Brian Brooks: Token Securities Framework and Launching a Network

[Music] today is really two things one is I want to give you a quick orientation to the framework and especially the securities law framework that you will encounter as you launch your various businesses and networks and then I want to talk about some choices that you'll all confront for a legal perspective as you launch your various kinds of projects slightly different issues so I'm going to separate those and we're gonna start with just a little bit of background so it's a moment about my own background because it's a little bit of the kind of bifurcated background that you will all need to develop in order to be successful in this space so I have spent the last couple of years as the chief legal officer of coin base but I also have a background in FinTech and traditional finance and I'm not gonna say a ton about my own background a you're welcome to look at what's in front of you on the screen obviously but what I will tell you is crypto is the most perfect intersection of tech and finance crypto projects are fundamentally trying to disintermediate traditional money and traditional finance but the regulatory regime that you have to deal with as you do that is a financial services regime and that's the education I want to give you today so I'm going to try to address four basic things in this talk the first is I want to orient you to the background that governs crypto generally and as you'll see there are a number of different agencies and a number of different legal regimes that you need to be familiar with as you launch your projects the one I want to focus on is the securities law regime and I think for many of you who are at least some way down the pike in your project you've probably heard that it's a bad thing to be a security I want to disabuse you of that notion a little bit and to make clear that being a security doesn't mean that you're illegal but it does mean that you have to comply with a set of disclosure rules and other things that you need to be ready for if you go in that direction I want to spend a few minutes talking about the crypto raiding Council which is a group coin base helped found that has developed a tool that will help you navigate securities law both in the United States and later elsewhere and then finally I want to help you think through some of the trade-offs you will probably encounter as you launch your businesses so that you can think upfront about what your priorities are and then optimize for legal compliance in the lightest weight way possible let's go to then again by saying that you are for those of you who are right at the startup phase as I assume most of you are in this crypt of startup school you're going to make some early choices early on that are going to affect your a viability legally down the road and so I'm going to assume that all of you have three things in mind and the question is where are you in your journey and which things do you need to optimize for at which point right so all of you are building networks of some kind that you hope to operate it could be a media network it could be a sort of a ledger network it could be a financial services operation or something else but you all want to operate a network with members and nodes on your network you also of course are going to want to raise money and generally speaking part of the initial offering of a token is designed to raise money it may also be designed to do other things and finally there will likely be some point in the future where you're gonna want to go public now that could mean a traditional IPO it could mean some kind of a token process that will allow your coin to be your way of accessing public capital markets but in one way or another it's highly likely that all of you will want to do all three of these things and so I'm going to try and get into the details of how to think about each of those each of those milestones the ahead so I promise you we do a little bit of background on regulation and this is the background piece you need to know is that there are multiple regimes that matter when you're launching a crypto project and there multiple agencies both in the United States and abroad that will become second nature to you even if you haven't heard about them before so I'm going to start by orienting to the idea that the Treasury Department in the United States is a very important stakeholder in a couple of different ways and they're important even if your project is not based in the United States okay so the Treasury has several offices that have an in act on crypto projects there's an office called the Financial Crimes enforcement network or FinCEN which police's money laundering laws in the US and also is relevant to terrorist financing laws Vinson is the organization that looks at at SAR filings for suspicious activity that might occur on your network and they also make sure that you're not in the business of using your token to allow criminals to launder money in ways that can't be caught during the normal bank surveillance process Treasury also enforces a rule that is administered by the Ofek office the Office of Foreign Assets Control they also Foreign Assets Control is an important sanctions tool that the US government maintains to make sure that sanctioned individuals whether they are war criminals or people who live in countries that are sanctioned are not able to receive money through the financial system and then there are other Offices of Treasury like the IRS who is responsible for tax regulation in the u.s. who may become relevant to you depending on exactly how you're distributing your token and how you're accounting for the value of the token at the time that people acquire it so these are all important in many ways now I said a moment ago that even though the Treasury is a US agency it will matter to you if you're launching abroad and that is because the Treasury has the ability to impose sanctions through various of these offices and so even if you are launching in Asia or in Europe or in some other part of the world the Treasury has the ability to dictate that your project has to be sanctioned and excluded from any financial system that does business with the United States so the important takeaway here is that if you have money laundering issues terrorism financing issues or other other regulatory issues related it who your customers or users are the Treasury has a very long arm and has the ability to affect your operation even in other countries now the second agents that I want to talk about just for a moment and I'll say a lot more about this later is the Securities and Exchange Commission or SEC well I'm sure most of you have heard from your B C's or from any of your advisers as you're launching your products is the single biggest impact that regulation has on Krypt projects is securities regulation and that's because of the SE C's view that certain tokens may constitute securities I'll talk more about that and what that means in just a few moments but understand for the moment that the SEC is responsible both for securities enforcement so if you offer an asset that is deemed to be a security you have to comply with certain disclosure rules and then they're also responsible for enforcing exchange rules so if you're launching a D Phi