Initial coin offerings, or ICOs, represent a new funding mechanism for companies building blockchain-based business models. The company’s “white paper” has become the go-to document for evaluating these new blockchain-based business models. Sometimes, the white paper is a deeply technical document. Many times, however, it reads more like a marketing brochure to hype a future ICO, and publishing these “hype” white papers in advance of an anticipated ICO carries potential liability for both the company and its founders. Review of the white paper by legal counsel before publication is often a good idea to mitigate these risks.
White papers that include statements designed to condition the future sale of tokens in an ICO – such as how the tokens will increase in value or how token holders will be able to sell their tokens on secondary markets – could be deemed to constitute “general solicitation” of a future securities offering. According to Rule 502(c), general solicitation means any attempt to sell or offer securities that includes, but is not limited to:
- Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television and radio; and
- Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising.
Until recently, general solicitation was prohibited in connection with a private offering of securities. Now, under Rule 506(c), companies can generally solicit the public about the offering, but there is a higher regulatory burden for companies to comply with Rule 506(c) than for private placements under Rule 506(b), which does not permit general solicitation. For example, securities offered under Rule 506(c) can only be sold to accredited investors and the company must use reasonable know-your-customer measures to verify the purchaser’s identity and accredited investor status. Therefore, if a white paper does include general solicitation statements, it could foreclose the company’s ability to use the Rule 506(b) private placement exemption that prohibits general solicitation.
Material Misstatements and Omissions
Each offering of securities, regardless of the applicable offering exemption (i.e., Rule 506(c) or 506(b)) or whether or not the investors are accredited, must comply with Section 10(b) of the Securities Exchange Act and corresponding Rule 10b-5, which make it unlawful for any person, in connection with the purchase or sale of any security, to, among other things, make an untrue statement of a material fact or omit a material fact necessary to make the statements not misleading. Both the SEC and private citizens can enforce the requirements of the rule through lawsuits. Indeed, many of the recent class action securities lawsuits brought against ICO issuers allege one or more 10b-5 violations.
Federal law includes certain doctrines and safe harbors that offer some protection for forward-looking statements if accompanied by certain cautionary language and identify risk factors that could cause actual results to differ materially from such statements. Rarely, however, do white papers include such cautionary language. Nor does it seem appropriate for the white papers to include such cautionary language, less the white paper turn into the private placement memorandum for the future offering.
Avoid “Pulling a Munchee”
As noted in the SEC’s order to stop the Munchee ICO, Munchee’s statements in its white paper, including claims about the future value of its tokens or the availability of token sales on secondary markets, was cited by the SEC evidence that the tokens constituted securities under federal securities laws. In Munchee’s white paper and on the Munchee website, Munchee claimed that it would run its business in ways that would cause the tokens to rise in value. The SEC believed that such marketing efforts were directed at investors interested in profits, rather than at the users who might have wanted to purchase the tokens for their utility on the Munchee platform.
Back to Basics
Satoshi Nakamoto produced a true work of art in his white paper, Bitcoin: a Peer-to-Peer Electronic Cash System. The paper not only described the business model for a new electronic payment system that could operate without financial institutions serving as trusted “middlemen,” but also launched an incentives-based economic system that has transformed the bitcoin network into arguably the world’s most powerful supercomputer. Satoshi accomplished all of this in only nine (!) pages, which included an abstract and references.
Based on Satoshi’s white paper, we can distill a few best practices:
Do you define the “middleman” problem(s)? For Satoshi, the middleman problem was the banking system itself, which Satoshi viewed as huge impediment to a more efficient peer-to-peer financial system. Like Satoshi’s version, white papers should seek to define their middleman problem and how the new token-based platform might eliminate this middleman, leading to a more efficient business model.
How will your token create network effects? Bitcoin has grown into the massive, worldwide network it is today because miners have a financial incentive to contribute compute power to the network. Companies building new token-based economies may consider whether their token creates incentives for greater user participation or whether their token seems to have been shoehorned into the model for the sake of having a token and conducting an ICO.
What are the possible use cases for the network? The bitcoin network has one purpose – verifying bitcoin transactions between buyers and sellers. Some white papers describe a new token-based economic model for one vertical without considering whether that token could be used across multiple verticals.
Avoid forward-looking statements. The white paper should be scrubbed of statements that make claims about the potential future value of the token or how the token could generate profits for its holder.
The Internet has become littered with long white papers that read more like marketing campaigns for a future ICO. By re-focusing the white paper on the basics – articulating the middleman problem, how the token’s structure creates a network effect, and potential use cases – companies could reduce their legal exposure from potential securities law violations as well as focus on potential existing blockchain-based solutions to real world middleman problems.