Are tokens securities? The Howey Case on orange groves is the test used by the SEC today.
Last year ICOs raised $5 billion across 800+ projects and even more are expected this year. There is a lot of enthusiasm but still more questions than answers. One of the pressing questions is how ICOs will be regulated by the SEC. There are no firm directives yet but there are growing legal standards on what to consider before launching an ICO.
SEC’S ROLE IN ICOS — Starting high level, the Securities Exchange Commission (SEC) regulates securities in the United States. Their primary question around ICOs is whether a token is a security or not. If it is a security, then the company and it’s buyers and sellers must abide by existing securities laws to issue it.
Many voices in the blockchain community argue that tokens are a new type of financial mechanism and should not be treated like a security at all. They deem tokens utilities, let’s call these utility tokens. The SEC, however, says if it looks like a security and acts like a security, then it needs to be regulated like a security, let’s call these security tokens. So how does the SEC define a security vs. a utility otken? Using the Howey test.
THE HOWEY TEST — In 1946, the Supreme Court heard a case (SEC v. Howey) that concerned whether a leaseback agreement was legally an investment contract (one of the types of investments that is listed as a “security” under the Acts). The SEC sued the defendants over these transactions, claiming that they broke the law by not filing a securities registration statement.
If you plan to ICO, you should understand the Howey Test. The original case was focused on orange groves but has remained the standard to define what is or isn’t a security for the past 70 years.
CASE STUDIES OF ICOS — The SEC hasn’t explicitly come out stating what is a security token versus a utility token. Instead of proactively pushing regulation forward, the role of the SEC is to be reactive against fraudulent behavior. They are less focused on winning, and more focused on not losing. Which means it may be awhile before they have more specific guidelines on definitions. The best reference we have to their thinking are the two published reports on ICOs, The DAO and Munchee.
- The DAO: SEC Issues Investigative Report Concluding DAO Tokens, a Digital Asset, Were Securities. (Full Case Report)
- Munchee: Summary of SEC’s Cease and Desist (Full Report)
These two reports are the only public case studies of what the SEC deems not to do. If you plan to ICO, these are worth the read. Your legal counsel will likely reference these two cases as context for how to proceed. There are additional public statements from the SEC on what they may do, but nothing definitive yet.
If you want to go a step further, you can also read the Monetary Authority of Singapore’s (MAS) public stance on ICOs and securities. There is still no published information from Switzerland on how they will proceed.
PROCEEDING WITH AN ICO — So how do you proceed to plan an ICO without SEC clarity? According to the ICO lawyers we’ve spoken with, here are the key steps you can take based on what we do know:
- Get familiar with the Howey test. It’s been time tested over decades so thoug simple, it’s the gold standard for determining whether a token is a security or not.
- Even utility tokens should respect security regulation standards. If after the Howey test, you have the documentation to prove it’s a utility token, not a security, it’s still may be worth the effort to abide by security regulation. Proactively being a good actor will better prepare you if legislation changes.
- If you get press for your ICO, expect a subpoena. The SEC is reactive. If you get covered in press for your ICO, it’s likely that you will get a subpoena so they can learn more. Preparing good documentation in advance helps.
- Target your token sale to people who will use it. The Munchee case was targeting global investors for a token that would only be used in the US. That’s a red flag that it wasn’t a utility token.
- Choose your promotional language carefully. If you are making claims that your token will appreciate in value, it sounds more like a security. A security would expect to appreciate in value over time. A utility token would not.
- Global regulators are still undecided, so avoiding the US doesn’t solve the problem. There are more hurdles in the US but without more clarity on regulation elsewhere, things can change. Simply avoiding US investors in the ICO may avoid this but a publicly traded global token may be published by US investors later and still face regulation.
- The SEC regulation is only one of many regulatory bodies looking at ICOs. Other organizations oversee regulation on holding, trading, sharing information, and taxable events. Hire good lawyers and accountants to help navigate these before an ICO, pre-token launch, and after launch.
Taking the extra steps early to plan your ICO will pay off. This is a new industry so history isn’t repeating itself but it does rhyme. Look at the early derivates markets. There was a lot of enthusiasm for a few years before stronger regulation like Dodd Frank emerged. Years later after busts it was regulated again, and then again.
For ICOs, it’s likely that the same thing will happen. If fraudulent behavior is low, then there is less reason to hurry legislation. The work of the SEC is never done, but it’s there to protect people not prevent innovation. To stay up to date, you can follow them on Twitter @SEC_News.
As a community, we all benefit if ICOs are proactive in being good actors. Learn from DAO and Munchee’s case studies to stay off of the bad actors list. It only takes one big bad player to change the speed of innovation for everyone.
FURTHER DISCUSSION — If you want to learn more about Legal Frameworks for ICOs, join us at our next Lattice Ventures : BlockTalk on February 12th. SEC regulation is one aspect to consider before an ICO but not the only one. I’ll be covering more aspects of ICO structures in later posts.
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Disclaimer: I am not a lawyer or financial advisor, please consult proper counsel and do not take this as legal or financial advice. I am an early stage investor and will do my best to disclose any potential conflicts.