project that might arguably look like a broker dealer if you're trying to help people operate a trading platform in various ways it's conceivable that the SEC would look at your project and determine that what you're doing is operating a broker dealer which requires special licensing so I'll come back to the SEC in a lot more detail in a few minutes there is another agency in the government another independent agency called the Commodity Futures Trading Commission or CFTC and the CFTC regulates some of them were interesting and exotic cutting-edge crypto project projects projects like margin lending for example or crypto futures or crypto swaps these are things that have gotten more traction in Asia than in the US but people in the US including coinbase are looking at different variants of this and in those cases the CFTC is your agency and you need to understand the details of their regulations if you want to offer those kinds of products finally many people think well if I operate outside the US I can avoid this heavy regulation by going somewhere else and what I would tell you is there are different gradations of regulation depending on the jurisdiction you're planning to launch from the European Union tends to have a regulatory environment that looks fairly like the United States not radically different from the United States in its shape Singapore on the other hand recently adopted a law that is simpler lighter way through the US but does provide some amount of regulatory oversight for crypto I would argue Singapore is probably a more clear and more certain regime than the EU or the United States but don't think there's no regulation over there and then there's Japan where I know some folks on this on this call are located and Japan has a vid on the one hand one of the very biggest crypto markets in the world but on the other hand a very very complicated regulatory regime so don't think that simply by basing yourselves outside the US that you can avoid crypto regulation the jurisdiction in which you're locating and where you plan to serve customers will have its own rules and it's going to be important to understand those consulting with your own Council so I really want to focus most on in this conversation is securities law I say that because it's the most overweight part of any legal analysis you're going to do because it affects both the nature of the token that you're allowed to offer and the manner in which you can distribute that token so I want to help you understand just in a laypersons language the way that federal securities law in the United States works so the question is why do we have securities law in this country and how can it affect a token project the reason we have securities law in this country is because of a belief that if someone is making an investment in you and when I say you I mean you as a human being they're entitled to know who you are what you're doing what risk factors you perceive where your money's coming from what kind of governance you deploy right and so the whole issue to think about when you ask yourself if securities law cares about you or not is the question of whether the value of the token you're going to offer is dependent on whether you as a management team succeed or whether it's based on something else right so if you have a token that is entirely based on its utility in a functioning Network right if if in other words the value of your token is similar to the value of a baseball ticket and getting admission to a ballpark then you may not have a securities issue but if the value of the token is based on whether you are successful in building something you haven't built yet or marketing an asset to a market that's uncertain then it's highly likely that the securities regulators are going to want you to provide disclosures to your customers that's the simple way of thinking about it if the token of if the value of your token is contingent upon your success then it likely is a security and people are going to want to know information like the information on this slide and if you use your token to raise money and if you're asking people to pay you for the token an investment of their own funds then there's some risk that your token is going to be deemed to be a security subject all of these laws okay so we're gonna get into this in a lot more detail here in a moment you don't need to know a lot about securities law to launch a successful token project and you certainly don't need to go to law school to do that but there's one thing you do need to know because you'll hear this a lot from your lawyers and that is something called the Howey test the Howey test which many of you have probably already heard of comes from a Supreme Court case in the 1940s that defined when a given kind of a transaction is a securities transaction versus when it's something else okay and all you need to know for today's purposes is that the how we test impose a four-part test right each of these parts must be satisfied in order for something to be a security first somebody has to invest money in it right so if you just give something away for free it's likely that that transaction is not a security if someone earns something through work or through taking a course or something it may not be a security right but if they give you money in exchange for a token that's one factor that weighs in favor of being data security the second factor is whether there's a common enterprise going on so in other words when they pay you money are you all coners of a company who's going to rise or fall in value based on various factors right so if you're all now cool ventures and co-owners of a single enterprise that tends to suggest that there is a security transaction going on the third factor is pretty easy do people who are giving you their money expect to make a profit on that money if they don't then that's a helpful fact but if they tend to expect a profit as most people do that suggests again that it may be a security and finally and this is the point I made a moment ago finally it's a factor in favor of it being a security if the transaction is going to generate a profit based on your work right so if I give you a hundred dollars and I'm asking you to work really hard to grow my hundred dollars into two hundred dollars that tends to suggest that it's a security because I'm entitled to know who you are what you're doing and what your business plan is so those are the factors that the SEC and any court in the United States we use to determine whether you're covered by the securities laws the problem in the US and one of the reasons it's worth having something like crypto startups cool is that how the four factors apply to any given project is unknown and the SEC is not in the business of providing very much clarity right so that's what I want to help you with here in the next couple of slides before I tell you the tools the coinbase and our partners the crypto rating council have built to help you navigate these shoals let me tell you that there may be some good news on the horizon right so if you're a technologist and you're thinking geez Brian I've got a great idea for bringing decentralized you know finance to the world but I have no idea how to comply with these securities laws then the good news is that one of the SEC commissioners