In 2017, initial coin offerings (ICOs) raised approximately $6.2 billion globally. By the second quarter of 2018, ICOs already exceeded the 2017 total, raising approximately $6.3 billion.
To maximise the investor pool and fundraising, many ICOs try to avoid having their tokens classified as securities. Because a classification of a token as a security automatically comes with various regulations and limitations on who can invest in the token and how they can be exchanged, many ICO projects market their tokens as utility tokens.
A utility token is a type of token that provides users with future access to a product or service on a blockchain. Notwithstanding this, it may be possible that regardless of how a token is packaged and the name it is given, a utility token offering in an ICO context may be a security in the form of an investment contract under Korean securities laws.
Howey test: US and Korea
The US Securities and Exchange Commission (SEC) published a report in 2017 that the DAO (Decentralised Autonomous Organisation) token, an ICO project in a form of investor-directed venture fund, was a security. In December 2017, the SEC halted Munchee's ICO, a restaurant review platform on a blockchain, through a cease-and-desist order. Consistent with this trend by the SEC, in February 2018, SEC Chairman Jay Clayton in a Senate hearing stated: 'Every ICO I've seen is a security.'
Chairman Clayton's view on token offerings in an ICO as a security is mainly based on how such token offerings indicate a sale of an investment contract under the US Supreme Court's decision in SEC v W J Howey Co. This case is the source of the Howey test, a four-part analysis to test whether a transaction qualifies as an investment contract:
- It is an investment of money (including assets such as bitcoin or ether).
- There is an expectation of profits from the investment.
- The investment of money is in a common enterprise.
- Any profit comes from the efforts of a promoter or third party.
Korea has a similar concept of an investment contract security analysis modelled on the Howey Test. As most investors in a token offering view their participation in an ICO as an investment opportunity, there is a risk that investors could be purchasing unregistered securities through an ICO.
To determine whether or not a token offered in an ICO is a security under Korean law, we can apply an investment contract security analysis under Korea's Financial Investment Services and Capital Markets Act (FSCMA). If a token offering meets these criteria, then the token will be considered a security and will become subject to the FSCMA's additional disclosure and regulation requirements.
FSMCA's regulatory constraints
Though there is a lack of any directly applicable law or guidance from Korean regulatory authorities, it is possible that in the context of an ICO, many utility token offerings (in the form of a contract, scheme, or arrangement related to offering) could be considered an offering of investment contract securities under the FSCMA. The Korean legal analysis for such a classification is broadly similar to the Howey test, which determines whether an investment contract is a security under US law.
To be considered an investment contract security under Korean law, an investment contract must include: (i) an investment of money; (ii) a common enterprise; (iii) an arrangement to share profits or losses as a result of the enterprise; and (iv) the operation of the enterprise mainly by a third party. Assuming that an offering of utility tokens in Korea is an investment contract security under the FSCMA, the offering will be subject to the FSCMA's offering restrictions, including the requirement that the issuer file a securities registration statement with the Financial Services Commission in certain cases.
Investment contract securities
Under Article 4, Paragraph 1 of the FSCMA, the term securities is defined as:
'Financial Investment Instruments issued by a citizen of Korea or a foreigner, where an acquirer does not owe any obligation to pay anything in addition to any money or other consideration such acquirer already paid at the time of acquisition.'
The term financial investment instrument is defined as a 'right acquired by an agreement to pay, at a specific time in the present or in the future, money or any other valuable thing, with an intention to earn a profit or avoid a loss, where there is a risk that the total amount of such money or similar, paid or payable, for the purpose of acquiring such right may exceed the total amount of money or similar already recovered or recoverable from such right.'
Korea has a similar concept of an investment contract security analysis modelled on the Howey test
Securities under the FSCMA consist of: (i) debt securities; (ii) equity securities; (iii) beneficiary certificates; (iv) investment contract securities; (v) derivatives linked securities; and (vi) securities depositary receipts.
Under article 4, Paragraph 6 of the FSCMA, investment contract securities are defined as 'instruments bearing the indication of a contractual right under which a specific investor is entitled to the profits earned, or liable for losses sustained, as a result of a common enterprise in which the specific investor invests money, etc. jointly with a third person (including other investors; hereafter the same shall apply in this paragraph) and which is to be run mainly by the third person.'
