Ekaterina Malyarova (Law&Trust): checking according to Howey test does not provide any guaranties

Law&Trust Company is one of the leading worldwide players in the field of complex legal support for ICO start-ups: today the portfolio of the company exceeds 33 projects.

Ivan Aleksandrov, Managing Partner of Memorandum Capital, had a conversation with Ekaterina Malyarova, Leading Lawyer of Law&Trust, on the topic how to determine the nature of the token and what are unobvious moments in this regard.

IA: Ekaterina, hello. Thank you for agreeing to have a meeting with us. Let's first outline the range of issues that fall within the competence of the legal partner. I would highlight the following aspects:

The first aspect is the question of correspondence of the structure of the token and ICO structure to the legislation of different countries, that is, the question of legality, falling under the regulation, etc. The second aspect is the tax structure and the issue of reducing the cost of raising capital. The third aspect is the design and arrangement of marketing materials: WP, website, video and so on. What can or can not be indicated in the aforementioned? The fourth aspect is the compliance of the start-up with norms that are not directly related to ICO. For example, the GDPR and other rules regarding personal data. The fifth aspect includes the corporate structure, the publication of reporting, financial transparency, etc.

EM: Yes, I think that you have identified all the key aspects for ICO.

IA: There are many aspects, let's define what to consider as the most important. For example, the key point of ICO procedure for a start-up is transfer or conversion of cryptocurrency into fiat money ...

EM: Actually, the process of transferring the cryptocurrency into fiat money is one of the final stages of ICO. It is preceded by many stages, without elaboration of which you can not legally withdraw funds to fiat. From the legal point of view, everything begins with the definition of the legal nature, the essence of the token, which you will offer to future buyers. First of all, you need to decide what it will be: security or utility token.

IA: There are many different tests that allow to distinguish utility-token from security: Howey test, risk capital test, and others. What is the legal significance of these tests?

EM: Many projects believe that Howey test is a test allowing to accurately determine whether the token is a security or utility one, but in fact, this test has an advisory nature, and the evaluation of the token within the test is based on extremely subjective criteria, and the regulator can interpret them in one way in the first case, and in the other way in the second case.
Accordingly, after passing this test, we can only tentatively say whether recognition of the token as a security is possible, or it is unlikely. But the foregoing test does not provide any guarantees, and no one lawyer in either Russia or the US can exactly tell you how a particular start-up will be evaluated by the regulator according to any criterion of Howey test.

IA: Is Howey test universal for different jurisdictions?

EM: Howey test is an exclusively American one. Recently it was modified directly for ICO, but it was developed much earlier, and its purpose was to determine what is an investment contract, that is, whether certain transaction is a securities transaction.

IA: If all existing tests are recommendatory in nature, then what can a start-up tending to get a clear answer to the question about the status of the token do? Is it possible to get it in the state bodies of the country of registration before offering? The question is especially interesting in the context of the recent situation with the MUNCHEE start-up, which was simply forced to cancel ICO and return the money by the SEC: the token was positioned as a utility, but as a result, the features of a security were revealed ...

EM: To get an unambiguous answer, you can apply to the regulator with an application for registration of a security. If the regulator indicates that there is no need for such registration, you can safely position the token as Utility. However, this process is quite long and not many projects legalize their ICO in this way.
Its expediency is to be determined separately in each specific case, and as a rule it is quite easy. By the way, in the case indicated by you it was obvious that this token was a security.

IA: We will shortly return to this case. How do you determine the nature of the token in Law&Trust? Do you use tests?

EM: Of course, we use tests of the most popular jurisdictions: Howey test, Pacific Coin test, and, if necessary, we often conduct additional less known tests. There are several more tests even within the USA. We analyze the White Paper and all the documents that the project can provide. Based on the results, we conclude whether the token is a security or utility.

IA: From my experience I can say that 90% of start-ups adhere to the opinion that if the token does not give the right to passively receive a part of the company's profits, but is used only as an internal cryptocurrency of the created ecosystem, then it automatically is a utility ...

