A Crypto-Capital Markets Lawyer Looks Back on 2017

Lewis Cohen is a corporate attorney experienced in all aspects of blockchain and distributed ledger technology, smart contracts, cryptocurrencies and other new capital raising techniques. The exchange below looks back at the past year and some of the themes I believe will be most relevant in 2018.

tl;dr: Blockchain technology had a transformative impact on capital raising in 2017 but the most important effects will be felt in 2018 and beyond as the traditional players in the capital markets, including the Securities and Exchange Commission in the U.S. and other market regulators around the globe, start to come to terms with the many ways in which blockchain technology and tokenization will affect capital raising.

Critically, although there needs to be a push for greater regulation of capital raising through token sales — particularly when “Main Street” purchasers are involved, market participants need to thoughtfully distinguish between digital tokens which are functional elements of a blockchain-based network or ecosystem (and are not themselves “securities” that should be regulated as such) and “investment schemes” developed by sponsors, which are appropriately subject to traditional standards, such as the “Howey test,” to determine whether the scheme should be subject to regulation. Examples are given, thankfully.

The below represents my personal observations only and not the views of my firm or of any other person, client or other entity. And, of course, nothing below constitutes legal or investment advice.

Let’s start with an overview of 2017. What do you see as the key themes for the past year as a lawyer specializing in blockchain, cryptocurrencies and capital markets?

Cohen: Undoubtedly, 2017 was the year that legacy participants in the capital markets woke up to the opportunities (and threats) that blockchain technology and tokenization could pose to the way in which funds are raised and capital is accumulated for investment. With the equivalent of about $5 billion in funds raised in 2017 through the sale of digital tokens according to some estimates, it was hard for mainstream players not to take notice. However, much of this fundraising was accomplished with little regard to regulation and this tension shaped the dynamic, particularly in the second half of the year. Also, the often breathless reports of huge sums raised through token sales may well overestimate the impact of this activity on the real economy. Investments in new token issuances were generally funded in cryptocurrencies (rather than dollars or other “fiat” currencies) that themselves had appreciated dramatically in the preceding 12 to 18 months, meaning that, if measured in the original fiat amounts invested into the “crypto” ecosystem, the allocation into tokens would be much less.

Okay — there’s a lot there to unpack. First, what do you mean by “legacy players”?

The basic way in which capital has been accumulated for investment in the U.S. has changed relatively little over the last 80 or more years. The Great Depression ushered in the two landmark pieces of U.S. securities legislation: the Securities Act of 1933 and the Securities Exchange Act of 1934, as well as several other important laws that followed. Two particularly important premises girded this legislation. The first was that the investment of wealth in securities is inherently risky and that financially unsophisticated investors needed to be protected against a wide range of potential frauds and deceptions. More sophisticated (read: wealthy) investors who were deemed to have the capability and leverage to conduct their own investigations (or who had the resources to pay for others to do so on their behalf) were generally exempted from these protections, as were other forms of capital raising where the protections of the securities laws were considered unnecessary — for example, because there was already another regulatory framework in place. The second premise was that securities by their nature were readily transferable and that the markets that formed for trading securities could easily be manipulated and, therefore, these markets would need their own sets of protections. This framework, once adopted, quickly created an infrastructure of symbiotic businesses and institutions that not only helped to enforce the newly enhanced regulatory regime in the 1930s and ’40s, but who also profited greatly from the closed system of access to capital these regulations effectively created. That infrastructure includes an ecosystem comprised of global investment banks, broker-dealers, stock exchanges, futures, options and other derivatives markets, investment advisory firms, rating agencies, custodians, trustees, and investment funds, as well as lawyers, accountants and a myriad of other service providers. All of these “legacy” players are at risk of being disrupted through the use of blockchain technology and tokenization.

Interesting. You are suggesting that the risk of disruption posed by blockchain technology to the existing regulatory framework may be less dramatic than its potential to disrupt the entrenched interests of the traditional market participants– is that right?