Similar to the Howey test, the analysis of investment contract securities under the FSCMA can be broken into four elements: (i) whether there exists an investment of money; (ii) whether there exists a common enterprise; (iii) whether the investors share profits and losses as a result of a common enterprise; and (iv) whether the common enterprise is operated mainly by a third party. If all elements are satisfied, then a contract, scheme or arrangement will likely be an investment contract security. Under Korean law, if any one of the elements is not met, the contract, scheme or arrangement is not an investment contract security.
Below is an analysis of each element under the FSCMA's definition of investment contract securities for utility tokens in a typical ICO context.
Investment of money
For most ICOs, an offering of tokens requires participants to deliver fiat currency such as US dollars or an equivalent value in a digital asset such as bitcoin or ether. The FSCMA refers to 'money etc' as money or any other property with value, which arguably can include digital assets such as bitcoin or ether. In the offering of tokens in an ICO, since it usually accepts US dollars, bitcoin or ether in exchange for the tokens, it is likely that this element of an investment of money is satisfied.
Direct token private sales, presales, or crowd sales, including offering the rights to purchase tokens, often have an element of a common enterprise. A common enterprise can exist under a horizontal commonality test, where multiple investors pool assets and share the profits and risks of the enterprise. In most ICOs, a company or a foundation will lay the groundwork for meeting this element when the company or foundation pools all the money raised to build the network and the tokens. Hence, it is possible that most ICOs meet this element of a common enterprise.
Sharing of profits and losses from a common enterprise
The FSCMA requires that the investors in the investment contract securities share the profits earned and the losses sustained as a result of a common enterprise. In most ICOs, the purchaser can receive the tokens before the launch of the main network (Mainnet), the actual blockchain where the tokens can be used, or the decentralised application (DApp), the application layered on top of the Mainnet, and trade on a cryptocurrency exchange upon listing of the tokens. (The closest analogy, though not exact, is to compare the Mainnet to IOS or Android and a DApp as an app such as Pokémon Go, the application layered on top of the operating system.)
In most cases, the tokenholders usually gain a profit when their tokens are listed on a cryptocurrency exchange and once the Mainnet or DApp is launched. This is primarily because they purchase the tokens at a deep discount during the ICO, similar to purchasing securities of a company before an initial public offering. However, though investors purchase the tokens in an ICO, the Mainnet or DApp may never launch or the tokens may never get listed on a cryptocurrency exchange. As a consequence, the tokenholders may lose all of their investments, which means the investors will be liable for the losses sustained. Because the investors are entitled to the profits earned or liable for the losses sustained, it is possible that this element is satisfied.
Common enterprise mainly operated by third party
This element asks whether the common enterprise is run mainly by a third party other than the investors (though the third party can be one of the investors). For most tokens, the tokens usually do not confer any voting right or other governance rights to the purchasers. The token purchasers will typically have no control the common enterprise, while the company or foundation will mainly run the common enterprise when developing the Mainnet or DApp. (For example, the Iota Foundation runs its Mainnet called the Tangle for its native token Iota, which is one of the major cryptocurrencies. The owners of Iota do not have any voting rights or other governance rights with the Iota Foundation.) Thus, the common enterprise (ie building the Mainnet or DApp and the tokens) is run mainly by the efforts of a third party and, hence, this element may be satisfied.
FSCMA restrictions on security token offerings
Given the above, an offering of tokens may be subject to the offering restrictions in Korea if such tokens are classified as securities or, namely, security tokens under the investment contract security analysis of the FSCMA. Under the FSCMA, an offering or sale of security tokens to 50 or more non-accredited investors, which exclude certain accredited investors and related persons of the issuer, would be regarded as a public offering and be subject to offering restrictions under the FSCMA. Any offers undertaken by the same issuer or seller involving the same type of security tokens within a six-month period will be aggregated for the purposes of calculating the 50 or more non-accredited investors.
The distinction between offshore and domestic issuances is not always clear
Further, though an offer is made to fewer than 50 non-accredited investors, a security token offering may be deemed a public offering if certain conditions are met. For example, in the case of a domestic offering of security tokens to investors, this could be a deemed public offering if there are 50 or more securities issued or if the securities can be further divided into 50 or more fractional securities after the issuance, even though the offer is made to less than 50 non-accredited investors. In the case of an offshore issuance of security tokens, it is possible for the offering to be deemed a public offering if the issuer has listed its securities in Korea or the Korean residents hold more than 20% of the total issued equity securities of the token issuer.
