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What Token Issuers and Exchanges should consider when undertaking an Initial Exchange Offering (IEO)

Initial Exchange Offerings (IEO) have become a popular means of raising funds for blockchain startups, replacing ICOs, which have seen a dramatic drop in traction.

An IEO mainly consists of an ICO held via an existing cryptocurrency exchange, which administers the fundraising event. There is an agreement between the Token Issuer and a Cryptocurrency Exchange, whereby the latter conducts an initial placement of the tokens to their users.

The exchange assumes a role similar to that of an underwriter in traditional finance. They vet issuers and purchasers and distribute their tokens via their distribution channels and client base.

From an exchange’s perspective, an IEO platform represents another source of revenue, as large fees are charged to the issuer, and it can also potentially acquire new users that have been attracted by a given token offering. Furthermore, an exchange usually requires participants to purchase with the exchange’s digital token, which can lead to greater demand, and consequently, a price increase.

An IEO also has some clear benefits from the Token Issuer’s perspective, as it leverages the exposure, popularity, and liquidity of a given exchange and provides access to a large potential purchaser base, while also taking advantage of the exchange’s technical infrastructure.

For a buyer, an IEO allows access to projects that have been vetted by a ‘third party’, potentially avoiding scams and other quasi-scams. This places some burden on the exchange; a ‘rotten apple’ may heavily impact the reputation of a given exchange and have negative commercial consequences.

Some relevant players have argued that the need for a ‘trusted party’ to screen issuers and investors defeats the whole ‘trust-less’, ‘peer-to-peer’ ethos of cryptocurrencies. There is a middleman and central authority that decides which projects should raise funds through their platform. There have been initiatives on decentralized IEO platforms as well. However, that discussion is totally out of the scope of this article.

There are certain caveats to consider when operating an IEO platform or issuing a token via an IEO. The fact that the token might be more likely to be considered an investment instrument in certain jurisdictions – and the Exchange may be required to obtain a license for underwriting investment instruments – are among many other potentialities to take into account.

In this article, we review some key aspects that IEO platform operators and Token Issuers should consider from a legal perspective, as well as how they can better manage risks using the proper corporate structure. This article does not intend to be a comprehensive review and is not legal or tax advice of any kind.

Utility Tokens vs Security Tokens

Whether the token issued and sold during an IEO is considered a security or not will have an enormous impact on the regulatory and compliance requirements for both the issuer and the exchange acting as underwriter. A year ago, we discussed the first and most important rule of doing an ICO: Know Thyself.

If the token is considered a security, then the Exchange may need to be registered as a financial intermediary in the jurisdiction in which it is operating, and potentially in each of the jurisdictions in which it’s marketing the IEO. Depending on how transactions are structured, the Exchange may be required to obtain an investment dealer license, which usually carries higher licensing and ongoing requirements.

In turn, the issuer will still be subject to securities laws and prospectus requirements in each of these jurisdictions as well.

At the time of writing, most ICOs and IEOs have been offering utility tokens not registered as securities.

Utility tokens are usually designed to grant access to a certain product or service offered within the network that the company was developing, and they do not confer any type of financial, ownership or voting rights in the issuer or in any of their related companies.

We’ve seen utility tokens that resemble digital gift cards, software licenses, membership access or reward points. Utility tokens are generally treated by the issuer as a consumer product, rather than an investment. Utility tokens are not backed by any type of financial asset.

On the other hand, generally speaking, security tokens are a digital representation of a security. They could represent equity, debt, rights to profits, derivatives or any other financial instrument.

An intended utility token may still be considered a security in certain jurisdictions. Some countries have issued guidelines on the legal treatment of these assets depending on their specific functions, while others have not.

The US Securities and Exchange Commission (SEC) might have the most restrictive view on the categorization of these assets, and their transactions usually fall under the Securities Act and the Securities Exchange Act, whose definition of securities is broad. Furthermore, the SEC issued a guidance paper recently, bringing further clarity on the matter.