Yes — that’s it. The broad framework for securities regulation in the United States, which involves many checks and balances as well as economic incentives running in various directions, has served us remarkably well for many, many years. And one reason it has is that regulation here has been principles-based and adaptive. It is now time for the many businesses and institutions that have grown wealthy protecting this system — but also exploiting it for their own pecuniary gain — to start to adapt themselves.

So what exactly is it about blockchain technology that is giving rise to this disruption? After all, the market infrastructure you describe above has been quite stable for a very long time now.

I think that it has something to do with how the capabilities offered by blockchain fused in the popular imagination with a separate groundswell toward liberalized equity crowdfunding. You could reach back further in history, but to my mind the best place to start is with the Jumpstart Our Business Startups Act (better known as the “JOBS Act”), which was enacted by Congress in 2012 to help small and medium-sized businesses raise funds in the public capital markets by streamlining the offering process and eliminating unneeded regulatory requirements. However, we had to wait until 2016 for the implementing regulations for equity crowdfunding to come into effect, and some key issues remain — a strong, but slower-than-hoped-for rate of growth in the amounts invested and a paucity of market infrastructure, such as data aggregation, research and trading venues. The burst of investment in blockchain-based token markets stands to change all that and substantially deepen the “crowdfunding” market for capital, even if it was not at all in the way the drafters of the JOBS Act anticipated. Whether the JOBS Act was a cause or a symptom of this growing interest in crowdfunding, though, is difficult to say.

Can you expand a bit more on what you see as being the main drivers of the explosive growth of “ICO”-style crowdfunding in 2017?

Money, opportunity and liquidity. Let me break this down: First, the money. The first watershed moment in the history of blockchain technology’s effects on markets was the remarkable appreciation of several core blockchain-based digital assets, starting with bitcoin and ether and, as 2017 progressed, extending into many others, such as Litecoin, Ripple and Dash. This run-up in valuation (in many cases approaching or exceeding 1,000% in 2017 alone) allowed many purchasers of new tokens to spend “house money” — with such high returns on their pre- or early 2017 purchases of these digital assets, many felt that they had little to lose by purchasing some of the rapidly increasing number of new digital tokens being issued. If a new platform were not to work out as hoped for by a token purchaser with large previous gains, the financial consequence to the purchaser would generally be minimal because, for many purchasers, their new found “crypto wealth” typically had not yet impacted their lifestyle or personal financial planning. Even more so, with so many new tokens being issued in 2017, purchasers were generally happy to “roll the dice” as they expected to recoup potential losses in one digital asset with huge gains in one or more others. Most importantly, these purchasers had already bought into the blockchain ecosystem by establishing accounts at token exchanges and getting comfortable with the use of the “wallets” (such as Trezor) needed to store the private keys that controlled their digital assets. As a result, the incremental effort to acquire new tokens was minimal.

So the pump was primed, so to speak. What about the second factor you mentioned — opportunity?

Exactly — the pump was indeed primed! However, although I would say that the availability of a readily investible supply of crypto assets was another necessary condition for the explosion in capital raising through token sales that took place in 2017, I do not see it as sufficient to explain all that we saw in the market last year. That’s where the “opportunity” factor comes into play. In August 2016, Union Square Ventures published their highly influential blog post on so-called “fat protocols”. The thesis was that value in a blockchain-based environment would accumulate at the shared protocol layer, that is, in the relevant blockchain itself, rather than at the “thin” application layer. It did not take many long to reach a corollary conclusion: that in an open-source blockchain-based system, the best way to benefit from the projected exponential demand for “fat” protocol layers would be by purchasing and holding the tokens needed to power these systems. This investment thesis represented a massive new opportunity in the minds of both institutional and retail investors — similar to other watershed moments in the history of technology, like the popularization of the Internet in the mid- to late-1990s and the emergence of smart phones in the late 2000s.

Could you explain a bit more?