It is worth noting that under the relevant regulations, an offshore issuance of securities is defined as an issuance of securities where the major activities relating to the issuance (such as solicitation and offer) are conducted outside Korea. However, in practice, the distinction between an offshore issuance and a domestic one is not always clear. While the Korean regulator has not opined officially, if less than 20% of the securities being offered are allocated to Korean residents, it would be likely that the offering may be regarded as an offshore issuance.
In a public offering of securities in Korea, an onshore or offshore issuer must file a securities registration statement for the security tokens to be offered in Korea with the relevant financial regulatory authorities. Many token issuers try to minimise the risk of being deemed a public offering of securities under Korean law by offering the tokens to accredited investors in Korea and limiting the purchase of the tokens by Korean residents to less than 20% of the total issued tokens by the company or foundation.
Substance over form
Under the Korean investment contract security analysis, a token offering in an ICO context, despite labelling the token as a utility token and disclaiming it as a security, should be reviewed based on how the offering, in the form of a contract, scheme, or arrangement, is actually structured rather than how the token is intended to be used. This analysis may lead to the offering of utility tokens in an ICO context being classified as a security, and namely an investment contract security.
The reality is that most investors purchase tokens in an ICO primarily because of an anticipation of profits. Therefore, token issuers and purchasers have to look at the substance over form when assessing the offering of tokens in an ICO. Even though tokens may be marketed as utility tokens, the issuer could be selling and the purchaser could be holding unregistered securities without an exemption in violation of the FSCMA pursuant to the Korean investment contract security analysis. Regardless how such a token is labelled by the issuer, a token by any other name may be a security in an ICO context.
|About the author|
Samuel Yim is a senior foreign attorney at Kim & Chang's e-finance and fintech practice, where he focuses on blockchain and cryptocurrency matters. He regularly represents token sellers, cryptocurrency exchanges, ventures, hedge and private equity funds and their portfolio companies, token marketers and broker-dealers, funds interested in trading digital assets, global investment banks, financial institutions and asset managers, and others in the space. He has advised foreign and domestic clients on major industry defining matters such as, among others, initial coin offerings (ICOs) and reverse ICOs, token private placements, the establishment or acquisition of cryptocurrency exchanges, cryptocurrency arbitrage, and the establishment of cryptocurrency not-for-profit foundations.
Prior to joining Kim & Chang, Samuel worked at Allen & Overy and served in the US Army. He received a BS from the United States Military Academy (West Point) and a JD/MA from Georgetown University Law Center and the Paul H Nitze School of Advanced International Studies, Johns Hopkins University. He received the Fulbright Fellowship and studied at Yonsei University in Seoul, Korea. Samuel was also an adjunct professor at Yonsei University Law School and a Term Member on the Council on Foreign Relations. He is admitted to the New York bar.
|About the author|
Joon Young Kim
Joon Young Kim is a senior attorney at Kim & Chang. His practice focuses on e-finance and fintech, insurance, non-bank financial companies, corporate governance, mergers & acquisitions, and foreign direct investment. Joon Young regularly advises financial industry clients on regulatory, governance, and corporate law-related matters. He has also successfully advised clients in disputes and in litigation, as well as in responding to inquiries or investigations from government and regulatory authorities.
He regularly advises clients on legal issues relating to the latest innovations, such as blockchain technology, cryptocurrency and cloud computing. Joon Young has been actively involved in publishing on various Korean and international journals and conducting lectures related to e-finance and fintech, blockchain technology, cryptocurrency, insurance and corporate governance. His expertise and experience have been recognized by industry experts. He has been named as a Next Generation Lawyer for two consecutive years in The Legal 500 Asia Pacific 2017 and 2018 editions.
Joon Young received his LLM from Harvard Law School in 2016 and his law degrees from Seoul National University (LLM in 2009 and LLB in 2005). He graduated from the Judicial Research and Training Institute of the Supreme Court of Korea in 2007. He was admitted to the Korea bar in 2007, and in 2016 passed the New York bar exam.
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