The Howey Test is used to determine whether these transactions fall under the Securities Act, and are thus subject to registration with the SEC, or required to apply for one of the exemptions provided by the legislation.

Under the Howey Test, if the transaction is an investment of money in a common enterprise, there is an expectation of profits from the investment, and if profits may result from the efforts of a promoter or third party – the transaction would be considered an investment contract, and therefore, the underlying asset would be considered a security.

Put simply, most ‘utility tokens’ would be considered securities, taking into account that there is an investment in a common enterprise – the issuer who collects all the proceeds -, there is an expectation of profits – tokens are traded in secondary markets -, and the performance of the token may depend largely on the efforts of the issuer or any related party.

Arguably, only truly decentralized networks or enterprises issuing tokens that only provide consumptive rights, are ready to be redeemed for a product or service (the platform is live) and are not available for trading in a secondary market, may fall outside of the remit of securities regulations.

This led to a significant number of ICOs restricting their offering to US citizens and residents and avoiding the US for their fundraising efforts. Some jurisdictions, such as Malaysia or New Zealand, have taken a restrictive approach too. However, there are substantial differences.

Most ICOs looked at more favorable locations such as the UK, Switzerland, Estonia, Singapore or offshore jurisdictions such as the Cayman Islands and the British Virgin Islands (BVI).

There are jurisdictions that enacted specific legislation for utility ICOs; Thailand, Malta, and Bermuda being some of the most relevant. Other jurisdictions such as Switzerland, Estonia, and Singapore issued ‘ICO guidelines’ on the legal treatment of digital asset offerings, based on current capital markets regulations. Roughly speaking, ICOs’ underlying assets were categorized as either Utility, Payment or Security/Asset Tokens, the latter being subject to their respective capital markets’ regulations and prospectus requirements.

A number of ICOs set up shop in these jurisdictions and relied on these ‘favorable’ ICO guidelines. Generally, if the token solely conferred a right to a product or service, or was designed as a means of payment, securities law wouldn’t apply.

However, with Initial Exchange Offerings (IEO), a number of other factors come into play. The fact that the Exchange ensures that the token will be traded in a secondary market, i.e. on the exchange platform, may result in this utility token being considered an investment, the exchange subject to financial markets regulations, and the issuer subject to prospectus requirements.

A utility token offering conducted via an IEO may provide for a clearer investment purpose at the time of its issuance, as the token would be sold via a crypto trading platform, which would list the token for secondary trading after a given period of time.

In an uncertain regulatory landscape, and given the global approach of ICOs, most issuers conservatively avoided marketing the secondary market availability and disassociated themselves from any effort related to listing the token in an exchange, to maintain the rationale that the token was merely a consumption product rather than a financial product.

The goal was to eliminate the ‘investment purpose’, which might have a significant impact on whether the token would be considered a security or not.

For instance, in Switzerland, although the Swiss Financial Market Supervisory Authority (FINMA) guidelines provide that utility tokens will not be treated as securities if their sole purpose is to confer digital access rights to an application or service and if the utility token can actually be used in this way at the point of issue. However, if the utility token also has an investment purpose at the point of issue, FINMA may treat such tokens as securities.

Furthermore, FINMA stated that in the case of the pre-financing and pre-sale phases of an ICO, which confer claims to acquire tokens in the future, these claims will also be treated as securities if they are standardized and suitable for mass standardized trading.

There are jurisdictions that might have a more flexible approach. For instance, the Monetary Authority of Singapore (MAS) concluded that the ability for a digital token to be traded on the secondary market alone does not result in a digital token being construed as a capital market product under the Securities and Futures Act.

Securities Regulations

As we have commented, the IEO model may be more prone to fall under securities regulations than the ICO model. Even if the token is meant for granting access to a product or service or as a means of payment, it could be considered a hybrid, in the sense that it might possess features of an investment instrument.

In an IEO, the exchange acts as a broker and uses its platform to market a given offering, charges a listing fee to the issuer, and potentially a commission on the funds raised. The exchange will list the token immediately after the IEO, with secondary trading, speculation and the potential profits it can bring being one of the main drivers for users to participate in such events.

