The Fight Over the Fate of Cryptocurrencies (Part 1)
What the SEC’s Recent Statement Means for Initial Coin Offerings
The Fight
On a brisk fall night in Philadelphia in September 1952, Jersey Joe Walcott stepped into the ring to defend his heavyweight title against the challenger, Rocky Marciano.
Walcott wasn’t an especially powerful fighter, but his feet were magnificent. Full of grace, Walcott danced in the ring. He was also a technically savvy fighter. Marciano, on the other hand, was awkward and clumsy. His style was often wild and reckless, although he had the kind of power that could level an opponent with one blow. Marciano entered the ring a full decade younger than the champion.
When the opening bell rung, Walcott took control immediately, catching Marciano with a compact left hook that knocked Marciano down in the first round. It was the first time anyone had KO’d Marciano in 43 professional fights. His quick pop up from the floor did little to alter the view from the stands — Marciano looked wounded, shaken, and outmatched.
Walcott went right back to the attack. He pummeled Marciano throughout the first three rounds. As the rounds passed and blows landed, Marciano found something of a groove, settling in and inflicting a bit of damage on Walcott in the middle rounds. But, time was running out. At the end of round 12, it looked bleak for Marciano — all three scorers had Walcott solidly in control. All Walcott had to do was stay up for three more rounds — nine more minutes of dancing in the ring, Walcott’s specialty.
Thirty seconds into round 13, neither fighter had thrown a punch when Marciano backed Walcott into a corner. Walcott responded with a signature move: feinting with his left and following with a right cross. The move left Walcott exposed and failed to register on Marciano, who was busy launching his own right — a straight, powerful blow that landed flush on Walcott’s jaw. Walcott’s legs crumbled. He sought temporary balance with his left arm over the ropes. Marciano, following up with a left uppercut, realized in mid swing that the job was already complete and pulled out of the punch as Walcott stumbled and slipped to the canvas, unconscious. The 10 count was perfunctory.
Nine months later, Walcott’s shot at redemption ended in round 1 when Marciano connected with a right uppercut that took Walcott’s legs out from under him. Walcott would never fight again.
Similar to the tale of these two boxing legends, there is a fight underway between two different types of brawlers. In one corner are the virtual organizations that use blockchain technology to facilitate investment and secondary market trading via Initial Coin Offerings (ICOs). Like Walcott, the Securities and Exchange Commission (SEC) is the nimble reigning champion. The SEC is technically savvy and moves easily through the regulatory game. In the other corner, ICOs like Rocky Marciano bring youth, grit, power, and the heart of a determined challenger.
On July 25, 2017, the opening bell rang for this match. The SEC came out swinging, issuing its investigative report on The DAO, a decentralized autonomous organization that offered and sold DAO Tokens via the Ethereum blockchain.
Among other findings, the SEC determined that The DAO had violated federal securities laws by offering and selling securities — DAO Tokens — without registering with the SEC. The SEC noted that the “automation of certain functions through [the use of a distributed ledger or blockchain technology], ‘smart contracts,’ or computer code, does not remove conduct from the purview of the U.S. federal securities laws.” What’s more, the agency cautioned market participants, warning that “offers and sales of digital assets by ‘virtual’ organizations like The DAO remain subject to the requirements of the federal securities laws.”
With this report, the SEC sent a clear message: the agency is still relevant even as the paradigm shifts through distributed ledger and blockchain technology.
Now, we’ve just finished round 1 of an epic bout that pits young, gritty entities working to implement new forms of capital raising by leveraging revolutionary technology — distributed ledgers and cryptocurrencies — against a more seasoned bureaucratic agency. At stake in this fight is not just who has to register securities offerings with the SEC, but something much deeper. And, if the fight goes the way I anticipate, it will revolutionize not just our relationship with the US federal government, but the nature of regulation itself. Before I weigh in on how this one is bound to end, let’s give more context to the fight.
About the Challenger: Initial Coin Offerings (ICOs)
An ICO, or an Initial Coin (or Token) Offering, refers to a method of raising capital that is similar to an Initial Public Offering (IPO) sans ethereal investment banker commissions and seven figure legal bills. You can think of ICOs as the IPOs of the cryptocurrency sphere.
