3 Initial Coin Offering Pitfalls to Avoid
Initial coin offerings (ICOs), also known as token generation events, are an innovative method of capitalization for blockchain startups and experienced developers alike. Coindesk.com’s ICO tracker lists more than 150 ICOs during 2017 alone.
But despite the exuberance with which developers and Internet enthusiasts have greeted the explosion in ICOs, such offerings are subject to significant legal pitfalls for which developers must be prepared.
This article briefly considers three such pitfalls:
- The classification of utility tokens as securities;
- The ways in which white papers can lead to liability; and
- How failure to plan for taxes can derail a project.
1.Utility Tokens Can Be Securities
Virtual tokens can be broadly classified into one of two categories: security tokens and utility tokens. Security tokens are similar to traditional equity interests in a business, affording their holders voting rights or dividends. In contrast, utility tokens are more like coupons, which can be exchanged for products or services.
Most developers are comfortable with the idea that security tokens are securities under applicable law. However, many mistakenly believe that utility tokens are, by definition, not securities. The reality is more complicated, because both security tokens and utility tokens can be securities. This typically happens when the tokens satisfy the four elements of the Howey test:
- An investment of money
- In a common enterprise
- In which investors are led to expect profits
- Predominantly from the entrepreneurial or managerial efforts of others.
To avoid classification as a security, developers must ensure that their token will not satisfy at least one of the above elements. They can do this by, for example:
- Only selling the tokens when the platform on which they will be used is completed. If the utility tokens are actually functional at the time of sale, then it will be likely that any expected profits are the result of diverse market factors, not the entrepreneurial or managerial efforts of others.
- Providing users with meaningful entrepreneurial or managerial control over the fate of their investment. If token-holders are given a sufficient degree of influence over the token’s success, it will fail the “efforts of others” element of the Howey
2. White Papers Can Lead to Liability
It is customary for an ICO to be accompanied or announced through a white paper published by the token’s developer. In general, the white paper introduces the development team, describes the token and its implementation, and includes terms and conditions or legal disclaimers.
White papers can lead to liability in at least the three following ways:
- White papers and Howey. Courts and regulators will rely in part on the representations in a token’s white paper to assess whether the token is a security. This was the approach of the Securities and Exchange Commission (SEC) in its report on DAO Tokens, for example.
- Too many—or too few—disclosures or disclaimers. Determining what disclosures and disclaimers to include in a white paper is a balancing act. If too many are included, so that the white paper resembles a private placement memorandum, regulators may classify the token as a security, even if they wouldn’t have otherwise. On the other hand, if the token is a security, then omitting certain disclosures or disclaimers may be illegal.
- Consumer-protection laws. As promotional material, the white paper must comply with state and federal laws prohibiting the use of false advertising, fraud, and other deceptive practices. Failure to do so can lead to significant civil liability, often including a multiplication of actual damages, plus attorneys’ fees and court costs.
3. Unexpected Taxes Can Derail a Project
In 2014, the IRS released guidance stating that virtual-token transactions would generally be treated in the same way as transactions involving other property for tax purposes. For virtual-token developers, this means that any funds raised through an ICO will be taxable income to the developer.
Without proper planning, the income-tax liability resulting from an ICO can cripple a developer’s ability to develop the token or the platform on which it will be used. However, by understanding how U.S. tax laws apply to ICOs and planning for them effectively, the taxes due can be greatly reduced.
Initial coin offerings present an innovative and exciting approach to capitalization for blockchain startups. But they also pose significant legal risks for inexperienced developers. From classification as a security to violation of consumer-protection laws in drafting the white paper, to an unanticipated tax bill, developers must work closely with a knowledgeable blockchain attorney to avoid the pitfalls of an ICO.
Those interested in learning more about avoiding ICO pitfalls should contact the blockchain attorneys of Dilendorf & Khurdayan, a New York City law firm committed to helping startups and others successfully engage in ICOs and other innovative forms of capitalization.
Other ResourcesALL ARTICLES
Our Founding Partner
Max Dilendorf is an internationally recognized authority and pioneer in legal issues involving cryptocurrencies and blockchain technology. Max is an early adopter who joined the blockchain industry in 2016. Max was named a 2018-22 New York Metro Super Lawyer in digital asset and cryptocurrency law practice. ...Learn More
Adam is one of the nation’s leading young whistleblower lawyers. He brings with him a special ability not just to litigate, but to investigate – and understand – complex organizations and transactions. His extensive familiarity with tech issues is built on a computer science degree and work as a ...Learn More
Bari Zahn, Esq.
Bari Zahn has nearly 20 years of experience practicing at global law firms in New York. Bari has represented a broad array of multinational clients on U.S. and cross-border transactions. She has supervised legal teams worldwide and has extensive management experience as the Founder, former CEO and General ...Learn More
Steve contributes extensive business and problem-solving experience to challenges that may require litigation – or may help avoid it. Indeed, his perspective on litigation is influenced by his experience as a three-time internet start-up CEO.
Steve served on Ronald Reagan’s 1980 presidential campaign ...Learn More
Pamela A. Fuller, Esq.
Pamela A. Fuller is a corporate and international tax attorney, with over two decades of experience. She advises a wide range of clients–including private and public companies, joint ventures, private equity and hedge funds, C-Suite executives, private U.S and foreign individual clients, and government ...Learn More
Ivanna has 7 years of law practice in Europe, namely in the field of corporate law, M&A transactions, banking and finance. As a senior associate, she advised local, EU, US and multinational clients with respect to their business activities in Ukraine.
Particularly, Ivanna, together with junior associates ...Learn More
Robin Gerofsky Kaptzan, Esq.
A New York licensed attorney with three decades of legal and business experience in the U.S. and Asia, Robin recently joined the law firm as a partner and leads the Asia-Pacific practice.
While acting as an international business lawyer and global corporate general counsel, Robin is sought out by clients ...Learn More
Julia joined Dilendorf Law Firm in 2021. She handles all aspects of firm administration while providing paralegal support and litigation management. Julia also has a broad base of knowledge in human resources and communications.
Prior to joining Dilendorf team, Julia worked as an administrative assistant ...Learn More
Craig S. Redler
Craig S. Redler has held positions with Amicorp in its offices in Auckland New Zealand and Miami Florida, and Southpac Trust International, Inc. with offices in the Cook Islands and Tauranga New Zealand. His responsibilities included serving as Trustee for off-shore trusts settled by high net-worth clients ...Learn More
Sharon Kaye Mauer, Esq.
Sharon Kaye Mauer’s practice focuses trusts and estates and corporate law.
Sharon has practiced law for twenty year. She helps navigate her clients through various aspects of estate planning, such as wills, trusts, probate and administration, powers of attorney, and health care proxies and ...Learn More