recently came out with a proposal to give you clarity now I want to emphasize this isn't law yet and you can't rely on this yet but it's on the horizon and may provide you some help in the future and so this particular SEC Commissioner Commissioner named Hester purse recently put forward a proposal that would scrap everything I just said and make it much simpler what Curt proposal would do is it would say that if you're launching a token project you have three years to achieve utility on your network or to achieve decentralization in your network and if you can do one of those things inside of three years then it doesn't matter what happened at the beginning of your token project you're not a security and you have a safe harbor to proceed doing what you're doing on the other hand if at the end of three years you haven't achieved all those things then there's a safe path to securities registration and no one will come after you for violating the law that seems to coinbase it a lot of other big companies in the space a very sensible proposal because it provides a path to legality and it gives you a period of time to build your project while still raising money but I emphasize that's not the law yet and so what we need to focus on today is how to get your projects launched now but a year from now you may see the safe harbor product proposal take effect in which case things will be a lot simpler so let me talk to you about the way the law is today right today it's not as simple as in the purse proposal today we have the Howey tests you may be subject to securities regulation and so with that in mind a group of companies including the eleven companies that you see on this list led by coinbase put together something called the crypto rating Council and the idea was to develop what we think of as the Securities equivalent of the Motion Picture Association movie rating scale so most youever most of you are familiar with the idea that when you go out to see a movie in this country and many others we will tell you based on the rating of the movie how much violence you might see how much nudity you might see how much offensive language you might see and everyone's come to understand how an r-rated movie is different from PG read we all know what that's like so the concept of the Krypton rating Council was to bring that approach to crypto tokens to let you know that hey here's a token that is a little bit risky and here's another token that's a little bit less risky you know this is an r-rated token this is a pg-13 token this might be a g-rated token and so the purpose is to bring that same level of clarity to crypto so that you all have a sense of where you are on the risk spectrum the key is to understand that like with the movie rating scale these Security's risk ratings have to be objective they can't be based on somebody's opinion and so we built an objective numerically based rating scale that can be applied to any token to tell you where you are in terms of your risk of an SEC investigation so the crypto rating Council got together and we put together a 36 question framework here you can just see the first three questions but you see how it works so the framework asks a series of yes/no questions and we weighted each of those questions so that the most important ones have more points associated with them and the less important ones have fewer points associated with them but all of these questions roll up to a bottom-line score and they tell you on a one to five scale where you fall in the view of the cripton rating council members who represent most of the market in the United States a five rating on the CRC scorecard is very likely a security and most of the exchanges who are in the crypto rating Council will not list a 5 unless they have a broker-dealer license so if you're scoring a 5 or something very close to a 5 it's likely that that's going to be difficult to list in the United States on the other hand if you're getting something that's a 1 2 or 3 or even really anything less than a 4 most of the Krypton rating council members will see that as sufficiently different from a security even though it may have indicia of a security it is safe to list okay and so again without belaboring the point you'll see some of the questions here on the left side of your screen along with the waiting's that that we give to a yes answer or a no answer on various of the howie factors now you might ask yourself how do these scores all roll up to one of these one two three four five scale scores and if we go to the next slide I'll show you how that works so the concept is if on the for Halle factors if three of those factors have a scorecard score below 100 we regard that as perfectly safe it looks nothing like the security we have no issues to give you example of a one Bitcoin as a one and we know that it's a one because the SEC has told us that is definitively not a security and when we ran Bitcoin through our scorecard we came up with that result it really doesn't have any indicia of a security it is entirely decentralized there is no central management team it is a fully functioning network it really doesn't look anything like as a speculative investment to give you an example of a two aetherium scores a two on the crypto rating council scorecard if yeoreum did originally have a central management team right there was a group of people who invented this thing and it achieved decentralization only a little bit later and so it's slightly different from Bitcoin but still so far away from a security that we see very little risk that aetherium would be deemed to security but you can see what happens as you go up the scale score you can get closer and closer to a five and again I would just tell you that as you go north of for most US exchanges will be very very careful about listing your token and so it's important that you know where you are on this scaling system before you go too far down your building path right you want to know as you're building the token that when you're done building it someone will list it so in terms of this one to five point scale there there are really two things to be thinking about which is at which of which is super important so what is the token itself right does the token itself have the hallmarks of a security on the scaling system that I just described and then there's the question of regardless of whether the token is a security are you distributing in a manner that triggers Security's concerns or have you distribute in a way that avoids those concerns even if the token itself might be a security so what we try and talk about here and we'll say more about this in a moment is even if your token is a security let's say that it's totally an investment of money let's say that your network is not yet functional let's say that most people are buying it with the expectation of profit and let's say that it's all dependent on the success of a central management team it's still legally possible for you to issue that token without piling in securities laws as long as there's an exemption that you can fall within or as long as there's some other strategy that isn't directly a securities listing and we're going to talk about some options for you on that but the point is before you can figure this out you need to think about where am I on this crypto