$20 Billion Reasons: Token Sales, ICOs, Securities, Commodities*

1. $20 Billion Reasons: Token Sales, ICOs, Securities, Commodities* *or, how we made a lot of money, a big mess, and guaranteed lawyers will be busy for the next decade… and maybe ignited a multi-trillion dollar revolution

2. Somehow we went from this:

3. To this…

4. To this…

5. Token Sales, Part I What is an ICO Distributing Tokens History of ICOs Typical characteristics of pre-2017 ICOs Arguments for ICOs: Forman Utility theDao collapse opens the door for the SEC Securities Overview

6. Token Distribution Milestones: 2009: Bitcoin bootstraps & uses mining for distribution 2013: J.R. Willett- premines and pre sells Mastercoin/Omni 2014-2015: Factom/Ethereum token sales Nov. 2015: ERC20 protocol (Buterin, Vogelsteller)

7. Initial Coin Offering Distribution of assets created on a network by controlling party Raise funds Bootstrap network effect Typically conducted without regulatory compliance Sometimes conducting using a smart contract with (or without) a conventional contract Via Internet- Borderless Usually lacking disclosures common to other products Whitepaper instead of Prospectus/PPM Funding obtained used to build system Asset distributed expected to have future use on the system Access to product or service to be available in the future.

8. Token Distribution Milestones: 2009: Bitcoin boostraps & uses mining for distribution 2013: J.R. Willet- premines and pre sells Mastercoin/Omni 2014-2015: Factom/Ethereum token sales Nov. 2015: ERC20 protocol (Buterin, Vogelsteller) April-May 2016: TheDao raises $210mm in Ether (others, add’l $90mm) July 2017- SEC issues TheDao Rule 21 Report 2017- Over $6 Billion raised by ICOs 2014-present: $20billion USD raised overall by token sales 2017-present: “dynamic” regulatory environment 2019: token sales taper off due to regulatory issues

9. Raising Capital By Token Offerings • Tokens may be acquired: • As compensation through the “mining” process • From another holder • Through direct sale: • “Initial Coin Offerings”, “ICOs”, “token sales,” “token launches,” “airdrops” • Through a sale conducted via an exchange • “Initial Exchange Offering”, “IEO”, • Tokens are not a homogeneous asset class • May feature characteristics of securities, commodities, currency units, or a combination thereof

10. Many ICOs were odd, ridiculous, or fraudulent • Dentacoin • Coinye • Useless Ethereum Token • KodakCoin • Petro • BitCoen • SpankChain •  ACChain, Puyin, and BioLifeChain- Shenzhen Puyin Blockchain- $60mm • CryptoKami- $12mm • Savedroid • Prodeum • Alleged Ponzis- Bitconnect • www.deadcoins.com

11. ….and very lucrative: by 2019, $20billion

12. The ICO Epidemic “I have yet to see an ICO that doesn’t have a sufficient number of hallmarks of a security” Walter Joseph “Jay” Clayton III, Chairman, US Securities and Exchange Commission “Telegram is on track to pull in a billion dollars in just four months – long before the product the company is raising money for is even built” The New York Times

13. Securities vs. “Utility Tokens” • Generally debt or equity • Equity: ownership, dividend, participation in governance • Debt: promise to repay • Entity/control of issuer disclosed • Registration or exemption • Disclosures/disclaimers • Offered either via markets or via issuer • Regulated Secondary markets • Typically distributed by broker dealers

14. Securities vs. “Utility Tokens” • Instrument generally not described in financial terms • Limited or no utility at the time of sale • May include a software use license • Sold to fund the development of a system or product • Upon development, instrument will have some utility in that system • Diffuse Marketing- Whitepaper, web site, social media, chat channels/apps. • May include: • Exchange Listing • Value • “Bounties” • Feeder discounts • Listed “partnerships” • celebrity endorsements

15. Argument that Utility Tokens are not Securities? • If a token is structured so that it: can be currently used to purchase goods or services from its issuer, or operate a website or an application of its issuer, as in the case of the so called “utility tokens”, and does not have traditional characteristics of securities, including an expectation of profits derived from the efforts of others, … then the token may not be deemed a security. However, the value of a token may be influenced by the increased demand for services or goods of a token’s issuer, and therefore cause the token to take on securities-like characteristics.

