The ICO problem: One firm’s plan to satisfy regulatory concerns

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The world of initial coin offerings has had no shortage of colorful entrants.

There’s CryptoKitties, with its stoned-looking-cat cartoons and its “white pa-purr.” There’s the Red Bus Coin ICO, launched by a guy who wanted to raise money to buy a red bus he could convert into his home. There’s the Useless Ethereum Token, whose creator says on his website, “Seriously, don't buy these tokens,” yet thousands of people have.

Then there are the downright scams. The Securities and Exchange Commission has issued several warnings about fraudulent ICOs. It shut down AriseBank in January, saying the company used social media, a celebrity endorsement and other tactics to raise an alleged $600 million in just two months and falsely stated that it purchased an Federal Deposit Insurance Corp.-insured bank.

But there’s also a groundswell of people who want to use initial coin offerings as a way to legitimately raise money using tokens rather than issuing stock or pitching venture capital firms. But figuring out what is legal in the murky world of ICOs can be tough.

“I see technologists, exchange owners and entities being very thoughtful about what all the limitations and concerns could be,” said Jennifer Connors, a financial services attorney with Holland & Knight. “It’s good for their business model to be able to indicate to issuers that they know what the law is and what the requirements are. The thing is, there are not answers to a lot of the questions.”

One startup, Prometheum, has proposed what it claims is the first legal route to a U.S. ICO.

Within the week, the company will refile for its Reg A+ offering — the right to issue its own SEC-approved ICO on its own platform. It plans to use that platform to offer its own Ember tokens, which people can buy and use to invest in future ICOs launched on the platform. (Reg A+ is a clause of the JOBS Act that lets private companies raise up to $50 million from the general public.) Ember tokens will have embedded smart contracts that will help enforce compliance with SEC requirements.

The SEC did not respond to a request for comment.

Prometheum, which is based in Delaware, was founded a year ago by father and son Martin and Aaron Kaplan, securities attorneys at Gusrae Kaplan Nusbaum in New York.

They're working to turn their startup into a a broker-dealer and provider of a blockchain-based alternative trading system for tokenized securities. They're attempting to create an SEC-registered and regulated market for compliant cryptographic securities or tokenized securities, which will provide a venue for the issuance of initial coin offerings. They aim to provide secondary trading, settling and clearing, and monitoring of custody for ICOs.

“Prometheus was the god who gave man fire, and we are seeking to be the first to offer the public access to free-trading, federal securities laws compliant ICOs, so we thought the name Prometheum was appropriate,” said Aaron Kaplan, co-founder and COO of Prometheum and a former SEC investigator.

In October, Prometheum submitted a no-action letter to the SEC that explains its plans and asks the agency to let it continue in peace.

“Our thought is that cryptographic assets are going to be the way of the future,” Kaplan said. “There are advantages of cryptographic tokens representing assets and securities that are beneficial to investors and we’re hoping to create a soup-to-nuts ecosystem where all tokenized securities processes occur.”

Part of what Prometheum is doing is building an Ethereum-based permissioned blockchain with a team of eight developers.

The reason for a private and permissioned, rather than a public, blockchain is to force all participants to comply with certain rules, such as Know Your Customer and anti-money- laundering regulations.

“Furthermore, should there be a bad actor on our ecosystem, we had to have the mechanism and the ability to knock them off the network,” Kaplan said. “That’s why we chose to run our own blockchain and have it as a permissioned rather than a decentralized blockchain.”

Each ICO will have its own smart contract that automatically executes the terms of the offering.

As a broker/dealer, Prometheum will have to do some vetting of the companies that launch ICOs on its platform (Kaplan rejected the offered word “vouch”).

“We will have due diligence responsibilities, to make sure what the issuer is saying is possible,” Kaplan said. “Can they get it done? If I say I’m going to create a time machine and I have no background in nuclear physics or whatever is required for that, it doesn’t make sense. We have a responsibility to ensure that what the issuer says it can do is possible, that we think they have the proper team for that, that they’re allowed to do what they say they’re doing under the federal securities laws and that these individuals involved meet KYC/AML requirements and they’re not barred from the securities industry.”

Why legal ICOs?

If all these tokens are going to be registered as securities with the SEC, why not just issue traditional securities? Kaplan says there are benefits to using tokens.

“They’re fungible, you can hold them yourself in your own wallet, you don’t have to have the securities held in a centralized depository as they are now,” he said.

And they represent something very different than equity.

“An ICO is not a traditional security,” Kaplan said. “It’s a new type of asset. An ICO is really, in theory, a securitization of user interest in an ecosystem. It’s not a bet, not a preferred. You’re selling a token, hoping future interest in the ecosystem will grow, and in addition to the user interest you have additional utility in your token itself.”

Prometheum’s founders spoke with the SEC last week about the alternative trading system and how the secondary market transactions will work for tokenized securities. The SEC hasn’t given Prometheum an official seal of approval.

“It has said at a high level that ICOs are securities and now we’re working through how these tokenized securities processes will actually occur,” Kaplan said.

The company hopes to have a technical demonstration ready by the end of June to show regulators.

Why should people trust Prometheum? Kaplan notes that the startup was incubated within a security law firm that’s been operating on Wall Street for 40 years.

“We have experience and expertise dealing with securities elements Promotheum is going to have to conquer, whether that be on the brokerage side, the regulatory side, dealing with the SEC, this is what we’ve done for a very long period of time,” Kaplan said.

In other words, the company won’t have to hire a team of lawyers; it is a team of lawyers.

“We’re used to dealing with molecular and complicated securities issues such that we feel we are in the strongest place to do this,” he said. He also asserts that Prometheum is the only group proposing a complete ecosystem for ICOs, including issuance, brokerage, trading, clearing and settlement.

Connors suggested Prometheum’s plans make sense.

“It appears they’re cognizant of what the limitations are from a securities law perspective, and they’re trying to build a structure that would be compliant with current regulations,” she said.

In its Reg A+ offering document, Prometheum acknowledges the risk that competitors may beat it to its goal.

Others including bank-led blockchain consortium R3 and the Delaware Board of Trade, a blockchain-based alternative trading system that's licensed by the SEC, are thinking about ICO solutions, she said.

tZero, a subsidiary of, is also pursuing the use of its alternative trading systems for compliant tokenized securities.

Banks will also get into this business, Connors predicted.

“It’s inevitable that they probably will in some way or another,” she said. “I don’t see them necessarily being on the forefront. I think it’s inevitable that most of the financial services firms are probably looking to catch up at some point.”

Next steps

Prometheum initially filed for a Reg A+ offering in November. The SEC came back with comments and Prometheum will soon file an amended Reg A+.

“We’re hoping to be qualified and have the first free-trading ICO available to all types of investors within the next 60 days,” Kaplan said.

Once SEC approval is granted and the Ember tokens issued, Prometheum will have to get its no-action letter approved to proceed.

Prometheum hopes to have its first issuers live on its platform toward the end of the first quarter of 2019.

“We’ve already spoken to some issuers and hope to go live before then,” Kaplan said. “We believe there’s a major demand for this because people have invested billions of dollars in what we think are illegal ICOs. People want access to this type of investment and we’re hoping to have the first free trading, liquid ICO available to investors.”

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