This piece will provide an overview of the following aspects of US regulation of cryptocurrency ICOs:
As stated in the SEC mission statement, “The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” The SEC was created by Congress in 1934 as the first federal regulator of securities markets following the stock market crash of 1929, when it became clear that many companies had provided false or misleading information about their performance and future prospects to investors. Since then, the SEC’s main functions have been verifying statements from corporations and ensuring that securities institutions (like brokers, dealers, and exchanges) treat investors fairly and honestly.
To determine if an offering is a security, the SEC employs the Howey Test, which classifies an offering as a security if it meets all four of the following conditions:
Since being included in 1946, the Howey Test has been the default assessment for determining if an offering is a security, and there have been few exceptions made.
As explained by FindLaw, “The Securities Act and Securities Exchange Act have broad definitions of the term security. Under these Acts, a security includes many familiar investment instruments such as notes, stocks, bonds, and investment contracts.” Whether or not an investment is a security is important because securities are subject to meeting regulatory requirements. All securities must be registered with the SEC, with few exceptions. Along with registering with the SEC, a company offering securities must disclose:
The requirements are in place to ensure that investors receive accurate information and that management teams enforce proper governance. Failure to register with the SEC and comply with securities requirements leads to legal action.
Almost all ICOs are security offerings, at least as the laws are written currently. As explained by Kirk, Caiazza, and Rosenblum from WSGR, “There apparently has been significant shock and surprise over recent reports that the Securities and Exchange Commission (SEC) has issued a large number of subpoenas to initial coin offering (ICO) issuers and to ICO gatekeepers who may have been involved in token transactions that potentially did not comply with the federal securities laws. To a large extent, this shock and surprise is shocking and surprising. The SEC has been as clear as it knows how to be that it believes virtually all tokens (and simple agreements for future tokens, or SAFTs) are securities for purposes of the federal securities laws.” Of the major law firms that have issued opinions in the space, WSGR is considered to be amongst the more conservative and traditional. However, as the laws are written and how they have been historically interpreted, this must be regarded as correct. Many ICOs do pass the Howey Test because they “represent an investment of money in a common enterprise with an expectation of profits coming from the work or influence of a third party.”
For ICOs that have already been issued, the group from WSGR offers the following advice: “Fix the problem before the SEC fixes it for you. If you have sold tokens to unaccredited investors, or if you have otherwise not complied with the federal securities laws, strongly consider fixing the problem before the SEC finds you. Potential approaches include doing a rescission offer, forking or burning certain tokens, and self-reporting to the SEC. All of these are unpalatable, to be sure. Having the SEC show up at your doorstep likely will be even more unpalatable, especially if you have not taken steps to address known securities law violations.” This will be very difficult for past projects that have issued a significant number of tokens that have gone on to trade on exchanges. If this is what is needed, it is likely the case that projects can make a best effort but not truly remedy the problem.
It is to be seen what the outcome of the subpoenas issued by the SEC to ICOs will be. This week (March 14th & 15th, 2018), the House Financial Services Committee has been holding hearings with members of the cryptocurrency industry to better understand regulatory concerns. From the regulator perspective, the most significant concerns have been related to how cryptocurrencies may enable money laundering and the funding of terrorist groups through near-anonymous transmission of funds.
In the same, the group from WSGR concludes with a slightly optimistic outlook for the potential to adapt current laws to accommodate cryptocurrencies: “In the short term, ICO issuers and their legal counsel can work with the SEC to attempt to tailor existing registration, reporting, trading, and exchange rules to better reflect the nature of tokens and token platforms. In the longer term, the crypto industry perhaps can work with the SEC, other regulators, and Congress to develop a modified registration, reporting, and trading system that is designed specifically for cryptocurrency.” This process of collaboration with industry has been ongoing and the hearings this week may lead to positive regulatory developments that allow innovation to take place while preventing investors from being defrauded.
I’m trying something new: if you’d like to chat about cryptocurrencies or anything else technology related drop me a line at [email protected]
Note: I do not and will not provided investment advice or recommendation.