16. Support for the “Utility” concept United Housing Found., Inc. v. Forman, 421 U.S. 837, 852-53 (1975) Facts: Co-op residents sued under securities antifraud claims (‘33 & ’34 Act) in connection with the sale of shares of the common stock of the Co-op housing Corp. To acquire a Co-op City apartment, a purchaser must buy shares of Riverbay stock. The shares could not be transferred to a nontenant, pledged, encumbered, or bequeathed (except to a surviving spouse), and do not convey voting rights based on the number owned (each apartment having one vote). Ownership provided a discount and paid against overall mortgage on property. On termination of occupancy, a tenant must offer his stock to Riverbay at $25 per share, and, if Riverbay doesn’t repurchase, resale capped at original price, plus a fraction of the mortgage amortization that he has paid during his tenancy, and only to a future qualified tenant . Tenants still obligated to pay lease. Trial Court- Not securities, claims dismissed. Appellate Court- Shares were securities. Called stock, conferred benefit in the form of discount on rents.

17. “Utility” concept United Housing Found., Inc. v. Forman, 421 U.S. 837, 852-53 (1975) Supreme Court: Looking at the economic realities of the transaction, the instruments were not ordinary shares of stock No dividends, Not freely negotiable, No voting rights, No appreciation Were purchased to acquire subsidized low-cost housing. Was not an "investment contract" no profit expectation, focus was on acquisition of a place to live.

18. theDao in summary Slock.it creates a decentralized investment club Over 28 days sells DaoTokens for ETH: ~$210mm USD Dao Tokens evidenced control/participation Dao Tokens were actively traded Investment Projects proposed, whitelisted by Curators, voted on by Investors 20% quorum/ majority vote to adopt projects Marketed for investors to obtain a return Hacked/failed after several weeks Resulted in a community wide change to the core ETH software, splintered into ETH/ETC Many angry investors called the SEC asking for help

19. US Securities Law Basics Main federal securities laws introduced in 1933, 1934 ‘33 Act- registration, disclosure to the public in the offering & sale of securities Rule 144 Offering Exemptions (4)(a)(2) Anti-fraud offering provisions ‘34 Act- secondary trading of securities Regulates Exchanges Broker Dealers Self Regulating Organizations- FINRA Provisions against fraud in the markets, insider trading

20. What exactly is a “security” • Under Section 2(a)(1) of the Securities Act, the term “security” is defined as any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.

21. The Securities Exchange Act of 1934 Securities Exchange Act of 1934 Created the Securities and Exchange Commission, - Power to register, regulate, and oversee brokerage firms, transfer agents, and clearing agencies as well as the nation's securities SRO’s. - Identifies and prohibits certain types of conduct in the markets - Provides the Commission with disciplinary powers over regulated entities and persons associated with them. - Allows SEC to require periodic reporting of information by companies with publicly traded securities. Corporate Reporting- Companies with more than $10 million in assets whose securities are held by more than 500 owners must file annual and other periodic reports. See SEC's EDGAR database (edgar.sec.gov). See also Rule 12(g) Proxy Solicitations- The Securities Exchange Act also governs the disclosure in materials used to solicit shareholders' votes in annual or special meetings held for the election of directors and the approval of other corporate action, must be filed in advance, requires disclosure. Tender Offers- Requires disclosure of important information by anyone seeking to acquire more than 5 percent of a company's securities by direct purchase or tender offer- allows shareholders to make informed decisions on these critical corporate events.

22. The Securities Exchange Act of 1934 Insider Trading- Prohibit fraudulent activities in connection with the offer, purchase, or sale of securities, power to bring disciplinary actions, including actions against fraudulent insider trading. Insider trading is illegal when a person trades a security while in possession of material nonpublic information in violation of a duty to withhold the information or refrain from trading. Registration of Exchanges, Associations, and Others- requires market participants to register with the Commission, including exchanges, brokers and dealers, transfer agents, and clearing agencies. Maloney Act, 1938 authorized the formation & registration of national securities associations (later termed SROs), which would supervise the conduct of their members subject to the oversight of the SEC.  Financial Industry Regulatory Authority (FINRA) is current major SRO. SROs create rules that allow for disciplining members for improper conduct and for establishing measures to ensure market integrity and investor protection. SRO proposed rules are subject to SEC review and sometimes approval, and are published to solicit public comment.