EM: The problem here is not even that start-ups consider lack of profit as a sufficient condition for recognizing the token as a utility, but that for most start-ups the concept of lack of profit is blurred, that is, many think that if a start-up does not accrue dividend for token holders, this means no profit distribution. In fact, the profit from the project can be formed in different ways: trading on the stock exchange, resale and many other ways that do not seem so obvious, but at the same time form a passive income and serve as a source of speculative investment expectations. That is why, these projects most often fail.

IA: Do I understand correctly that the fact of offering tokens on cryptocurrency exchanges can be interpreted by the regulator as manipulating investment expectations?

EM: Yes, unfortunately, this excludes the nature of the token as a utility.

IA: Tell me please, the laws and approaches of which countries should be taken into account when determining the nature of the token? For example, I am a citizen of Russia, a tax resident in Germany, a company is established in Singapore, and tokens issued are purchased by US citizens. Who can eventually come to me with questions about the nature of the token?

EM: In certain circumstances, the state bodies of all the above countries can have questions to you, and in fact, involvement of lawyers is needed for the foregoing in order to calculate the risks that may arise specifically for you at any stage.

IA: Can I be secured with the prohibition on purchasing tokens by citizens of the United States and other countries prescribed in all documents?

EM: If your token has key security features, you have not obtained permission from the US regulator, and simply indicate that US citizens can not participate in ICO, you will incur consequences after ICO under US law. You must take all the measures that depend on you, which will prevent US citizens from participating in ICO. Sometimes even blocking IP addresses is also not enough.

IA: Is it enough to have a confirmation from the user when selling a token that he/she is not a US citizen? Or is it necessary to verify documents?

EM: Ideally, you need to verify, because if a US citizen does take part in your ICO, then you will have to prove that he/she was able to pass through all the obstacles that you set, he/she overcame them and took part. But in general, you will be responsible for the above.
The SEC constantly tightens its policy in the field of ICO, so if you do not obtain an exemption in the USA and do not register with the SEC, then you must do everything possible from you, so that US citizens can not in any way participate in ICO.
The US has sufficient authority to hold ICO organizers accountable, up to their arrest in the territory of another state in some cases.

IA: Clarify, please, if the token has the features of a security, what should be done? Is it necessary to cancel ICO and throw out a white flag or register it as a security falling under an uncountable number of claims?

EM: If the token positions itself as a security, the project should contact the regulator with corresponding documents to understand whether the continuation of work within the framework of the security is possible. In many jurisdictions, such tokens can be offered not as securities, but rather it is possible to obtain an exemption. Sometimes it is enough to notify the regulator in order to offer it to the buyers without a full procedure for registering tokens as a security.

IА: And why then it is impossible to follow this path by default, taking into account those risks, which you mentioned earlier? Well, okay, my token will be recognized as a security, doesn't matter.

EM: Registration in the SEC is very expensive and time-consuming, it takes about six months. Serious demands are made on the company, which will offer securities - starting from ensuring its activities and experience of the founders, and ending with the presence of a full audit.

However, it is often possible to obtain an exemption, i.e. exemption from registration for the offering of securities. This procedure is much easier, a little cheaper, and its successful completion allows you to raise funds from certain groups of investors legally.
There are not so much projects that resort to this, although it is very strange for us. Among the known start-ups, I can name FileCoin, which collected about $250 million with an exemption under rule 506B.

IA: At what point does the start-up have to start thinking about starting the procedure for obtaining the exemption?

EM: If you follow the exemption route, you can apply for it before the entry into ICO and not later than two weeks from the start of the sale. The term for filing documents depends on the exemption, and the simplest exemption has character of a notification, so you just fill out the form and submit it to the SEC. After submitting an application, the company automatically appears in the register of these exemptions and you can not be refuse or allowed, as you notify the state that you want to exercise this right.

IA: At what point does the start-up have to refer to lawyers? Before the first published document, directly pre-ICO?

EM: In fact, the sooner the better, because recently as we see in the case of MUNCHEE, not only legal documents are important in qualifying the actions of the organizers, but also marketing materials, so if you are already go to public with your sketches and promise something, this obviously can lead to certain consequences for you. But the main legal work begins when the WHITE PAPER is prepared, when the main idea is ready and accordingly we can already offer something concrete to the client, because when he does not know what a TOKEN is and what he wants from the project, the lawyers can offer nothing precise.

