Legal Compliance Framework and Considerations for an ICO

Family-owned businesses contribute a significant share to a country’s GDP and to promote them is a desirable outcome for Small and Medium Enterprise Development authorities of any country. ICO has raised $7.3 billion in 2018 so far, while the overall funding in ICOs has touched $22.5 billion – far ahead of any combined funding for a new technology in the history of the world. It offers an immense and timely opportunity to raise funds and scale up businesses.

At the same time, we need to be conscious that the ICO is not crossing any ethical boundaries of the society it operates in. For example, the money should not be used for or come from ignoble businesses like pornography, Darknet, ransom, killing, drugs or sex trafficking. Further, it should not be used with any business involving crimes, illicit use and commonly overlooked societal ills like cyber-bullying, cyber-stalking, revenge porn, child pornography, data ransom, kidnapping ransom, identity theft, or to support any hostile acts against nations.

Blockchain is borderless, nations are not, and therefore we should be very careful about legal compliance when our ICO is seeking funds from multiple geographies. Following is the list of nine compliance categories one should be aware of before launching an ICO.

1.    Legal Framework: Based on the nature and location of your ICO and prospective investors, which legal bodies and frameworks does one need to adhere to? Securities and Exchange Commission (SEC), the Commodity Futures and Exchange Commission (CFTC), the Internal Revenue Service (IRS), and the Financial Crimes Enforcement Network (FinCEN) are a few relevant institutions. Confirming the legal framework will guide us towards compliance for each statuary authority and its respective regulations. A recent Bank of England’s taskforce report on crypto assets will be really helpful to understand the legal framework you operate in.

2.    Legal Status: Are you planning to launch the ICO in the US and Europe? If so, you would like to know the legal status it will fall into in the US and Europe. Please confirm it with the SEC framework for ICOs in the US and European Union Law. European Union has recently issued several warnings for ICO investment and one should ensure the compliance for ICO. Will it be considered as a security (or investment contract under standards established by the U.S. Supreme Court in SEC v. W.J. Howey Co.) or a token? Does it pass the Howey Test in the US (a token is a security when there is an investment in a common enterprise with an expectation of profits from the efforts of others) or could it be classified as a utility token? Can it be classified for private sale under Rule 506(b) of Regulation D or for general solicitation under Rule 506 (C)? How will it affect the sale of tokens in the secondary markets? Can the token tradability be classified as a commodity under US Commodity & Exchange Act? Which legal framework would be applicable to the exchange facilitating the ICO; does it fall under the US Exchange Act or European Securities and Market Authority (ESMA)? Here is a good resource to look for the comparison of the two. Does it prohibit US and EU residents to participate in the ICO? Would it make it unlawful for the exchange (directly or indirectly) to conduct these transactions? How would the legal status differ under UK’s Financial Conduct Authority (FCA) framework? How does our ICO measure against the Simple Agreement for Future Tokens (SAFT) framework and what we can change to make sure regarding the compliance? Does it fall into Anti-Fraud SEC Rule 105b? Knowing the legal framework would help us craft a safe compliance strategy.

3.    Agent/Partnership: Who is in your sales team? What are their backgrounds and are they under investigation by SEC for any past endeavors? Does it affect your ability and credibility to launch the ICO with them? Does their work fall under Investment Advisor’s Act of 1940? Does it make us liable for any of their past wrong-doings? Knowing the nature and responsibilities for engaging with the sales team will allow you to gauge the efforts and resources you need to commit before making the decision.

4.    Jurisdiction: Where is the corporate office located? How would it affect your ability to raise funds from the US and the European Union citizens? Do you need to register a satellite office in the US and the Europe as well or can you raise the funds without a local physical presence? In case of dispute or lawsuits, which country’s law will be followed? Do you need to deal with each case respective of its origin? Knowing the real geo-spatial boundaries and applicable regulations would help you form the ICO launch strategy while making sure of the complete geographical-legal compliance.

5.    Sanity Check on Funds Distribution: Please review your white paper and see if the post-ICO funds distribution is legal – the amount of tokens you will give to founders, advisors, developers, bounty hunters, and investors. Do you have to change the percentages to comply with the US or European Law or is it open to decide as you will? Can you peg the token value to a FIAT for volatility control? Knowing the fairness of funds distribution on legal grounds will help you market it with confidence.

6.    Money Transfers and Regulations Arbitrage: How do you comply with AML/CTF/KYC (Anti-Money Laundering, Counter-Terrorism-Financing, and Know Your Customers) laws on each state and jurisdiction you raise the funds from? As the US and the EU have different compliance laws, you may like to give flexibility to your investors wherever it is available. How do you comply with the US Bank Secrecy Act (BSA)? Or do you need to acquire a money transmitter license? Knowing the answer to these questions will save you legal troubles in respective geographies and help you avoid big legal battles for money laundering and counter-terrorism. A quick look at the US Patriot Act’s KYC section and SEC AML toolset would help you understand the dynamics of these requirements.

7.    Taxation: IRS defines tokens as “property” and thus it is taxable for the party selling it. How does it affect the legality of your ICO? How much money do you owe to IRS, being a non-US company? How will the newly crafted Cryptocurrency Tax Fairness Act of 2017 bill, if passed, change the situation? Knowing your tax liabilities will help you manage the funds better.

8.    Personal Identifiable Information (PII): Which laws do you need to comply with for investors’ privacy, as you are taking personal and financial details of your investors? Which security guidelines and framework should you use for international transactions and to guarantee the anonymity of your investors (especially if they are from outside the US and EU)? Knowing the underlying dynamics of security PII will help you plan a better security strategy for your ICO and respective investors’ data.

9.    Customer Engagement Model: You also need a legal review of your “Terms and Agreement” that is available on your website. You need to make sure it reflects your compliance and standards for the cross-border fund-raising and money transfers. Knowing the legal consequences of customers’ engagement model will help you improve the user experience and to comply with the legalities of forming a legal contract online.

Based on this legal compliance framework, one should get an overall idea of where one stands for legal compliance. It also informs one of the possible corrective measures one can take to change the trajectory towards legal compliance. How to avoid falling into regulation arbitrage and AML/KYC/CTF legal traps, for example? This framework will come handy. You need to add your local country laws in this list to make sure you are not risking non-compliance.

I’ve recently published a book — Introduction to Blockchain with Case Studies and it’s available from Amazon worldwide, Gufhtugu Publishers in Pakistan and here is my Urdu Book (بٹ کوائن، بلاک چین اور کرپٹو کرنسی) on the subject as well.