One Toke(n) Over The Line - SEC Tackles ICOs
Regulation is local, which means regtech cannot be seamlessly global as public blockchains can be. Radically different beasts.Nick Szabo (@NickSzabo4) June 19, 2017
By now you have probably heard about the U.S. Security and Exchange's ("SEC") formal (read: boring) Report on the DAO. The SEC also issued a more accessible Press Release, which succinctly noted (emphasis added):
The SEC's Report of Investigation found that tokens offered and sold by a "virtual" organization known as "The DAO" were securities and therefore subject to the federal securities laws. The Report confirms that issuers of distributed ledger or blockchain technology-based securities must register offers and sales of such securities unless a valid exemption applies. Those participating in unregistered offerings also may be liable for violations of the securities laws. Additionally, securities exchanges providing for trading in these securities must register unless they are exempt. The purpose of the registration provisions of the federal securities laws is to ensure that investors are sold investments that include all the proper disclosures and are subject to regulatory scrutiny for investors' protection.
Oh boy. Let's unpack what this means for:
- Companies considering ICOs to raise money;
- Investors participating in ICOs; and
- Third-party cryptocurrency exchanges.
You Want to do an ICO in the USA? Better look to the Howey Test (i.e. hire a lawyer)
The Report noted (citations omitted, emphasis added):
An investment contract is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. The “touchstone” of an investment contract is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. This definition embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.
I know this shit is boring, but stay with me. The SEC is saying is that if your ICO meets this Howey test, which is flexible and broadly applied, you need to register your token as a security with the SEC.
Is it a Security?
So, you look at the following elements:
- Did Investors Use Money to Buy? - Come on, of course they did. That's literally the entire point of an ICO. Also, don't get cute, of course your stupid $ETH is "money" under the test - this definition is broad.
- With a Reasonable Expectation of Profits? - Yes. Of course! Why else would people buy your shitty ICO token?
- Derived from the Managerial Efforts of Others? - Yup, of course. You know how you always look at the team of the shitty coin you want to invest in? It's because they're running the show and you're hoping they succeed and make the coin valuable.
The problem with having to register your ICO as a security with the SEC is that it comes with a TON of regulatory burdens/headaches, like fiduciary duties, keeping track of your investors (who probably appreciate their anonymity!), limiting the number of investors, ensuring they meet certain income requirements, etc.
And as Barry tweeted:
It gets better. Any ICOs deemed to be "securities" will also carry with them resale restrictions and limits on holder countBarry Silbert (@barrysilbert) July 26, 2017
The Report noted that "those who participate in an unregistered offer and sale of securities not subject to a valid exemption are liable for violating Section 5." So if you're a U.S. citizen and participated in an ICO, you very well may have violated federal securities law.
However, I don't think you'll be following Martha Stewart to federal prison (yet). Considering this is a relatively novel area of developing securities law, it is my opinion that it is unlikely any participate will be prosecuted.
However, that will likely change now...
I think the take home message is that if you're thinking about participating in an ICO from here on out, you better be awfully sure that it is registered with the SEC and that you meet the requirements of an accredited investor.
Or, if you really want to make the big bucks, just become a whistleblower for the SEC instead. Some dude just got $2.5 million for a tip!
This is the most overlooked aspect of the Report, in my opinion. The Report notes:
Exchange Act Rule 3b-16(a) provides a functional test to assess whether a trading system meets the definition of exchange under Section 3(a)(1). Under Exchange Act Rule 3b-16(a), an organization, association, or group of persons shall be considered to constitute, maintain, or provide “a marketplace or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange,” if such organization, association, or group of persons: (1) brings together the orders for securities of multiple buyers and sellers; and (2) uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of the trade.
Obviously the U.S. exchanges we all know and love like Poloniex, GDAX, and Bittrex would all meet these three elements. What is unclear is whether the SEC will now go after these exchanges, since none are currently registered with the SEC (as far as I know).
I hope that the SEC continues it's reasonable and measured approach and works with these exchanges to ensure compliance without shutting them down. Bittrex's statement on the Report noted it is working with Perkins Coie, which is one of the best law firms in the country.
And y'all have been helping the exchanges make tons of money for their legal defenses by buying $DGB at 2000 sats lol.
A line in the Sand
All in all, the SEC's report was a measured response. No one was taken out in handcuffs and the language in the press release is actually a bit soft. But make no mistake, this is a line in the sand. In my opinion the SEC is effectively giving all previous market actors a free pass.
However, from here on out it is unlikely these actors will enjoy such leniency. If you want to do an ICO, solicit investors in the US for an ICO, or start an exchange, please contact a lawyer who knows a lot about this stuff.
If you want a recommendation, look at Marco Santori at Cooley LLP @msantoriESQ.
Stay safe out there, friends!