IA: There is such a question. Many times I faced such ICO structure, namely: when offering a utility token, investors of, let's say, zero-stage, financing pre-ICO get certain privileged conditions. For example, a guarantee of a refund immediately after ICO or even pre-ICO. Does this change the nature of the token?

EM: It depends on what privileges are obtained by those who came at the start, because if they receive dividends and passive income, then the fact that there is 1% of such investors does not change the fact that the token is a SECURITY. If they receive just conventionally more functions for accessing the internal functional abilities of the service, or some other UTILITY privileges, then there is nothing wrong with that.

IA: The question is, do any security privileges make the entire token a security one, even if they are used by a very limited number of people?

EM: Yes.

IA: So it is better to form this kind of relationship with investors of the first round as a venture history or a loan, without tying them to a token?

EM: Yes, many projects follow this path.

IA: What is the legal significance of the disclaimers "the token is not... US citizens are prohibited from..." and so on?

EM: It looks quite funny when the White Paper is full of phrases: “it is passive income”, “you will get 30% every month”, etc. And at the end it is indicated: Our token is not a security. It is funny, because the phrase "our token is not a security" does not change the legal nature of the token in any way. The fact that you write that US citizens can not participate does not matter if in fact they have free access to your ICO. Accordingly, all these disclaimers are more to calm the organizers of ICO, but basically they have no binding legal force.

IA: I heard the opinion that it is necessary to avoid the abbreviation “ICO”, using “token launch” as possible. Why? Does it save or prevent you from something? Does the principle “substance over form” make all these naming games meaningless?

EM: Actually, the answer can be yes and no, because there are so many projects that scatter these phrases, but in fact they are not needed in their legal documents, because their token is a utility, here it is absolutely clear that they need to be omitted, because they attract unnecessary attention of regulators, and there are projects that are really absolutely security ones, but in this case, we also recommend working with wordings, changing the nature of the token and still avoiding direct indications of investment, passive income, ICO. In principle, it is not very good attitude of regulators to the very abbreviation “ICO”, so it causes some negative, and that's why we advise you to refuse it, but, generally speaking, you are right: if the token remains a security, while the formulation of some key terms is modified - this does not save the project.

IA: What marketing materials should be checked by lawyers? Interview? Answers to the questions in the Telegram?

EM: Unfortunately, any marketing materials can be used against you: Chats in the Telegram, Facebook, White Paper, interviews, and publications in magazines, newspapers, and, as MUNCHEE case has shown, even materials that are not prepared by yourself, but rather prepared by other independent actors who simply position your token as a Security.

IA: Let's analyze the case "SEC vs. MUNCHEE". What did they do wrong?

EM: Actually, this case changed the general approach to the utility token. In my opinion, this is a very important decision, because the SEC described in sufficient detail what they do not want to see in the token.
This project, as we know, is an application for writing reviews about restaurants and dishes in these restaurants, and this application should be available only in the US, with organizers selling tokens around the world, which already raised questions, because if you have a utility token, and it can only be used within a certain application that is available only in the territory of one country, what is the point of selling these tokens around the world? Accordingly, there is some other component in the nature of the token.
In addition, the organizers did not hide the fact that this token will grow due to the actions of the organizers themselves, that is, the organizers are developing the project, making it popular, the audience is growing, so the price of the token is also growing.

IA: But this is a general economic law: the demand for a token is growing, so its price is growing.

EM: This is a general economic law, but the SEC interpreted it as one of the criteria of Howey test, that is, the expectation of profit from the efforts of others. The holders of tokens, according to the organizers, would not have any influence on the development of the project, that is, the organizers positioned their project as something that would only gain popularity from the actions of the organizers themselves.

IA: And this is the key point, since most utility tokens can become disarranged due to this item. Eventually, investors buy tokens, hoping that it will grow in price. And why will it grow in price? Because the project will develop, and the demand for the token will grow.

EM: Yes, but the utility token should not grow in price. Because it is a utility to stay within the same price for which you bought it. For this price, you can do something or get some kind of service, but it is not supposed that you will sell the utility token somewhere and gain profit due to the growth of its value.