rating Council scorecard right and I'll talk to you in a few minutes about how coinbase and others can help you think that through so in terms of where your risk factors are and when you're thinking about this from a start-up perspective what I want to suggest you today is that there are multiple things you might be trying to do in your project and if you manage it correctly you might be able to do any of these things as long as you're careful right and I'm gonna get into each one of these of detail in just a moment but let me first say as an overview that the main thing is you might be wanting to do in your project is you might be wanting to sell a service that's currently available so let's say that you are a fully functional network and the issue is getting a members on your network you might be trying to do that right that's kind of like selling baseball tickets I've got the team I've got the stadium I just need people in the seats a second thing you might be trying to do is to raise money let's say that you already have a fully operational project but you need to iterate it to the next level or you need to refine it or grow it or market it and that takes money well if you have a fully functioning Network there's a way to raise funds that is relatively uncontroversial as long as you're careful and again I'll talk to you about the details in a moment and that's a little bit different from if you're trying to raise money for a network that's not quite functional so here in crypto startup school my guess is that many of you have great ideas and you've written compelling white papers but the network is not yet live right you're still in test method or maybe you have any built them well that's a little bit riskier and you got to be a little bit more careful if you're going to raise money for a network is not yet operational right and then there's another methodology where and this is the seed users bit where hey the issue is I'm on the very front end the network may or may not be fully functional but I really really need people on the network for it to work here you might be more risky even than the the last example but there may be techniques you can use to mitigate that risk and still get launched in a way that US exchanges will list so I'm gonna start with the first of these concepts the idea of a fully functional network or what you're trying to do is sell that service right so the great thing is if your network is already fully live if that's the issue and fundamentally what you're trying to do is get people using the system in other words it take my baseball stadium analogy highly unlikely you're gonna be deemed to be a security at that point our general read subject to you know the specifics your project is that's gonna score a 1 like Bitcoin it's ready to go anyone can sign up but the ledger is functioning and you're off to the races fully functional Network on day one where you're not trying to raise risk capital you're instead just trying to charge money and generate revenue as an operating company that's not likely to be deemed a security my guess is that in a start-up program like this most of you aren't there yet but if you were we think you probably don't have very many securities law issues to worry about so here's a slightly different concept let's say that you have the project but it's not the ultimate project you need to add a lot of more a lot of new features right or you need to refine it to make the user interface better or something like that in that kind of a world the fundraising aspect and the idea that you are going to change the network is going to be seen somewhat negatively by courts and by securities regulators but still the fact that the network is fully available and the fact that the purpose of this is to fund the next iteration of networks which will benefit all of your current users is going to look less like a fundraise less like a securities offering and it's going to look more like a capital raise at your golf club or something like that it's going to seem more like it's it's just sort of iterating not not a during risk assets and while that will be harder to justify than the previous example it's still gonna be in the realm of an eighth score we're still gonna be pretty comfortable with that here's where things change my guess is that most of you on this call are in this bucket okay you all have a great idea you've written your white paper you've perhaps built some software but your success as a dev team is critical and if you fail the value of your token is going to be zero and if you see is going to be high right and so what token holders are doing is they're buying on the come access to a network that doesn't yet exist and in a case like this you're gonna be a little bit riskier right and if you do it wrong you're gonna trigger some of these factors in our scorecard that will mean coinbase and others will likely not list you so the trick here is to be very very careful about how you market this token right it's to make very clear that the reason you're selling the token is because you're gonna build something valuable that people will want access to in the future and you're not selling the token for investment purposes you're selling the token because people can get an early mover discount for this thing that's going to happen later so imagine if you're getting the early tickets to the next Star Wars movie before they've gone retail the movie might or might not be good but the odds are that the tickets are gonna cost 20 bucks and for 10 bucks today you can buy an early ticket right as the early ruler just kept that works some of these things also have other features and as long as there's no requirement that people opt into those features instead they're simply buying access to the network that will also help mitigate your score all I'm really trying to land though with you is the idea that if you're in this bucket you're gonna have to be a little bit more careful and we can help you think that through that's what I'm gonna get to at the end of this presentation is the way in which coin base and other companies can help you think this through before you issue the token let's look at one last slide here so here this is the thing that we think is probably probably the most risky so if your project depends on you scaling up rapidly and having a large number of users and and what you're trying to do is build a large network of people who are token holders the things you have to watch out for here are that not charging people for this right right that you're not charging for the privilege of being in your network these are you know this is a scenario where you can reduce your risk by giving away the asset for free or distributing the asset through an education program like an earn program at coinbase or similar programs that other exchanges offer the reason this is risky is because the value to these seed users is still dependent on the dev team and you may not yet have a functioning Network yet and you may mark it in a way that convinces people that the reason they should sign up early for your projects because they might make money on the token value not that they might achieve utility on the network all of those are risk factors and we can help you build mitigant into it on the front end if you if you identify