The marketing language used for promoting the issuance is clearly conditioned by the fact that the offering is made via a trading platform.

The exchange also uses its large user base, comprised of traders from a variety of jurisdictions, to promote a given token sale. They deliberately market a given investment to residents of a given jurisdiction and use their marketing channels and resources to bring buyers in.

In the US, an IEO platform would clearly be required to register as a Broker-Dealer, becoming a member of FINRA, and the Securities Investor Protection Corporation (SIPC). The exchange will likely need to notify the SEC to operate an Alternative Trading System (ATS), and might also need to register as a Money Service Business (MSB) with the Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN), and in the relevant States where it conducts its business.

Generally speaking, in the European Union, tokens might qualify as transferable securities if they can be transferred, represent membership rights or claims (or any comparable rights), are not payment instruments and are negotiable, i.e. capable of being traded in a secondary market.

If the Exchange facilitates the offering of transferable securities or its operator acts as a securities broker, the platform may be deemed to provide investment services and will need to obtain an investment firm license authorized for underwriting and/or placing of financial instruments. Furthermore, the exchange platform in which the token will be negotiated would need to be registered as a Multilateral Trading Facility (MTF).

Furthermore, if the token is deemed a transferable security, the issuer may need to comply with prospectus requirements in the jurisdictions in which the offered is conducted. In the EU, the minimum amount for exemption from prospectus rules is set at EUR 1 million, although member states can set higher thresholds.

For instance, Germany exempts offerings up to EUR 8.5 million, whereas the Netherlands exempts up to EUR 2.5 million. However, as a way of example, a German-based offering of EUR 5 million, which qualifies for exemption in Germany, may need to meet prospectus requirements if it is solicited to Dutch investors (as the Dutch threshold is lower).

As we mentioned above, in Switzerland an IEO platform would likely fall under regulatory purview and would be required to obtain authorization and a Securities Dealer License from FINMA to underwrite securities issued by third parties. Issuers would need to comply with prospectus requirements unless the issuer is raising less than CHF 8 million in total over a period of 12 months.

One should take into account local regulations in each of the jurisdictions the IEO platform is onboarding investors from, and consider the extra-territoriality element of financial market regulations in these jurisdictions. Marketing financial instruments to the public in a given jurisdiction may trigger regulatory approval and/or licensing requirements, regardless of the domicile or place of business of the issuer and the intermediary.

Considering the above, if the Exchange operating a utility coin’s IEO platform wishes to avoid the requirement of being licensed as a broker-dealer, the best approach would be to operate the platform in a jurisdiction in which, generally, utility tokens do not fall under securities regulations.

It would be recommendable to not allow residents of jurisdictions in which a given utility coin may fall under securities regulations to participate in their IEOs, as well as not onboarding issuers established in jurisdictions in which tokens may be considered investment instruments.

An IEO platform should also request the issuer to provide a legal opinion on the token from a reputed law firm in each of the most relevant markets in which the token will be sold and to ensure that the issuance and distribution of such tokens are compliant with local laws.

From an issuer standpoint, relying on the fact that most of the legal burden is passed to the exchange may not be the best idea. If the token is deemed a security in any of the jurisdictions in which it is marketed – regulatory requirements may apply to the issuer, including seeking prospectus approval.

Token Issuers must make sure that a given token is compliant with the laws of the relevant jurisdictions in which it is marketed, also considering that it would be issued via an IEO platform. Furthermore, as mentioned above, the issuer can expect that the IEO platform will request legal opinions on their tokens on a variety of jurisdictions.

IEO Structuring

For the Crypto Exchange

When it comes to determining the structure for a given Exchange that operates an IEO platform, we should consider the degree of inherent risk that the business entails.

The exchange platform is promoting and marketing the offering of a high-volatility asset directly to token purchasers, assuming a high degree of liability against its users. If their purchasers end up with heavy losses, and/or the issuer does not honor its promises, the exchange might be subject to legal actions brought by its users.