IA: So after this case, we can already unequivocally say that if the price of the token is supposed to increase, the SEC will treat this token as a security?

EM: Yes, but conditionally, here it is always possible to draw an analogy with Vkontakte votes: if it were tokens, it would be utility tokens. From the fact that the number of Vkontakte users is growing, VKontakte does not have much influence on the growth of the vote price. Accordingly, any utility token should remain within this ecosystem and within the cost that was originally designated.

IA: But the issue of VKontakte votes is not limited, and the growth in demand for votes is balanced by the issue. And most of the issued tokens suggest limited emission. That is, in any case, the growing popularity of the project and the demand for its services will lead to the fact that users will be ready and will buy tokens at a price higher than the nominal. This is the reality of any ICO with limited emission. Not to mention that in the absence of the foregoing, the investor has no motivation to buy a token at an early stage of project development. And the key question is - where is this border crossing of which changes the nature of the token with limited emission? In what plane does it lie? In the plane of positioning the token and marketing wordings or more deeply?

EM: The price increase is derivative and should not be positioned by the organizers of ICO as an argument in favour of buying tokens. The very essence of Utility token does not imply a speculative component. The token is being purchased to use in the network. The increase in price implies the use of a token not for its intended purpose.

IA: I have a question: do such tokens, as you mentioned earlier, in principle exist in reality? Those which always remain within their original value in dollars?

EM: There are few such projects, but they exist and they are the direct expression of the original idea of ICO.

IA: Is the case of Munchee unique?

EM: In fact, there are quite a lot of such cases. In recent years, there have been more and more of them, and I think that it is difficult to find a particular uniqueness in them, because all such projects always face the same problems: problems with unregistered securities or tokens incorrectly positioning themselves as utility tokens?

IA: Can they carry out re-launch of their token? Say, by following the path of obtaining an exemption described by You?

EM: If they get an exemption, they can legally conduct ICO. Exemption is an acknowledgement that your token is a security, but you are getting an exemption from the general rule. You say and presume the following: "I will only sell to qualified investors who understand in what and where they are investing, who understand that they are not giving the last dollar to ICO. I will sell only to them and no one else, I take responsibility that I will check and specifically identify these people, the fact that they are qualified investors", and the SEC informs you that you can not register and you can offer your tokens without appropriate registration. In the case of MUNCHEE, this option is also possible.

IA: Are there jurisdictions where a token like MUNCHEE will be treated as a utility by the regulator?

EM: I think that there are a lot of such jurisdictions, but the question is not only where ICO is carried out, but also the citizens of which states buy tokens, because, conditionally, if they are registered somewhere in the classic offshore and hold their own ICO, but a Hong Kong citizen's will buy token from them, then the following will happen: as we know, there is legislation in Hong Kong that indicates that if a Hong Kong citizen purchases a token, then irrespective of where ICO is conducted, it is considered as conducted in Hong Kong, and all the rules existing in the area apply to the foregoing ICO. Accordingly, from the point of view of the regulator of Hong Kong, the above token is again a security, and there are the same problems.

IA: Thus, there are three solutions.
1) to change the essence of the token
2) to set barriers for citizens of all jurisdictions where the token falls under the definition of a security
3) to obtain an exemption in all these jurisdictions.
Is the foregoing correct?

EM: If to generalize, yes

IA: Ekaterina, at the end of our conversation I will ask you to formulate a few basic simple rules for the reader that will help start-ups not be in the situation of Munchee.

EM: Firstly, remember that no disclaimers and declarations will change the nature of the token
Secondly, involve lawyers at the earliest stage, and the foregoing will allow to avoid irreparable mistakes in positioning own token.
Thirdly, be very cautious about any marketing documents and public statements.
Fourthly, remember that each country will consider your ICO in terms of protecting its citizens in accordance with its laws, regardless of jurisdiction selected by you.
Fifthly, remember that any tests do not provide you with a guarantee in determining the nature of the token, and they can only be considered as a guide or landmark.
Finally, if your token has the features of security-token, do not neglect the possibility of obtaining an exemption.

Source: https://www.memorandum.news/blog/ekaterina-malyarova-law-trust-proverka-...