these issues excuse me in advance there's one let me just say the last four scenarios are widely understood scenarios in the in the crypto world lots of developers have confronted each of those scenarios and we kind of have a track record of understanding how that works and how the securities regulators think about it there is a big new idea out there that people are talking about however and this has not yet been tested but a coin base we think that it has great promise this is a model that we think may allow you to sell the token and specifically sell it for the purpose of raising funds to build your network right and to not violate the securities laws in doing so there's just one catch which is in this model you can totally sell to a group of future users they can speculate on it they can buy it because they think they're gonna make money but the trick is that they agree when they buy the token that they will only sell the token to other members of the network they will not sell it to the public in a secondary offering this is what we call the membership model or the mutual model and as I'm gonna describe in a second I think this is going to sound very similar to other economic sectors that you're probably familiar with so the concept here is that you want to raise capital so this is not about selling tickets to your baseball stadium it really is about raising money to build your network and the token holders in buying this want to make money right so they're here definitely for the economic upside not just for the utility normally you would think that that would lead conclusion that you're offering a security as opposed to a utility token but what I want to land with you on this membership or mutual concept is the idea that as long as the economic benefit to the token holders is not in a secondary sales market but as instead because the network you've built is going to be profitable in itself okay that people are going to receive dividends from the operation of the network but they're not going to receive equity gains by selling to third parties you may be safe under the securities laws and if we go to the next slide I'll give you some examples of how this has worked in other industries so let's look at the next slide so for me who comes out of the financial services world the most obvious example of a membership model that isn't violating the securities laws would be mutual insurance companies so I think of my own personal insurance company Northwestern Mutual Northwestern Mutual is offering me two things three things really that would be consistent with an equity investment but that isn't in fact covered by securities regulation so the first thing they're offering me is utility right I buy an insurance policy and they give me the utility of promising to pay me a death benefit if I die during the policy term that's a good thing another thing they're giving me is the right to vote for the directors of the company that's a right that usually encourage to equity holders in a public company and it occurs to people who own insurance policies in a mutual insurance company and then there's a third thing they're offering me which also sounds very much like a traditional security they're offering me dividends so if the company is successful in a given year the company will achieve a rate of return and they will dividend and back to their owners namely the policyholders but the thing that prevents them from being deemed as security by the securities regulators is that the only person I can sell my insurance policy back to if I wanted to is the company right it has to stay inside of this closed circle so so again let's be clear I've given the company a bunch of money in exchange for which they've given me utility they've given me a right to vote and they've given me economic upside in the form of dividends all of that sounds really good the only limit I had to agree to in order to avoid secure regulation is that I won't sell my policy in the secondary market instead I'm limiting my ability to sell it back to people who are in the network namely in this case the issuer of the insurance policy now I'm giving you some other examples of companies like this on this slide as well one that you may be familiar with is REI the outdoors store for 20 bucks you can buy what looks like an ownership stake an REO and that entitles you to a dividend every year it entitles you to vote for the board and times lis to all kinds of other cool things but you can't sell your membership other than back to REI right so I think at this point you sort of see the analogy here a crypto project that had a functioning network could raise money through a token offering it could offer people dividends from the economic value of the network it could even let those people have votes for officers and directors and other things inside the network as long as you're willing to limit the secondary trading this is a big new idea that we've been pioneering over the last couple of months and the people are maybe have talked about but I emphasize it's a new idea it hasn't been tested with the SEC in our industry but it has a long enough track record elsewhere that we feel very comfortable exploring it and we'd love to consult with folks who are interested about it so having given you all of that there are a handful of over-the-top issues I want to make sure that you're warned about and aware of you're totally separate from the general regulatory regime that I've just talked about the first is there's a view on the part of many regulators not just in the US but also abroad that gambling tokens so-called are generally illegal they're generally against public policy and should be viewed very skeptically the reason I mentioned this is because a lot of things that the regulators think of as gambling tokens we in the crypto world think of very differently so you know we might think that the augur token is for prediction markets and the regulars might think that prediction markets are no different from gambling right because saying who we think is going to be President of the United States in 2020 is not that different from saying who's going to win a horse race or something and so regulators have a specific view of gambling tokens and you need to just know that so that when you're building your project if that's an issue for you you know to get out in front of that with your regulators but there's a lot of controversy around privacy tokens right I think everybody on this call knows that you know it's a misconception in the world that all crypto tokens are anonymous and private we all know that there are lots of tools like coin based analytics and elliptic and others who are very easily able to do forensic research on most blockchains but there are some tokens you know the dashes of the maneras the Z caches of the world that have privacy opt-in features and you need to know that law enforcement in some countries is quite skeptical that they believe that the ability to surveil transactions is more important to prevent money laundering and terrorism than the countervailing right to have financial privacy that's not coin bases view but there are law enforcement officials around the world who do have that view there's an issue of we call them fat if regulations fat if is a global treaty organization which