The exchange will also bear the burden of conducting due diligence on the issuers. If a bad actor is onboarded i.e. scam token it could have disastrous consequences legally, in addition to negative reputational and commercial implications, the details and effects of which are out of the scope of this article.

Furthermore, the exchange carries the burden of conducting due diligence on all purchasers and must ensure that only eligible participants are taking part in the sale.

The regulatory risk is also significant. As we have commented, the exchange is brokering tokens that might be considered securities in certain jurisdictions, with the additional risk that it has limited control/decision-making influence on the final purpose of the token after the sale.

Considering the above, the corporate structure should minimize and isolate the aforementioned risks from the main business activity: the Exchange platform.

One could consider setting up a distinct structure that owns and operates the IEO platform and concludes agreements both with the issuer and with participants. The IEO platform should be clearly distinguished from the main Exchange platform.

By segregating the IEO platform from the other activities of the Exchange, one could better manage the aforementioned risks and achieve a greater separation of legal and financial liability.

This will also allow for jurisdictional arbitrage to minimize regulatory uncertainty. One can pick a jurisdiction in which regulations set a narrowed definition of securities, which most utility tokens are not likely to fall under.

It may also be a good move to establish the place of effective management and business, have physical presence, and build an IEO-dedicated team in that territory to avoid having the company considered resident elsewhere, in a jurisdiction where regulations are not favorable.

The structure could consist of an orphan or a related entity(s), and could be directly or indirectly related to the exchange or the holding company.

One could set up a special purpose subsidiary to exclusively handle IEO-related matters with a simpler governance structure, or instead, create a trust arrangement with an underlying IEO-operating entity, and an appointed related entity as a beneficiary.

The trustee will administer proceeds received, and transfer them to the issuer in line with the contractual obligations. IEO operation profits could be distributed periodically to a holding company for further reinvestment in operating entities, or distribution to the beneficial owners. Using a trust arrangement effectively places a ‘wall’ between the IEO activities and other groups’ activities.

One should also consider other elements related to the IEO that might have an impact on the structure and/or the legal relationship between the entities.

For instance, the IEO structure may need to use certain intellectual property rights owned by another entity, such as trademarks or software copyrights, to operate the business. It could also delegate to third parties the administration of the proceeds, as well as the conversion of these proceeds to a given cryptocurrency, or fiat currency, depending on the agreements concluded with the issuer.

It may outsource the due diligence checks on participants, as well as the risk assessments on issuers, to third parties, whether they are related or unrelated entities. One should also consider whether there is a transfer of user data between entities, which should be properly arranged and governed, in line with data protection regulations such as the GDPR, if European Union citizens/residents are involved.

Commercial matters may also have a certain legal and financial impact. For instance, if the IEO platform is a clearly separate business from the Exchange, there should be marketing activities that will need to be paid for, such as any promotion or announcement made at the exchange platform level.

To achieve effective segregation of liability, and leverage risk management benefits, commercial and other operating activities should be strictly differentiated between entities.

The governance structure should be clear. Although the IEO structure may share board members with other group entities, management decisions related to the IEO platform should be made internally. The IEO platform operator should have its own board meetings, and control should not be carried out at the holding or exchange level. Agreements with stakeholders related to the IEO operator should be carried out by the IEO structure, and not by any other entity on behalf of the IEO operator.

For the Token Issuer

From an Issuer standpoint, although a significant part of the liability and risk burden is passed to the IEO platform when compared to the ICO model – like ICOs, issuing a token via an IEO is still, in fact, a high-risk/high reward business.

There are critical areas that a Token Issuer should address when structuring the business. These are typically related to securities regulations, post-sale business operations, liability towards investors, taxes, banking, and asset protection.

Even if you are not directly transacting with IEO participants, you still need to take into account the regulatory categorization of your token. You should jointly work with the IEO platform to make sure your token will not be considered a security in your place of business and the jurisdictions the IEO is onboarding investors from.