Sure. In the case of an open-source network such as Ethereum, there is no way to buy traditional “equity”. The Ethereum protocol is maintained by a Swiss-based non-profit foundation. If you believed in the growth of the Ethereum network in early 2017, you could not have bought shares in the Ethereum Foundation, but you could easily have purchased ether tokens. Ether tokens are needed to run smart contracts on the network; they are used to incentivize participants to commit the necessary computing resources to the network. So, if few people are utilizing the Ethereum network, there would be relatively less demand for ether tokens and the price of the tokens would also likely remain low. But if demand were to increase (or even be perceived to be likely to increase), the price of the ether tokens (which are in relatively limited supply) would be expected to increase. This increase in price should continue regardless of whether any particular decentralized applications built on Ethereum succeed or fail, so long as the total usage of the network continues to increase over time. For illustration, imagine a coffee bar where anyone can come up with unique types of coffee to sell, but you can only purchase the coffee if you have a mug marked “ether”. If at any time there are a finite number of “ether mugs” produced and you are insightful enough to buy up a lot of them early on, then you will surely do well if many people later on want to come to the coffee bar to drink coffee, even if any particular coffee vendor is or is not successful.

Got it — so in your example, Ethereum would be a “fat protocol” and applications built on Ethereum would be the “thin” secondary layer, right?

Sort of. You see, whether they are built on Ethereum or another platform (or, in some cases, projects in 2017 were creating brand-new platforms for launching decentralized applications), many secondary networks are also seeking to become their own “fat protocols” with further applications building on top of them. At least, this is the pitch they are using to raise funds. The one thing virtually all of these tokens had in common was that they were functional parts of some sort of software application — digital, “consumptive” goods. Not too far from my coffee mug example, if you think about it (though some platforms actually contemplate or at least allow for increases in the number of tokens in circulation over time, which can confuse the economics a bit).

Alright, so we have money and opportunity for profit. Anything else we should know that was driving the changes we have been discussing?

Yes. First, digital tokens are a product that is actually in great demand by the “crowd”. I would argue that it is this very thing about tokens — that they are a way of buying into the use of a new blockchain platform — that drives the tremendous global interest in them. In fact, John D’Agostino of DMS Governance called these types of digital assets the first “viral financial meme”, which I found very insightful.

Indeed, very interesting.

At the same time, this unusual character of tokens also confounds many in the legacy capital markets space who see something very different, much like the drawing that alternatively appears to be two ladies at a table or a skull. In 2017, I had many conversations with some really smart capital markets professionals, nearly all of whom looked at tokens as some newfangled type of “security” that would eventually get registered with the Securities and Exchange Commission (if you are in the US), put in a “box” and brought under control. But most blockchain tokens are something very different from traditional securities. Rather than representing fungible contractual rights or claims, such as the right to receive dividends or a residual claim on the assets of a corporation, in the case of stock, or the right to payments of principal or interest in the case of debt instruments, they are particularized digital assets, each immutably tied to a specific cryptographic key. It is not financial sophistication that is needed to understand these assets but rather technological sophistication and, if I may say, a healthy amount of imagination as to what the future will look like and the types of products and services that will be appealing to people. Some of the most important thinkers in the space have founded the “Brooklyn Project” to address this very issue (among many others). The protocols these tokens relate to are often open source, which means that these networks or systems cannot be controlled, censored or even owned in any meaningful way. It turns out that this is very appealing to many people. You might “invest” in tokens, but it is much more like buying up a bunch of “ether mugs” in my illustration above; unless the protocol (coffee bar) becomes successful, the tokens (mugs) won’t be worth very much. What will cause the platform to get adopted? That is the $64,000 question! One thing I will say though is that having a deep understanding of balance sheets and income statements etc. in itself will do you little good at all in evaluating the prospective viability of a proposed token platform. Certainly, having, for example $1 million invested in Dow Jones indexed large cap stocks would hardly prepare one for evaluating the merits (and risks) of purchasing a given blockchain token.

Is that the reason why, in some cases at least, current securities regulations — requiring disclosure of audited financial statements and other traditional disclosure items — may not provide the most useful disclosure to purchasers of blockchain tokens if they were to be considered “securities”?

Yes. Although our securities laws in the U.S. are remarkably flexible, I would argue that we will need to nevertheless re-think the standards of what constitutes “material information” in the context of sales of blockchain tokens. Some very interesting work will take okace in this area.

Very interesting, but you haven’t explained the last factor you mentioned — “liquidity”.