A typical ICO involves a decentralized company proposing a project to supporters who then acquire an amount of the company’s proprietary digital currency (also called coins or tokens). These tokens are issued on an indelible distributed ledger known as the blockchain, or blockchain technology, often on the Ethereum blockchain platform.
Project supporters exchange cryptocurrencies of immediate, liquid value for the proposed tokens. For example, a supporter may send bitcoin or ether to a designated wallet address and receive in exchange a digital coin, such as Crunchcoin, at a predetermined rate of exchange.
About the Reigning Champion: The Securities and Exchange Commission
The SEC was established by the Securities Exchange Act of 1934, which was adopted to govern securities transactions in the secondary market. The primary goal of the ’34 Act has always been to ensure greater financial transparency and accuracy. However, to fully understand the critical role the SEC has played over the years, we need to go back one more year to 1933.
To restore public confidence in the U.S. markets after the market crash of 1929, Congress enacted the Securities Act of 1933. The ’33 Act is based on a philosophy of required disclosure. The rationale is that buyers can make up their own minds about what investments to make and it isn’t the role of the government to do that for them. The role of the government is to ensure full disclosure. This is quite different from state securities laws (so called “blue sky” laws), which historically imposed merit-based reviews on securities offerings. The ’33 Act rapidly moved through Congress and was signed by President Franklin Roosevelt within weeks.
Section 5 of the Securities Act requires that all offers and sales of securities be registered with the SEC unless an exemption from registration is available. Registration is time-consuming and expensive, and exemptions from registration are limited in various ways. Often-used exemptions require that each purchaser of the securities be an “accredited investor,” which is someone who makes high annual income ($200,000 alone or $300,000 with a spouse) or has a high net worth ($1 million-plus without the value of their primary residence). Other exemptions require significant disclosures to investors, including audited financial statements. These exemptions are often not available or carry high compliance costs.
Selling unregistered securities without an exemption is deemed a Section 5 violation of the ’33 Act, which can lead to civil lawsuit or administrative actions. The SEC may ask a court to issue an injunction, forcing the defendant to undergo an audit. In other cases, they may seek civil monetary penalties or require the return of profits gained illegally.
The registration requirements are designed to provide investors with procedural protections and material information necessary to make informed investment decisions. These requirements apply to those who offer and sell securities in the United States, regardless of whether the issuing entity is a traditional company or a decentralized autonomous organization, the securities are purchased using U.S. dollars or virtual currencies, or the securities are distributed in certificated form or through distributed ledger technology.
ICOs: Attracting Attention
Millions of speculative dollars have flocked to ICOs in the hope of achieving unfathomable gains. Some tokens have increased in price hundreds or thousands of times greater than their initial offering price (among them, IOTA, Stratis, and Ethereum).
Stories of whopping early returns are adding fuel to the fire, attracting even greater participation in ICOs. ICOs raised over $1.3 trillion between January and August 2017 (not including the amounts raised by ICOs still in progress), according to CoinDesk. Cryptocurrency-related startups raised a record $540 million of capital in July 2017 alone.
By the end of July, more than 100 ICOs had closed this year. Of these offerings, 18 managed to accumulate their capped funding target within hours of revealing their “donation” addresses, and over 30 raised north of $10 million — a feat accomplished only twice in 2016.
The market price for many coins/tokens has increased significantly since their initial offering prices. Some prices have increased by an order of magnitude of 100 times or more. In 2014, the Ethereum ICO raised $18 million in bitcoin, or the equivalent of 40 cents per ether (the name of the Ethereum token, which is used to access and interact with smart contracts on the Ethereum blockchain). At the time of writing this article, Ethereum is trading above $300 and sports a market capitalization of over $30 billion.
Because ICO mania is taking on the look and feel of a speculative bubble, many are worried this ride may not end well. Despite Ethereum’s success, its co-founder Charles Hoskinson recognizes the inherent risk when it comes to ICOs and recently described the industry as a “ticking time-bomb.” In an interview with Bloomberg, Hoskinson also opined that, “There’s an over-tokenization of things as companies are issuing tokens when the same tasks can be achieved with existing blockchains. People are blinded by fast and easy money.”
Fear of a bursting bubble and the desire to avoid the resulting carnage has attracted the attention of government regulators, including one of the most powerful among them — the Securities and Exchange Commission.