23. Broker Dealers Actors in the business of buying & selling securities for its own account (dealer) on behalf of its customers (broker). May earn a fee on either or both side of a transaction - Purpose: providing investment advice to customers, supplying liquidity through market making, facilitating trading activities, publishing investment research, raising capital for companies. - Market-making: price announcing, duty of sell and buy of security at announced price, announcing of min and max number of securities that can be bought/sold at announced price, implementing time periods when announced prices are available. - Securities Underwriters: broker-dealer acts as an agent of the issuing company to distribute issuer’s securities for an underwriting fee. They may also acquire a piece of the securities offering for their own accounts, and may be required to do so if they are unable to sell all of the securities. - Must be members of FINRA SRO - A broker-dealer must maintain “physical possession or control of . . . securities carried by a broker or dealer for the account of customers.”  17 C.F. R. § 240.15c3-3(b)(1) (emphasis added). - Must file a Form BD disclosing activities to be conducted with SEC, must be approved by FINRA. - Agents of a Broker Dealer must qualify by passing NASAA or FINRA examinations.

24. Peek ahead… the problem of Ethereum SEC broadly rejected “utility token” concept However, the problem of Ethereum lingered: Ethereum was sold via ICO. It’s probably a security. What are the implications for trading, using ETH as gas, booking the purchase and sale of ETH? Has every smart contract been the purchase and sale of a security? How should the execution of a smart contact be booked for tax purposes? Payment of funds equivalent or securities transaction?

25. Director Hinman June 2018 “When Howey Met Gary (Plastic)” Director William Hinman gave a speech called “When Howey met Gary (Plastic)” Asserted that Tokens may can become “sufficiently decentralized” “Funds are raised with the expectation that the promoters will build their system and investors can earn a return on the instrument – usually by selling their tokens in the secondary market once the promoters create something of value with the proceeds and the value of the digital enterprise increases.”

26. Director Hinman June 14, 2018 comments “Can a digital asset that was originally offered in a securities offering ever be later sold in a manner that does not constitute an offering of a security?” “Where the digital asset represents a set of rights that gives the holder a financial interest in an enterprise, the answer is likely “no.”” “But what about cases where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created? I believe in these cases the answer is a qualified “yes.”

27. Director Hinman June 2018 comments Important points: Sales to passive investors, broad solicitation, uncertain business model, uncertain viability of business- all suggests reliance on issuer to build. Token itself may not be a security (like Howey’s orange groves are not securities) What happens when there is no longer reliance on issuer to build the tech or business? Discusses Gary Plastic where Certificates of Deposit, which are not securities, are sold as part of an interest/tax arbitrage scheme, become a security. Even digital assets with utility that function solely as a means of exchange in a decentralized network could be packaged and sold as an investment strategy that can be a security. If a promoter were to place Bitcoin in a fund or trust and sell interests, it would create a new security. GBTC

28. Director Hinman June 2018 comments

29. Director Hinman June 2018 comments How to analyze whether a third party drives the expectation of return? – (Ethereum) - Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value? - Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset? - Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?

30. Director Hinman June 2018 comments How to analyze whether a third party drives the expectation of return? – (Ethereum) - Are purchasers “investing,” that is seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network? - Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset? - Do persons or entities other than the promoter exercise governance rights or meaningful influence?

31. Director Hinman June 2018 comments What is “sufficiently decentralized”? How is it measured? - Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation? - Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading? - Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent? - Are the tokens distributed in ways to meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? - Is the asset marketed and distributed to potential users or the general public? - Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application? - Is the application fully functioning or in early stages of development?

32. Director Hinman June 2018 comments More questions than answers: How to measure decentralization? When to measure? What does this mean for traders/holders? What does this mean for consumable tokens? Do contractual obligations “disappear” if a token becomes sufficiently decentralized? If not, where do they go? “Decentralization” used as a proxy for “efforts of others”

33. Director Clayton, Sept. 13, 2018 comments What does this mean for Hinman’s speech?

34. Token Sales, Part 2 The SEC’s response to theDao Rule 21 Report SEC v. Howey Co., 328 U.S. 293 (1946) SAFT Agreement SEC begins enforcement against frauds, unregistered offers Plexcorps Munchee Tomahawk Commodities Issues McDonnell

35. Investment Contract: S.E.C. v. W. J. Howey Co., 328 US 293 (1946) • 4-pronged test applied to determine if a financial instrument is an “investment contract” (the “Howey Test”). Whether purchasers of the instrument contributed money (or valuable goods or services) Whether purchasers invested in a common enterprise Whether purchasers reasonably expected to earn profits through that enterprise Whether the expected profits are to be derived from the entrepreneurial or managerial efforts of others its definition of a security “embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”