The last element driving this change in 2017 was the liquidity (real and perceived) of these newly issued tokens. For various reasons, purchasers of tokens immediately started trading them with each other and developing markets and exchanges to facilitate this activity. This meant that those holding large amounts of bitcoin, ether or other digital assets who found it difficult to sell those assets directly were able to purchase tokens on new platforms being developed and then sell the new tokens to others, allowing these bitcoin/ether holders to effectively exit larger positions without moving the markets in these assets — the new platforms that acquired the bitcoin or ether in exchange for their new tokens typically held onto those assets, rather than immediately reselling them. This gave large holders of bitcoin and ether a further motivation to purchase the new breed of digital tokens being sold in 2017 — the new tokens functioned as an efficient “exit ramp” for portions of their holdings. The other side of this phenomenon though was that these buyers were less interested in the long-term viability of the projects and more interested in the near-term liquidity of the tokens, meaning that larger token sales (with greater anticipated liquidity) were favored, even if the platform developers had no idea what they would do with all the proceeds. Also, those active in the space knew that the liquidity they were looking for could be remarkably ephemeral. The markets and exchanges that had formed did not themselves provide any guarantee of buyers or sellers (much less professional-class market makers) and the constantly shifting regulatory and compliance framework meant that buyers for tokens could come and go in a flash. Unfortunately, new entrants and less sophisticated participants may have missed this “memo” and assumed that they could always find buyers for their tokens. That is far from the case, I am afraid to say.

It all seems too easy.

In many ways it was. Securities regulators around the world took notice as the size and scale of the funds raised through these token sales increased throughout 2017. The immediate instinct of regulators was that something unsanctioned was going on, but due to the nature of tokens it was difficult for them to say exactly which token sales violated which laws. More importantly, as a decentralized global movement, this activity proved particularly difficult for regulators to come to terms with — there was no single or even small number of “facilitators”, such as investment banks or advisory firms. The exchanges that sprang up to trade these assets didn’t create them and shutting down the exchanges in a given jurisdiction did not stop the interest, it just pushed it elsewhere. Importantly, new, decentralized exchanges started springing up as well. The rapid growth of the market for digital tokens was occurring organically — it was truly a “crowd sourced” movement. A great pre-blockchain (2008) book to read on this topic, by the way, is “The Starfish and the Spider: The Unstoppable Power of Leaderless Organizations” by Ori Brafman and Rod A. Beckstrom. I recommend anyone interested in these topics to pick it up.

So what did the regulatory response look like?

Initially, it mainly consisted of warnings by securities regulators to market participants in many jurisdictions, including regulators in the U.S., the U.K., Singapore, Hong Kong and Canada advising investors to be mindful of the potential risks involved in purchasing tokens and of the existing legal frameworks relating to the sales of “securities” which may (or may not) be applicable. For reasons believed to be as much political as they were regulatory, China and South Korea took the additional step of actually banning “initial coin offerings,” which was generally viewed by the market more as a pause than a permanent position. The only problem was that developing an appropriate “regulatory perimeter” is not easy and, perhaps wisely, most regulators did not attempt to do that in 2017.

Could you expand on that?

By “regulatory perimeter.” I mean specific guidance to market participants as to when the offering of a particular digital token would (or would not) constitute the offering of a “security”. This is difficult because most digital tokens share few, if any, characteristics with “equity”, “debt” or most other recognized types of securities, and generally fall outside of the relevant definitions of “securities” in most jurisdictions. Even more problematically, many digital tokens did share many characteristics with other “consumptive goods” that were generally not thought of as securities. A clear “perimeter” will ultimately be needed so that the law can be enforced fairly and consistently. For example, if a large software company were to sell a tradeable license to use its online word processing application through a limited number of digital tokens, should these tokens be considered “securities”? Of course not! An overly broad treatment which deemed all digital tokens to be “securities” regardless of the “facts and circumstances” would also pick up a great deal of activity that almost all agreed did not involve offerings of “securities”, meaning years of costly and unproductive litigation. A regulatory perimeter, once developed, could be a key element in avoiding a permanent state of “regulation by enforcement”. One interesting direction is a recently enacted statute in Wyoming, which seeks to define a type of token that would not be considered a “security” under local Wyoming law. While Wyoming cannot override federal securities law, their statute does point a direction for other states and, perhaps at some point Congress, to go in order to start to establish that perimeter. Whether or not one likes or agrees with the definition in the Wyoming law, I see their effort to move the dialogue forward in this area as highly laudable. Of course, on the other side of the coin, some states, including most notably, New York in its “Martin Act”, have state-level definitions of “securities” which may be considerably more broad than the federal definition.