What is a Security?
The SEC has its own parameters for defining securities (sometimes also called “investment contracts”) using the Howey test. Back in the 1940s, a Florida business owner and farmer named W.J. Howey offered real estate contracts for the development of citrus groves through a leaseback. Buyers purchased land and then leased it back to the W.J. Howey Co., which would tend the land, harvest the crop, and subsequently market the citrus. Since most of the buyers had no expertise in farming, they were happy to lease the land back to the defendants.
In the SEC v. W.J. Howey Co. majority opinion, the U.S. Supreme Court held that the leaseback agreement was an investment contract and constituted the sale of a security. The court laid out the following elements, which comprise the definition of a security:
● There is an investment of money;
● There is an expectation of profits from the investment;
● The investment of money is in a common enterprise; and
● Any profit comes from the efforts of a promoter or third party and is largely outside the investor’s control.
Although the Howey test is more than 70 years old, it remains the go-to standard for determining if an instrument is a security. This is principles-based regulation at its finest. None of the elements of the Howey test are cut and dry rules. They expand, contract, and evolve to fit the context and the SEC’s beliefs about what is right and equitable in a given situation.
The Howey court explained their intent to set out a test that is “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.” The test “permits the fulfillment of the statutory purpose of compelling full and fair disclosure relative to the issuance of ‘the many types of instruments that in our commercial world fall within the ordinary concept of a security.’” In analyzing whether something is a security, the court noted that “form should be disregarded for substance,” and “the emphasis should be on economic realities underlying a transaction.”
While the elements of the Howey test are clearly stated and firmly entrenched, their application from case to case is unique. This is precisely what makes practicing securities law challenging. The field is defined at the margins — the tough calls and slight nuances that turn the advice provided to a client.
Despite incorporating different language and marketing spin, ICOs have the look and feel of securities offerings. Many of the coins/tokens function like stock or other more exotic investment contracts. Due to their clear investment nature, securities lawyers like me have been speculating on when we’d see the SEC step in to the ring. Understand that this was not a question of if the SEC would show up; it was a question of when.
Round 1: The DAO
Without a doubt, the SEC has been watching closely as the cryptocurrency industry has taken off. The agency even released an “investor alert” about bitcoin back in 2014, warning that “using Bitcoin may limit your recovery in the event of fraud or theft.” However, the SEC’s official decision about The DAO packs a much stronger punch.
The DAO was a digital decentralized autonomous organization controlled and directed by DAO token holders. Its goal was to provide venture funding for commercial enterprises and non-profit entities. A team called Slock.it created The DAO, which was built on the Ethereum blockchain, ensuring that every transaction would be publicly visible. Significantly, the organizers took no steps to hide who they were and what they were doing. Transparency was a stated goal — the organizers wanted the public to see exactly what they were doing. It’s important to note that the goal of transparency was also the stated goal of the ’33 Securities Act, and the DAO was working to accomplish its own form of more efficient self-regulation to this end.
The DAO organizers speculated that it would replace established organizational constructs. With its backbone on the Ethereum blockchain, contracts between individual owners of the organization would be “formalized, automated and enforced using software.” Instead of relying on a conventional corporate governance structure like a board of directors and CEO, The DAO was designed to utilize smart contracts to overcome the issues inherent in traditional corporate structures.
The DAO was crowdfunded via a token sale in May 2016. In this sale, The DAO raised $150 million — the largest crowdfunding campaign in history at the time.
Under The DAO’s business plan, companies and other crypto projects were expected to make proposals for funding. The DAO token holders would vote on the proposals, and if a proposal received a 20% quorum, the needed funds would be released into the digital wallet of the proposing company. If the project generated returns, the holders of DAO tokens would participate proportionally. Essentially, The DAO functioned like a venture capital fund: investors put in money, the fund managers would identify and put money into opportunities, and when the opportunities generated returns, the managers and initial investors would be paid. Additionally, The DAO token holders could monetize their investments in tokens by reselling them in a secondary market through various web-based platforms.
Of course, someone had to be “in charge.” The DAO curators held a significant role in the organization. Ultimately, they decided whether a particular proposal was put up for a vote and had the responsibility of setting the order and frequency of introducing proposals. Essentially, the success of an investment in The DAO rested heavily on the work done by its curators.