Furthermore, it may also be a good approach to set up a special purpose vehicle to issue the tokens, separated and isolated from the main operating entities. This could have a number of benefits from financial, commercial, tax and legal perspectives. Furthermore, as the IEO platform may request the issuer to meet certain requirements related to the structure, the issuer should work with the IEO platform to make sure their interests are aligned.

This is especially important if prior to the IEO you already have an existing money-making business. A Token Issuance is a highly risky activity, and you want to make sure it doesn’t have a direct and negative legal and tax impact on your current business.

From a tax perspective, the sale of utility tokens is generally considered commercial activity, and proceeds received may be considered ordinary business income and, therefore, taxable. This is dependent of course on the specific tax laws in each relevant jurisdiction.

Many Token Sales are pre-selling access to a future product or service that will be delivered in 1, 2 or 3 years, which could lead to a substantial net revenue at the end of the financial year. This might not be an ideal situation as you may be offsetting 1-year expenses to, for instance, 3 years of revenue, and most jurisdictions do not allow the carryback of losses.

To address this issue, we’ve seen ICOs keeping these proceeds in tax-neutral entities, effectively managed in high-tax countries; or directly not reporting crypto proceeds to tax authorities, and just reporting proceeds converted to fiat.

This is not a good approach. It may be tax evasion, which may carry civil or criminal penalties, and it doesn’t give the flexibility of converting proceeds to hedge market risks and meet a business’ financial needs.

By properly considering elements such as the place of incorporation, the place of business and management, the beneficial ownership, as well as the relationship between related entities – one could 100% legally minimize or defer any tax burden.

Generally, it is a good approach to establish a vehicle for each of the purposes of an ICO/IEO, with the proper economic substance, and intra-group commercial substance to be compliant with current tax laws.

Issuing the tokens, managing the proceeds raised, developing, holding and exploiting the intellectual property, and operating the business, among others, are totally different activities – with different needs, and bearing different risks.

Jurisdictional arbitrage may allow you to minimize these risks, and better fulfill your needs. There are jurisdictions and legal structures that provide certain benefits for certain activities, but that they are not optimal for others.


Unlike ICOs – in which the Token Issuer should conduct KYC/AML checks on ICO participants – in an IEO, the compliance burden is passed to the IEO platform operator.

Even assuming that the IEO platform operator will conduct business in an unregulated manner, in certain jurisdictions ICOs, exchanges and IEO platform operators may be subject to relevant AML laws.

In this case, they are required to conduct customer due diligence, ongoing monitoring, record-keeping, report suspicious transactions with the relevant authorities, as well as comply with prohibitions from dealing with sanctioned individuals and entities.

The scope of activities subject to AML regulations may also vary across jurisdictions. For instance, the EU’s 5th Anti-Money Laundering Directive (AMLD5) covers fiat-to-cryptocurrency exchange platforms and custodial wallet providers, but not crypto-to-crypto exchanges.

AMLD5 will need to be transposed into local law to EU member states, and enter into force by January 2020. However, other EU jurisdictions such as Estonia, Malta, and Gibraltar have already included certain cryptocurrency business operators under AML regulations’ scope, and have enacted a specific regulatory framework for certain types of crypto businesses.

Furthermore, the UK’s HM Treasury has already set out consultation proposals to transpose the AMLD5 including the Financial Action Task Force’s (FATF) Recommendations on Combating Money Laundering for activities involving crypto assets. FATF’s recommendations include businesses providing crypto-to-crypto exchange services, among others. We can expect most countries to adopt FATF recommendations.

One should also consider the extra-territoriality provisions of AML regulations.  Onboarding customers from certain jurisdictions may directly subject the company to local AML regulations of said jurisdiction.

Even regulations of the country in which the Issuer and the IEO platform operator do not consider the activity as a relevant activity for AML purposes – the best approach is adhering to the best KYC/AML practices.