While the news from Wyoming sounds promising, overall, the whole situation still seems like a bit of a mess. Have any regulatory bodies stepped up and provide something that could be helpful?

In terms of regulators, in July 2017 the U.S. Securities and Exchange Commission issued a report looking back retrospectively at a particular token sale that took place in 2016 by a “decentralized autonomous organization” known as “The DAO” and concluding that the tokens sold by The DAO were indeed “securities” for purposes of U.S. securities law. This report was very helpful, but its utility was limited since most of the tokens being issued in 2017 looked very little like the tokens issued by The DAO the year before. The market had mutated and moved on significantly since then. In addition, the SEC stressed in the report that not all digital tokens were “securities” and that the legal status of each individual token sale needed to be considered on a “case-by-case basis”. Unfortunately, this also made it easier for many market participants to convince themselves that their specific case was not one of the problematic ones.

Sure, but a formal report from the SEC must have at least slowed things down a bit?

Not really. The warnings from the SEC and other regulators went mostly unheeded and the market for token sales largely continued apace well into September and October. The SEC did issue a couple of complaints subsequently, but these were against individuals that seemed to be obvious fraudsters based on the facts alleged, and so did little to slow down the pace at which funds were being raised. One important development that occurred during this period was a white paper released in early October as part of the “SAFT Project” which sought to start a dialogue around creating a token sale framework that would be easy for market participants to understand and more compliant from the securities law regulatory perspective.

What was the reaction to the SAFT whitepaper?

Response in the market was generally quite positive. Many viewed the SAFT Project as an important step forward in creating a discussion in the blockchain community around securities law compliance, and use of the a SAFT agreement quickly became quite popular. Nevertheless, like any first attempt, over time a number of market participants (me included) started raising concerns about the approach outlined as part of the SAFT Project. The SAFT whitepaper advocated creating a separate security, known as a “simple agreement for future tokens,” which could be purchased only by accredited investors under an exemption from registration with the SEC for securities offered in a private placement. The tokens themselves would only be released to SAFT purchasers when they were “functional”.

I’m afraid you have me confused at this point. What could be objectionable about developing a more compliant framework for token sales?

There is too much to go into here. Best to give a close read to a research report published by the Cardozo Blockchain Project. More recently, criticism has come from other quarters as well. In summary, although the SAFT approach sought to address the understandable confusion in the market regarding the regulatory position of token sales, in the view of some of us, it over-simplified a highly complex legal analysis by focusing on one aspect of token sales — the technical functionality of a blockchain platform — while largely ignoring concerns about the “manner of sale” (the way in which the funds are being raised by the platform). Absent registration with the SEC, only accredited investors are permitted to buy into token sales through SAFTs. This opened a window and both new and existing investment funds targeting digital tokens jumped in, with the result that both SAFTs and tokens were openly pitched as financial investments to these buyers. Rather than making token sales more compliant, the end result of this approach (whether or not anticipated in advance) was to make the tokens themselves look more like investment securities. After all, if an investment fund wanted to acquire tokens in bulk, what else could they be?

Go on.

In an attempt to define this new fundraising technique, some started rebuilding the old pre-blockchain model, pushing token sales back into that more centralized approach with these new funds functioning like gatekeepers, much like many venture capital firms had been doing in the more traditional start-up market. This environment lasted through early December, but then things got much more serious. On December 11, the SEC issued a cease-and-desist order against Munchee, Inc., a company in the food review/rating sector that had started out by developing a smart phone application, before attempting to switch to a token-based blockchain model. The SEC successfully stopped the token sale Munchee had undertaken.