The DAO struggled with typical startup issues. These were the same sorts of issues facing any revolutionary business model, but they were exacerbated by The DAO’s leaderless governing structure. Seemingly every token holder had a suggestion for what needed to be done differently. We won’t know whether The DAO would ultimately have worked through these issues and become a viable organization. In June 2016, a hacker exploited several vulnerabilities in the code underlying The DAO and stole 3.6 million ether, worth roughly $50 million at the time of the attack.
The downfall of The DAO shook the entire cryptocurrency industry. Like all ICOs built on blockchain technology, The DAO had told investors that it was immutable and entirely safe.
The extent of the losses from the hack and betrayal of public trust set the stage for the SEC’s first official decision regarding ICOs. Right out of the gate, the SEC tendered this statement:
“Based on the investigation, and under the facts presented, the Commission has determined that DAO Tokens are securities under the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”). The Commission deems it appropriate and in the public interest to issue this report of investigation (“Report”) pursuant to Section 21(a) of the Exchange Act to advise those who would use a Decentralized Autonomous Organization (“DAO Entity”), or other distributed ledger or blockchain-enabled means for capital raising, to take appropriate steps to ensure compliance with the U.S. federal securities laws.”
In a press release issued along with the ruling, Stephanie Avakian, co-director of the SEC’s enforcement division, issued a warning that reverberated around the cryptocurrency space: “The innovative technology behind these virtual transactions does not exempt securities offerings and trading platforms from the regulatory framework designed to protect investors and the integrity of the markets.”
The Substance of the SEC’s Ruling Regarding The DAO
In its ruling on The DAO, the SEC easily determined that three of the four elements of the Howey test were fulfilled: purchasers of tokens invested money with a reasonable expectation of obtaining profits through a common enterprise.
The SEC spilled considerably more ink analyzing the fourth element of the Howey test: that the profits would be derived from the efforts of others. Among the facts contributing to the SEC’s determination that this element was also fulfilled were the necessary role of the cofounders of The DAO who served as curators of “projects,” the limited voting rights of The DAO token holders, and the dispersion and pseudonymity of the token holders, which effectively eliminated their ability to join together to exercise any meaningful control. All these facts indicated that The DAO token holders were relying on the efforts of others to generate profits, which the SEC viewed as establishing the fourth element of the Howey test.
The analysis of the fourth element is vintage SEC. If you want to understand the murky waters of securities law regulation, pick up a copy of the decision and read the analysis. It could easily be argued the other way, and the reliance on collaboration between token holders was particularly puzzling. The inability of shareholders to band together is not something that shows up in many securities law decisions. The SEC put this fact on center stage because they needed it to justify their decision, not because 80 years of securities law case history says it’s a critical consideration. As I said, we are wading through murky waters.
Further bolstering the SEC’s decision was that there were no limitations placed on the number of DAO tokens offered for sale, the number of potential purchasers of DAO tokens, or the level of sophistication required of purchasers of tokens. These facts are standard fare in securities law decisions, and they each play important roles in the framework of securities registration exemptions.
If The DAO’s fate was not already sealed, the secondary market concerns did the honors. Once in the hands of initial investors, DAO tokens could be resold, allowing further monetization of an initial investment via secondary markets. Furthermore, before The DAO ICO, Slock.it advertised they would make DAO tokens available on at least one US-based exchange, and promised investors the availability of secondary market trading for their tokens. The SEC has always been über-concerned about private company security trading in the secondary markets. Secondary markets are much tougher to police and control, and the perception is that less information will be available to purchasers than if the purchasers were able to deal directly with the issuer. The ’34 Act was enacted entirely based on secondary market trading concerns.
The SEC cautioned that new technologies and financial products, such as those associated with ICOs, can be used improperly to attract investors with the prospect of high returns in a new investment space. However, the agency went on to acknowledge that ICOs may provide fair and lawful investment opportunities. Again, we’re in murky waters here.
Does this Ruling Mean that All ICO-Offered Tokens are Securities?
No. Although the SEC determined that The DAO tokens are securities, not all tokens are created equally. In the SEC’s investigative report on The DAO, it noted that each ICO is unique and must be reviewed on a case-by-case basis.