stands for the Financial Action Task Force and the fat F believes that certain aspects of international transactions in crypto not not in country transactions but international transactions need to embed sender and recipient information in every transaction so that they can trace transactions back to their originating source this is controversial but fat F does have these rules and so if you're involved in a remittance project or any other international sort of cross-border project you need to be aware of fat.if regulations including something called the travel rule and finally there is a complicated issue in crypto of tax reporting this mostly has to do with people who acquire crypto without a cost basis or people who are engaged in very small dollar transactions the cost basis issue is if you're doing an airdrop or if you're running an errand campaign and the way that people acquired your token was without spending money then it's very difficult to calculate a capital gain on that and the tax authorities may well collect uns questions again these are just issue spotting for you and all of you will have your legal counsel and your advices as you launch but remember that regardless of your securities compliance any of these four things could inadvertently trip you up and you want to give careful thought in advance of launching to make sure that you've put in place mitigates for those kinds of things so I said earlier several times that there are people who can help with right and and obviously it's important to consult legal counsel when you're launching these programs particularly security as legal counsel if you're operating in the United States or in the EU but what I wanted to suggest on this call is that there are exchanges in the space and coinbase itself has a program called coin based launch where we are quite eager to advise you know it's in our interest and that projects that trade on our platform are doing so with a minimum of legal risk we want to make sure that we maintain our reputation as the most compliant place to trade crypto in the world that we can help you think this stuff through so you don't commit footfalls or otherwise inadvertently violate the law and so I invite you to reach out to the coin base launch team who can look at your project under the crypto rating Council scorecard and otherwise help you identify issues early enough they you can still launch your projects with a minimum of muscle fuss and with that I'd be completely thrilled to take your questions I really appreciate everybody participating in this program today it's super important and we hope we can add value thanks Brian that was great the first question is from Ryan and he's wondering how to burn models affect the classification of a token as a security and maybe I'll edit Oriole eyes a bit and add to that so burn model is when you when you have a token that you destroy in order to claim you know some value from the network and and so in some senses it's like a stock buyback when a company buys stock from the market and then takes it out of circulation that in theory should increase the value for for all the other stock holders a burn model is similar so he's asking how does a burn model affect the classification of a token as a security all right so so Ryan I really appreciate the question what I'm telling you is the the mere fact of making money through some activity doesn't make something as security so I come back to and the the core of securities law is if I'm taking a risk on you right by giving you 20 bucks hoping that you will succeed in some effort that you're doing but taking a risk that you won't succeed then I'm entitled to disclosures about who you are where you got your money who your partners are what your risk factors are etcetera right but the mere fact I might make money because there's some going on does not itself turn something into a securities transaction so you know there are a lot of examples like this I'll talk about the burn model in just a second but takes taking as an example staking is a thing you can do to make money right it's automated it's it's all you have to do is click a box or press a button and suddenly your tokens are being staked and then you're getting more tokens nobody thinks that by itself turns on an otherwise non securities asset into a security asset simply because you're making money so on the burn front the fact that you have something which is either inflationary or a counter inflationary right like reducing the number of tokens in the world and thus raising the relative value of the other tokens as long as it's automated as long as there's no risk factor in that it's unlikely to be deemed to be a security just for that reason now there may be other factors but that mere fact of burning the token is not likely to do that one piece of evidence for that is that many stable coin projects including coin bases us DC stable coin have a burn feature right when you redeem that token we burn that token to ensure that it's never reused and never double paid and if there's nothing else about the project that would suggest that it would be security and the regular than we've talked to have kind of confirmed that view so I would say that a burn feature although it might tend to raise the value of other tokens shouldn't itself barring other factors trigger securities laws yeah that's a really great explanation I think there's there's a number of projects in the space today that sort of have this model implemented and so hopefully that's relieving for them to hear okay so next questions from Stephan and it is what are the regulatory challenges of operating a fiat to crypto payment rail well that's a great question so this this of course depends on the country but generally speaking in the United States that kind of a transaction is regarded as money transmission okay and so you have both a state and a federal implication to being a money transmitter first of all in most states although weirdly not all but in the majority of states if you are either converting crypto into fiat or if you're selling crypto in exchange for fiat that's regarded as money transmission because those states regard crypto as sort of like a stored value instrument or a prepaid card or you know some other instrument that has some latent value represented by the cash price and so in those states you have to obtain a money transmission license getting the license interestingly isn't all that hard right but operating the license does subject you to examination and supervision by various state regulators so you have to know that coinbase does have money transmission licenses in the vast majority of states for that reason in addition to the state level of having to have this MTL license you also have to register with FinCEN remember that's that Treasury Bureau that I talked about as a money services business because there's an overlap in the definition of money transmitters and money services businesses and the point of all of that is is that there's a federal concern that if you're allowing people to turn dollars which go through the banking system into some other kind of asset that doesn't go through the banking system there's a possibility that in doing that you're laundering money right so so like hey I've got a bunch of money that I extraordin into