The IEO platform operator should comply with Customer Due Diligence (CDD), record keeping, monitoring and reporting requirements, especially for transactions that exceed prescribed thresholds, and appoint a Compliance Officer (CO), Money Laundering Reporting Officer (MLRO) and Deputy Money Laundering Reporting Officer (DMLRO) in line with local regulations.

Additional checks on the source of funds, regardless of whether these are crypto or fiat, should also be made.

By accepting payments from individuals or businesses, you are responsible for ascertaining their name and personal/company details, and conducting the appropriate checks to ensure that they are not sanctioned persons. If something goes wrong and your platform is used for illicit purposes – you could be considered an accomplice to money laundering, terrorist financing, or worse – and all the associated liability therein.

If you do distribute tokens to known terrorists or members who are on a list of economic or commercial sanctions (eg. OFAC, UN, Interpol, EEAS, etc.) you may unknowingly be committing a crime and the penalties may be severe.

A number of SAAS providers supply end-to-end solutions for streamlined KYC/AML checks. At Flag Theory, we have partnered with a number of providers that are vetted by and satisfy the requirements of a number of banks we work with.

Implementing the appropriate measures to effectively identify beneficial owners, and to prevent the platform from doing business with sanctioned individuals and entities may not only avoid placing the IEO operator into legal hot waters, but it is also essential in order to secure banking relationships.

Crypto-related business activities are considered high-risk for financial institutions. In fact, most banks are not currently onboarding clients in this industry. There are a number of banks that are providing services to crypto participants, some only to licensed entities, and others also to unregulated companies.

In any case, banks and other financial service providers will only onboard crypto-related businesses if they have taken AML seriously, and are compliant with local regulations.

Certain jurisdictions have enacted regulations in which CDD is explicitly allowed to be conducted in a fully electronic manner. That could also be an element to take into account when assessing potential options for the IEO platform operator, considering the international and digital nature of the business.

The Bottom Line

As we’ve seen, typical regulatory uncertainty that usually affects cryptocurrency businesses is considerably sharpened when it comes to IEOs.

Unlike most serious ICOs, which marketed their tokens as consumer products, a token issued via an IEO could have a clearer investment purpose. Generally, large ICOs took the conservative approach of not promoting any effort related to creating a secondary market for the token and highlighted its consumptive purpose instead. How you market a product may be relevant from a legal perspective.

In an IEO, the token is marketed as available for further trading in the same platform, and the purchaser is buying it in an exchange platform with the certainty that a secondary trading market for the token will be organized. The speculative or investment purpose for buying the token is clearly present on both sides of the equation.

This makes the token more prone for consideration as an investment instrument in a number of jurisdictions.

In such a case, the exchange may be conducting a financial services activity, which is regulated in most jurisdictions worldwide, and, generally, involves strict licensing and ongoing operating requirements.

Furthermore, a large number of jurisdictions have extra-territoriality provisions for foreign financial service providers, which are restricted in their ability to market their products to residents without obtaining authorization from the local regulator.

In IEOs, part of the risk burden associated with ICOs is passed to the Exchange, which may have significant commercial and legal consequences if not properly managed. The Token Issuer is not immune to these risks either, and still retains certain liability towards their token holders, as well as still being subject to the laws of the countries in which they are operating, and onboarding investors from.

Therefore, both the Exchange and the Token Issuers should properly take into account these facts when structuring their business activities. The proper structure will serve as an effective tool for managing their risks and liability, as well as for optimizing the tax situation, the business operations, and the financial services accessibility of their different business units.

Whether you are planning to launch an IEO platform or issue your token via an IEO, at Flag Theory we can help you leverage global structuring opportunities aligned with your specific business model and circumstances. We are experienced in structuring Exchanges and Token Sales. We take into account not only all the legal, regulatory, and tax elements, but also your specific commercial needs, priorities, and goals.

Our goal is to empower you to operate your business smoothly and hassle-free, while legally benefitting from the greatest asset protection, liability limitation, risk mitigation, and tax minimization strategies. Contact us today, it will be a pleasure to assist you.