36. The 6/25/17 Rule 21 Investigative Report on TheDao 1. DaoTokens were investment contracts based on Howey Test: Investment of money- ETH Common enterprise- Code Expectation of profit- expressly marketed for return Efforts of promoter or 3rd party- Slock.it Creators, Curators 2. Tokenized securities must be traded on valid ATS or Exchange* 3. The definition of “issuer” is broadly defined to include “every person who issues or proposes to issue any security” and “person” includes “any unincorporated organization.” 15 U.S.C. § 77b(a)(4). “Whether a particular investment transaction involves the offer or sale of a security – regardless of the terminology or technology used – will depend on the facts and circumstances, including the economic realities of the transaction.” 4. Are sold tokens always securities ?

37. What is a National Securities Exchange? Created by 6(a), Securities Exchange Act of 1934 Rule 3(a)(1)- The term “exchange” means any organization, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as that term is generally understood, and includes the market place and the market facilities maintained by such exchange. Subject to extensive regulation as to order routing, order disclosure, governance. List of SEC approved Exchanges here: https://www.sec.gov/fast-answers/divisionsmarketregmrexchangesshtml.html

38. The 6/25/17 Rule 21 Investigative Report on TheDao 1. DaoTokens were investment contracts based on Howey Test: 2. Tokenized securities must be traded on valid ATS or Exchange*

39. The 6/25/17 Rule 21 Investigative Report on TheDao

40. Alterative Trading System - Registered Broker Dealer (15 U.S.C. 78o) + Filed Form ATS - Institutional investors may use an ATS to find counterparties for transactions instead of trading large blocks of shares on national stock exchanges. - ATS do not set rules governing the conduct of subscribers or discipline subscribers other than by excluding them from trading. - ATS transactions do not appear on national exchange order books, and the size and price of orders are not displayed to other participants in the ATS (i.e. dark pools”). - Less than 10% of overall securities trading volume on ATS - The SEC must approve alternative trading systems. - Regulators have enforced against ATS for trading against customer order flow or making use of confidential customer trading information. Current list: https://www.sec.gov/foia/docs/atslist.htm

41. Alterative Trading System - Must disclose the securities the ATS expects to trade; - The manner in which the ATS operates; - How subscribers will access the trading system; - The class(es) of subscribers and any differences in services offered to each class; - Procedures for order entry and execution - Must be a member of an SRO (i.e. typically FINRA)

42. Simple Agreement for Future Tokens (“SAFT”) • A few law firms offered the Simple Agreement for Future Tokens (“SAFT”) as a way to pre-sell tokens. • Based on Y Combinator SAFE contract. • Investment contract whereby investors purchase the right to receive tokens upon the subsequent network launch. • Trades issuer’s promise to deliver tokens upon the launch of the network for the investors’ promise to immediately pay cash. • Under the Howey Test, the SAFT is an investment contract, assumed that the tokens to be transferred would be commodities. • OOPS: If tokens were not securities, may be construed as forward contracts for delivery of future tokens.

43. CFTC v. McDonnell: Facts: - Alleged that Defendant “operated a deceptive and fraudulent virtual currency scheme [Coin Drop Markets]. . . for purported virtual currency trading advice” and “for virtual currency purchases and trading . . . and simply misappropriated [investor] funds.” - Customers paid defendants for “membership” in virtual currency trading groups purported to provide exit prices and profits of up to “300%” per week. - “Investors” transferred virtual currency to the defendants for “day” trading. - After receiving customer crypto funds, defendants deleted their “social media accounts” and “websites and ceased communicating with . . . customers around July, 2017.” - Defendants provided minimal, if any, virtual currency trading advice and never achieved the promised return on investment. - Refused customer refund requests.