There are a couple key differences between The DAO’s ICO and certain other ICOs. Many coins or tokens have utility beyond investment potential, including a particular purpose within their ecosystem. For example, the stated purpose of tokens purchased in the Golem crowdsale — a project with the goal of creating a globally networked supercomputer — is a means of transacting computing power within the Golem ecosystem.
Another example of a token that fundamentally offers utility are the tokens offered by Giga Watt, a company that hosts and operates bitcoin mining equipment. Giga Watt tokens provide holders 50 years of rent-free space to host cryptocurrency mining equipment, rights that a token holder can use directly or sell to another miner. Giga Watt founder Dave Carlson told CoinDesk, “You can look at it as you’re acting as a power landlord, and people will pay to rent your power infrastructure.”
Because the Golem and Giga Watt tokens have fundamental utility, they stand up better against the expectation of profit element of the Howey test. However, one common thread among most coins — including the Golem and Giga Watt tokens — is the ability to trade them on an exchange. In fact, there are many more speculative investors in this inflated ICO market than purchasers of a given utility of a token. This is made particularly evident considering many of these projects have yet to see working products on which to utilize the distributed tokens. Whether an investor buys and holds, or invests for a quick flip once tokens hit exchanges, you would be hard pressed to find anyone that is involved in the ICO-craze not hoping their initial investment will balloon in the coming weeks, months, or years. The secondary market trading potential advertises investment intent, undercutting arguments that the purpose of purchasing is utilitarian.
In addition to the concept of prepaying rent for miners, there are also some cryptos that payout based on certain outcomes. Take, for example, Traffic Monsoon, which convinced its members to purchase what it packaged as “AdPacks.” By purchasing AdPacks, the customer was guaranteed a certain number of visits to the member’s websites.
In its opinion on a dispute over these “AdPacks,” a federal court determined that the AdPacks were investment contracts because demand was driven by members purchasing and repurchasing the AdPacks to drive returns on their investment, not due to demand for the actual service of driving traffic. In other words, the concept of AdPacks involved making money off someone else’s work or results, just like in the case of stock market investing or purchasing and leasing back citrus groves to the W.J. Howey Company.
The Howey test element regarding the efforts of others is an interesting one. The SEC dedicated considerably more of its analysis to this element than the others. It did so because this element was the least clear out of the four in the Howey test conditions.
The DAO token holders had voting rights, and the role of the cofounders was primarily one of curatorship, not control. If other facts and circumstances suggested no one was hurt and the equities of the situation didn’t necessitate SEC involvement, securities regulators could easily argue this one the other way. The SEC’s focus on the dispersion and pseudonymity of the token holders is somewhat troubling, however, in that those are key factors in any ICO.
Without more guidance from the SEC, it’s tough to say if there is adequate room to determine if any ICO is powered by the efforts of the token holders. If there isn’t — if the dispersion and pseudonymity factors are all that is needed to fulfill this last Howey test element — arguing against an ICO being a security will rest squarely on the shoulders of the expectation of profits versus utility because there is always an investment of money and a common enterprise.
But, the question remains: what does the SEC’s statement mean for future ICOs? For starters, it doesn’t mean the end of ICO’s. However, it means that if you plan on performing a crowdsale in the near future and including US citizens in it, you should probably hire a lawyer and discuss your plan with them and the SEC. In the SEC’s eyes, each ICO is different from all others and must be investigated on a case-by-case basis.
What to Expect in the Next Few Rounds
Despite the uncertain future for ICOs, nothing will stop the growth of blockchain technology. The advent of cryptocurrencies represents an opportunity for improved efficiency, transparency, and democratization. It represents the opportunity to not only change the way we do business, but the way that we live in tomorrow’s global world.
Continue Reading About the What the Future Holds in Part 2 of This Piece…
What’s Next for You?
Admittedly, I’m no expert in the field of cryptocurrency. But, my experience as a VC during the dotcom era and 20+ years as a business attorney make this transformative industry fascinating to me. If you’d like to check out more of what I have to say about business and business law, check out my Texas business law firm. I love to hear the innovative and interesting things my readers are up to, so don’t hesitate to reach out here or by phone at 512.888.9860.