Bitcoin which had a provenance that was different from the original money laundering I can then sell the Bitcoin back into dollars and that will launder the money in that way so as a result of that you have to register with Treasury Department as a money services business fairly straightforward right and and when I guess just for the folks in the program here who are starting out that's a not a light thing to do right it's a heavy-lift and so you know I would maybe add that as a startup you might want to lean on some someone else who's got that figured out because that's just one piece of the puzzle while startups have to figure out you know how to go the product that people use meanwhile you know Jesse is a totally great point I mean what I would what I would advise people is many people are doing a start-up are lulled into a false sense of security by how easy it is to get a license from one of these states you know you have to give your finger prints sign up wait six months you have the license the hard part is operating the license so when you get your first notice from New York that they're bringing a team of examiner's on-site to your office to come and turn over your books and records and interview all of your key people and look at your policies and procedures that's when you may ask yourself whether you did the right thing so a lot of people comply with us through partnerships right it's why it's hard to build an exchange and a lot easier build a single token project right great okay so next one is from Paul and he asked for not for non-transferable membership token can you transfer it to non-custodial address that you control so for example you know you have a paper wad or hardware wallet can you transfer on your membership token to that address and if so what's to prevent you from transferring it to a smart contract rather than an end user account and then selling control of the contract so so say it's a great question and I'm super glad that people are thinking about this membership model this way as I said I think there's a ton of promise in it the trick is in order to sort of fall within this general exemption to the securities laws the trick is to define a robust enough edge of who's in the community that anybody who came in to look at it knows that hey I know who's in and who's out and that you're only able to transfer this to people who were in so that has to be a meaningful limit but at the same time you know if you want to make this as useful as possible to your projects you wanted to find that as broadly as you can right so there has to be a knowable limit but it doesn't have to be a narrow limit right like Northwestern Mutual has millions of policyholders and I can transfer my policy to anybody within the Northwestern Mutual world or REI competitive into anybody with them that world that's fine doesn't have to be small but it has to be defined and that's really the key so if there's a way of writing the smart contract such that only nodes in the network or users or families of users or some other defined universe is in it then you're okay you know an example of this is sort of a funny example but it may resonate with some folks on the call is you know in the US we have financial institutions called credit unions and they have a similar rule which is that you can only be an equity owner or credit union if you're within a defined narrow supposedly narrow universe but some of these credit unions defined themselves as all people who live in Los Angeles County or all people who've ever served in the Navy or things like that so they're very large groups of people but they do have to be finite right and so so key element there is you got to know who who that people are right there's some record of who these people are and they're on a white list or at least a definition that would allow something later to engineer who they are right some sort of limiting principle right so so a related question here is from Stefan and if membership tokens can't be traded on secondary markets does that mean that they can't be listed on coinbase that is a great question what I would say is you know coinbase builds all kinds of different markets right and we have all kinds of different matching engines and so what I would tell you is this is a new enough idea that we haven't yet listed a project like this but conceptually there's no reason that we couldn't build an order book that was limited to people who were within a defined universe that's just ends work but as I say this is a relatively new idea which were really really excited about right and I'm as am i I'm very excited about this idea this is you know makes very concrete and intuition that I had a long while back when when thinking about crypto networks and thinking about cooperatives and Mutual's and some where our similarities between them and it's it's great that you've got you know the legal firepower to back it up with some precedent one one question that I have for you is also on on the topic of Mutual's and historically there's been a number of them that have converted from a mutual structure to another structures for example Visa famously did this they started out as a mutual with a number of member banks and then eventually they converted to a traditional you know Delaware C Corp and went public to the to the wider public and so I'm wondering if if there are circumstances that you think might make sense for D mutualization de mutualization of this membership model in the context of crypto and and specifically do you think it's possible for a membership token to transmute to something like a commodity and and what would what would that entail no question about it many mutual insurance companies and many mutual savings banks converted to stock corporations at a certain point in time so the way I think about it is you know I mentioned the safe harbor concept earlier this is like a synthetic version of a safe harbor so let's say that today let's say that you're a brand-new startup right and your networks not functional and you're a central management team and etc today you can potentially use the mutual structure to raise money and build your network today as long as you have the secondary trading limitation built in and then three or four years from now when the networks fully functioning you're throwing off cash and there's a big market that wants to invest in your enterprise you could say hey we bought ourselves three or four years of runway with this initial offering and we did that by limiting secondary trading so we didn't buy them in securities laws now however we have this giant IPO opportunity we would like to go public there is a process for D mutual izing as you say and I won't get into the details today except to say it's been done many many times by lots of companies in different industries so if you think about this as just a way of giving yourself a safe harbor if you can have a great big coin offering but with this limitation and you can live off of those dollars for a long enough to get your project launched then you can deem utilize and do a compliance stock offering on the back and it'd be just fine so until the Hester purse you know safe harbor comes into play this may be an attractive option to explore right one thing I might add is I think what the mutual model is also