44. CFTC v. McDonnell: “Until Congress clarifies the matter, the CFTC has concurrent authority, along with other state and federal administrative agencies, and civil and criminal courts, over dealings in virtual currency” Two questions : (1) whether virtual currency may be regulated by the CFTC as a commodity; and (2) whether the amendments to the CEA under the Dodd-Frank Act permit the CFTC to exercise its jurisdiction over fraud that does not directly involve the sale of futures or derivative contracts. CEA defines “commodities” as “wheat, cotton, rice, corn, oats, barley, rye, flaxseed, grain sorghums, mill feeds, butter, eggs, Solanum tuberosum (Irish potatoes), wool, wool tops, fats and oils (including lard, tallow, cottonseed oil, peanut oil, soybean oil, and all other fats and oils), cottonseed meal, cottonseed, peanuts, soybeans, soybean meal, livestock, livestock products, and frozen concentrated orange juice, and all other goods and articles . . . and all services, rights, and interests . . . in which contracts for future delivery are presently or in the future dealt in.” Title 7 U.S.C. § 1(a)(9) (emphasis added).

45. CFTC v. McDonnell: CFTC’s Argument: - A “commodity” encompasses virtual currency both in economic function and in the language of the statute. 7 U.S.C. § 1(a)(9) ( “all other goods and articles . . . and all services, rights, and interests . . . in which contracts for future delivery are presently or in the future dealt in.”) - CFTC’s broad authority extends to fraud or manipulation in derivatives markets and underlying spot markets. See 7 U.S.C. § 9(1). - CFTC may exercise its enforcement power over fraud related to virtual currencies sold in interstate commerce. See 17 C.F.R. § 180.1. - Exclusive jurisdiction over “accounts, agreements . . . and transactions involving swaps or contracts of sale of a commodity for future delivery” has been granted to the CFTC. 7 U.S.C. § 2 (emphasis added). Any commodity traded as a future must be traded on a commodity exchange approved by the CFTC.

46. CFTC v. McDonnell: CFTC already exercised jurisdiction over a Bitcoin Ponzi in CFTC v. Gelfman Blueprint, Inc., Case No. 17-7181 (S.D.N.Y. Filed Sept. 21, 2017) (suit brought by the CFTC alleging a Bitcoin Ponzi scheme, not involving future contracts). In Gelfman, the CFTC relied on the broad statutory authority in Section 9(1) of the CEA, and regulatory authority under 17 C.F.R. § 180.1, prohibiting “any person, directly or indirectly, in connection with any . . . contract of sale of any commodity in interstate commerce” from using a “manipulative device, scheme, or artifice to defraud,” or making “any untrue or misleading statement of a material fact.” CFTC does not have regulatory authority over simple quick cash or spot transactions (delivery within 2 days) that do not involve fraud or manipulation. Title 7 U.S.C. § 2(c)(2)(C)(i)(II)(bb)(AA) (The CFTC does not have jurisdiction over “spot” transactions that “[result] in actual delivery within 2 days.”). Unclear what “delivery” means in crypto exchanges- proposed 28 days.

47. CFTC v. McDonnell: Questions: Is everything (not expressly carved out) a commodity? CEA talks about things that are presently or in the future offered as an option or future. Is this an overly broad? Does the CEA definition matter at all? By this logic, can CFTC control the market for coffee, scrap iron, and orange juice? Should the spot market for cryptoassets look any different than for wholesale coffee? What should “delivery” mean in crypto? Does the asset need to leave the exchange? Proposed 28 days What would CFTC regulated exchanges for crypto assets look like?

48. Token Sales, Part 3 Enforcement & Settlement Orders Plexcorps, Munchee, Tomahawk, Coburn, TokenLot, Paragon/Airfox SEC Roadmap- Nov. 19, 2018 SEC Framework for Investment Contract Analysis of Digital Assets, April 3, 2019 KIK litigation

49. Significant Enforcement Actions: Significant SEC Enforcement actions: theDao- Token sales may be securities, exchanges must comply Munchee- No utility tokens TokenLot- Broker dealers* Tomahawk- Airdrops can be securities Coburn/EtherDelta- Exchanges must register/operate under exemption* Airfox/Paragon- Recession and registration as equity securities

50. In re: Munchee December 11, 2017- Cease & Desist Order Munchee’s white paper stated that it had conducted a “Howey analysis” and concluded that its tokens were not securities, SEC: even if Munchee’s tokens “had a practical use at the time of the offering, it would not preclude the token from being a security”. Sold MUN tokens for use on pre-development “Yelp” for specific dishes Promotional bounties, issuer and third-party social media marketing price increases, touted secondary trading Platform not yet developed Marketed as a utility token, would provide a return based on market value, listing on secondary exchanges Result: Unlikely that “utility tokens” exist under Federal law Expectation of return can be from market appreciation via secondary trading Promotion matters Focus on an assessment of “the economic realities underlying a transaction”.”