One of the biggest issues around ICO’s is that of a utility token vs a security token.
First lets go into what makes a token a security or a utility token.
The main test you should consider is the Howey test, which is used in the USA to determine if a instrument is a security or not.
The Howey test ask’s 4 main questions:
- Is the token an investment of money?
This is why ICO’s only accept digital currency
- There is an expectation of profits from the investment?
This is why in the fine print of properly run ICO’s the purchase of tokens is deemed to be a donation and hence the reason many of the ICO’s are run by non-profit foundations.
- The investment of money is in a common enterprise?
The definition of “common enterprise” has had federal courts using different interpretations. Usually “common enterprise” has been define as one that is horizontal, meaning that investors pool their money or assets together to invest in a project.
- Any profit comes from the efforts of a promoter or third party?
The people involved in the ICO technically can’t make any money from this ICO.
The final factor comes from how profit originates. If the token comes about due to factors outside of the investor’s control then the investment might be a security. However if the investor’s own actions largely dictate profitability then the investment is probably not a security.
I have also been told that the token cannot pay profits, royalties, dividends, have equity, debt, etc. basically any monetary value as this would obviously be a security.
Why a token security is bad
Whats the big deal is the token is a security any way? If the token is deemed to be a security then a number of laws apply then for instance in the US there will be:
- Restrictions around trading the securities
- Rule 144 will restrict issuances around the securities
- Regulation S will restrict selling efforts around the security
See more at wikipedia.
The fact is that much of the appeal around the ICO will be diminished if you have a token security (liquidity, lack of regulation, etc.).
Also the punishments meted out around trading in securities illegally are stiff.
Punishment for breaking securities law
The punishment will depend on the crime and there are a number of different issues that could arise:
- Misrepresentation or omission of important information about securities
- Manipulating the market prices of securities
- Stealing customers’ funds or securities
- Violating broker-dealers’ responsibility to treat customers fairly
- Insider trading (violating a trust relationship by trading on material, non-public information about a security)
- Selling unregistered securities.
There are two penalties that the SEC can issue:
- Civil monetary penalties which are based on monetary fines
- Administrative penalties include cease and desist orders, suspension or revocation of broker-dealer and investment advisor registrations, censures, bars from association with the securities industry, civil monetary penalties, and disgorgement.
In addition local federal law could prosecute as well based on their legal restrictions.