compatible with with other types of fund raising for example I could imagine you you raise say a seed round from from traditional VC and your private company and you're building the product then once the product is built to some extent you you start to build a community around it and then at that point you start to employ the mutual model to invite that community to have some real skin in the game by owning a piece of the product or service through this membership model and then finally you know once the community is active and participating in the network you could imagine at that point turning control just over to the community outright right and at that point perhaps maybe you're sufficiently decentralized so as not to be considered a security and lift some of them that's a little bit the etherium model in a funny way right I mean you had a central team who built it in everybody who they were and they did this thing and then their protocol became so popular that it became a platform I think that's absolutely a way the ones who do this yeah cool so I think yeah important to note this is brand new stuff so again just want to reiterate that but really exciting so moving off the the membership model that you proposed the next question is from Francisco and Mark and they asked from a tax and compliance perspective how do you think about a decentralized Network rewarding participants so what what about a business that pays the network to receive a service how do I compensate project members or advisers and tokens while not causing adverse tax effects like phantom income yeah that's a great question so and I'm gonna I haven't thought about this a ton before so I'm gonna free associate a little bit the first thing I would say is if it's truly a decentralized network and no one person owns it so in other words if people do not have an equity interest in the network but instead the benefits of this are kind of put back into the network I think what you would say is that there is no phantom income because I don't own a fractional share of the network I just own tokens let's say so I would begin with that concept I think that there obviously are a lot of different ways of distributing value back to the network holders IRA back to the token holders you know one is assuming that your network is live and the tokens are trading on a secondary you know market the idea would be that the more valuable the network is if the value of being plowed back into iterating the network at doing version two three four or five of the network and those kinds of things sort of by definition the value of my tokens will go up because more people in the external world will want access to the network so that's just regular equity type returns and having said that if the way that you distribute that value is in the form of staking rewards or you know sort of air drops or dividends or something like that you know that's when you get into the tax issue I was describing earlier which is it can be a good thing it can raise the value of everybody's tokens but because there's no tax basis in that it's hard to calculate taxes that that's always the issue right so you know if you think about it if you have a save as Academy or a certain rate of interest we all understand that the the interest itself is ordinary income if you have a stock and it grows in value and you say we understand that the value of the stock increase is a capital gain but if I've just been given something that I didn't earn and it isn't interest it's just shown up in my account that's where the tax authorities have a big gray area and so I would tell you that's a place where you really will need to consult some good tax counsel you know you'll also want to consult with your exchange to talk about programs that they can help you with we have a large tax department at coin base as do other exchanges but that's a complicated question that you'd really want to talk to your advisors about a specific circumstance right right and and this is all still very emerging and I would say the IRS has been relatively slow to to comment on it right ok cool so the next one is from ghee and yes not not considering investments how our existing projects held responsible for potential regulatory violations for example a privacy coin that makes anonymous payments possible without kyc AML but never had a sale of tokens or token took investment right well so so if you never had to say all the token and so you don't have a you don't have a securities issue or anything like that there's still the world of law enforcement rights so the agency that is most responsible for privacy tokens focus the most on it is not the SEC it's the Department of Homeland Security right and so the the concern would be if you are facilitating a criminal enterprise it doesn't have to be a financial problem that's just a crime right and so DHS the Department of Justice and investigate those kinds of things there hasn't yet been a significant prosecution of a privacy token as such but we know that in late 2018 and early 2019 the Department of Homeland Security did announce a wide sort of a wide-ranging investigation of privacy token projects generally and as I say the things that I would be concerned about would be just general criminal prosecution of obstruction of justice laws of you know money laundering laws not and that you are doing the money longer because you're not selling it open but you've built a technology that facilitates that which sounds like an aiding and abetting violation so don't don't think that just because you haven't sold a token there's no law that applies to you they're playing people who aren't selling things that nonetheless may be violating the law all right okay last one is from James and and yes whether you can touch on tokens that are made for the purpose of a video or social game and and some of the FinCEN or SEC considerations for in-game car in-game currencies that may not be crypto great question what I would tell you is and so I'm gonna give you sort of an impressionistic answer when I talk to the SEC about various token projects and try to help them understand what the point of crypto is in the first place one of the examples that they find most readily understandable actually are in game tokens you know we have a number of partners in in the Bay Area who are you know with making selling goods for quite a while about tokens of the using in gaming I have not yet heard anybody give a securities related or a commodities related legal problem with that and indeed they understand the utility of that better than almost any other scenario because they all have kids who are trying to get to the you know the next level at fortnight or they want to make sure that there's no latency in their gaming as as a credit card is pinged for additional lives or additional features so what I would tell you is if anything the gaming scenario probably is a little bit less risky from from that regulatory perspective than some other kinds of tokens I would be fairly bullish on that cool okay great well with that I think we'll let you go enjoy the rest of your Friday evening and Brian thank you so much for an amazing presentation that was so comprehensive so everyone please give a virtual round of applause Brian thanks for joining us watch good luck thank you [Music]