real value. When you consider this reality – there may actually be some merit in applying value to tokens over fiat currencies.  

Security Token Offerings
Interest in security tokens has grown significantly, and governments such as the Gibraltar government, are seeking an extension to its license so that it may provide a security token exchange on its servers – which would be centralized. While this initially sounds like progress – this walled garden approach is founded on flawed thinking. The appeal of the crypto market for many is that it is decentralized and is based on peer-to-peer (P2P) networks without intermediaries. Reliance on the Gibralter government or any other government undermines this philosophy.

P2P networks maintain the fungibility of cryptocurrencies because and there is no threat to the value of these assets being reduced arbitrarily in an open, decentralized market. Conversely, centralized exchanges have been known to selectively reduce the value of particular tokens at their discretion,  for example – when a token is of unknown origin the exchange may elect to reduce its value. In the world of fiat currencies, a dollar is a dollar is a dollar…and, currency values should not be reduced – but rather, compliance procedures should be actively implemented.

Centralization Doesn’t Equal Security
Centralization typically means points of weakness regarding security, stability, and a fair market. Most banks operate using a centralized database. It only takes one qualified hacker to code their way through the system and access the information needed to rob people of their life-savings. We also don’t know how “fit” the individual verifying values and transactions really is. The combination of cryptography and “sharing the burden” with a P2P network allows decentralized mediums like blockchain to enforce a secure value transfer.

Programmatic Compliance
There are many ways to enable compliant secondary trading without centralization. A viable alternative to the walled garden approach is embedding compliance into a token during token issuance. By using an accredited issuance platform, regulatory requirements are applied at the token level and this approach does not limit trading to one or few centralized exchanges but instead propagates trading across many decentralized exchanges.

Decentralization Protects More Than Just the Value of Your Tokens
In the early days of the world-wide-web desktop computers communicated directly to servers and other desktop computers. However, with the proliferation of digital giants like Facebook, personal information has become increasingly stored in centralized data banks by third-parties which have resulted in major data breaches such as the Cambridge Analytica scandal, in which Facebook profiles were harvested for the purpose of steering the 2016 political election. Decentralization means that these breaches can be more easily avoided.

Increased security and the ability to trade in larger and more liquid environments all make decentralization increasingly appealing. By removing third-parties the blockchain becomes a trusted ledger where all assets are equal – and wasn’t this the point?

Challenges of Decentralization
From a legal and financial perspective, aspects of decentralization do not come without challenges. For instance, global peer to peer indexing allows anyone to post a buy or sell order, against market rates, using a smart contract to fulfill the order, rather than an exchange. Compliance practices such as KYC and AML, as well as due diligence checks, are necessary to ensure the integrity of the blockchain ledger as a trusted record of trades – especially when the token is determined to be a security.

If compliance is embedded at the token level and value is assigned correctly to each token then trade in-between tokens and value systems offer fungibility in its optimal form. Security tokens and decentralization bring improvements to traditional financial products by removing the middleman from investment transactions. This removal has a ripple effect leading to lower fees, faster deal execution, free market exposure, a larger potential investor base, automated service functions and so on.

A New Source of Truth
The world is changing, decentralization and tokenization are no longer foreign concepts. The traditional and decentralized economies are becoming more integrated, and the preservation of asset-fungibility on peer-to-peer networks is successfully occurring without intermediaries.

Once an asset is tokenized using blockchain it can trade much more efficiently, but this does not eliminate the need for compliance. This means a shift in the status quo and regulations for both traditional and decentralized finance.

About Prefacto
Prefacto is a token compliance tool offering free audited smart contracts, global best-in-class KYC/AML for over 160 countries, source of funds reports to help issuers open bank accounts after completing a crowdsale, and programmatic secondary trade management. Register now: https://platform.prefacto.net/Account/Register

About iComply Investor Services Inc.
iComply Investor Services Inc. (iComply) is an award-winning software company focused on reducing regulatory friction in the capital markets. With powerful data, verification, tokenization solutions, iComply helps companies overcome the cost and complexity of multi-jurisdictional compliance to effectively access new markets. Learn more: iComplyIS.com

So you’ve issued a token, and things seem to have gone off without a hitch; however, that doesn’t mean that your compliance days are over – you’re still responsible for that token and the source of wealth for the person who holds it.

Unchecked secondary trading of tokenized asset opens the door to sanctions violations, facilitation of money-laundering and the ability for bad actors to use your token to fund the next terrorist attack.  

The use of blockchain in finance continues to grow exponentially – from central bank adoption to micropayments – with more successful use cases moving from pilots to production implementations. Perhaps no area has grown as much as the use of smart contracts to create “tokens”, fractional ownership units for private equity, debt, real estate, and funds. 

Awareness and usage of cryptocurrency have proliferated in recent years, with 2017 bringing an estimated $680 million of investment into blockchain assets. However, this dramatic growth was met with an equally dramatic number of scams and security breaches, with $23 million being lost daily due to malicious actors, gaps in compliance or sheer negligence.

This rapid growth comes as no surprise for those that have endured the inefficiencies, redundancies, and even human error or manipulation in the finance industry. These are some of the issues that have pre-empted the dramatic growth of the crypto and digital finance space at large.

Decentralization of financial services meant freedom from bureaucracy, gouging fees and piles of paperwork. Clearly, this was attractive. Financial services haven’t truly been disrupted at this level since the introduction of the banks themselves, which provided a trusted intermediary for transactions.

With Great Freedom Comes Great Responsibility
Despite its benefits, decentralization has also meant little protection for those choosing to engage in the early, wild west days of cryptocurrency. But this all changed forever in June of 2017 when the SEC announced that ICOs could be subject to securities laws.

As an issuer – from the moment you issue a token, you are responsible for that token for the rest of its existence. If an ineligible purchaser or a bad actor takes ownership of the token, perhaps via from one of the many crypto exchanges operating in grey markets or with meager KYC/AML requirements – the issuer is put at risk.

Multi-Jurisdictional Compliance
Running to Malta or the Bahamas also doesn’t change this requirement. One of the biggest knowledge gaps in this market is awareness of the fact that compliance isn’t actually about where the issuer is – but where the investor is. And each new locale – be it national or at the local level (various states in the U.S. have different rules around securities). Even if KYC/AML screening is adequate in one state, the requirements will likely vary and may even take on a different meaning in a different jurisdiction. Politically Exposed Persons Screening (PEP) varies significantly across different nations.  

Hair of the Dog – Programmatic Compliance
Interestingly, it is the same decentralized and public blockchain ledgers that opened the minds of the world to the benefits of decentralization (and gave us the wild-west of cryptocurrency) that also have the ability to technologically surpass the highest standards of compliance, integrity, and transparency of any multinational bank or financial institution.

iComply makes it possible for token issuers and investors to rely on Prefacto™ compliance, which means that the tokens have been developed to commit only those transactions which adhere to the rules that have been programmed into them. These rules could be securities laws for security tokens or other rules required for a particular utility token (eg. Sale restrictions).

See how iComply addresses these issues with a personalized demo.

About iComply Investor Services Inc.
iComply Investor Services Inc. (iComply) is an award-winning software company focused on reducing regulatory friction in the capital markets. With powerful data, verification, tokenization solutions, iComply helps companies overcome the cost and complexity of multi-jurisdictional compliance to effectively access new markets. Learn more: iComplyIS.com