Why was the Munchee order so important?

This was the first time a regulator anywhere had taken on an actual, ongoing token sale on something other than alleged fraud. Although the principals in Munchee were portrayed in the SEC’s complaint as relatively aggressive in their marketing efforts, by and large I would say they were not far outside the norm for the way many other tokens were being marketed in the second half of 2017. With the Munchee order, a regulator finally got many in the market thinking seriously, perhaps for the first time, about how to apply applicable securities laws to a token sale.

What was the SEC’s reasoning?

The SEC focused closely on factors relating to the “manner of sale” of the offered tokens — things like Munchee, Inc. endorsing statements about the ability of token purchasers to profit from anticipated appreciation of the MUN token being issued and also targeting financial investors, rather than those in the restaurant industry, in their marketing. Munchee, Inc. also undertook a social media “bounty” program in which tokens were awarded to those who promoted the token sale on various social media platforms. This effectively allowed compensated surrogates for Munchee, Inc. to make very aggressive sales pitches for the tokens. Of course, since these promoters typically did not acknowledge that they were being compensated, the market was left to scratch its head at the overload of personal “recommendations”, many of which fell below any standard for thoughtfulness, clarity or even common sense. All of this was highlighted as relevant to the question of the regulatory status of the token sale by Munchee, Inc. and very helpful to the market.

Does that mean the takeaway from the Munchee order is to be more careful about how tokens are marketed and sold?

That’s part of it, for sure. Clearly, manner of sale means a lot (though a number of us have been saying that for some time). Any token seller post-Munchee not carefully heeding this message is just asking for trouble, in my view. Munchee, Inc. was able to get off relatively easily without fines or other penalties. Future issuers may not be so fortunate. This said, the “manner of sale” concerns are relatively easy to address (at least for those paying attention). If the SEC had stopped there, then addressing the regulatory concerns around token sales would likely be fairly easy — change the way tokens are marketed and everyone’s troubles are over.

But is that where they left it?

Unclear. The SEC also focused on the “economic realities” of the sale. With the facts at hand, the SEC concluded that purchasers of MUN tokens reasonably expected that they would profit from a rise in the value of the tokens; that only Munchee, Inc. had the ability to make changes to the Munchee app; and that investors relied on Munchee, Inc.’s anticipated “efforts” to produce that rise in value. From the standpoint of the now well-known “Howey test”, the SEC therefore found that the offering of the MUN tokens met all four legs of the test and thus that an “investment contract” which constituted a “security” had been created. Since no available exemption from the registration requirements of the Securities Act had been met (and because the fundraising was done in a public way over the Internet but had not been registered with the SEC), a cease-and-desist order was issued. What is more difficult to say is how Munchee, Inc. would have fared if they had taken a wholly different approach to marketing and focused their message instead only on the functionalities of their platform (rather than on the profits to be made from holding the MUN tokens). One interesting side note: On the very same day in December 2017 that the Munchee, Inc. cease-and-desist was released, the SEC’s recently appointed Chairman, Jay Clayton, took the unusual step of issuing a personal statement on cryptocurrencies and initial coin offerings. Chairman Clayton’s statement accomplished two key objectives. First, it formalized several more informal warnings he had made to market participants in various settings over the six weeks or so preceding the release of the statement, admonishing those he called “gatekeepers” — very much including securities lawyers — to “focus on their responsibilities”. Yet, Chairman Clayton chose to close his statement on a different note, encouraging “Main Street” investors to be open to the opportunities presented by purchasing blockchain-based digital tokens, while reminding all purchasers always “to ask good questions, demand clear answers and apply good common sense when doing so.”

So where does all this leave the SAFT approach to token sales?

I would argue that a SAFT can still work, post-Munchee, but particular attention needs to be paid to paragraph 35 of the Munchee order. In that paragraph, the SEC states: “Even if the MUN token had a practical use at the time of the offering, it would not preclude the token from being a security.” In other words, the mere technical “functionality” of a token is not sufficient to prevent the token offering from being characterized as a sale of securities. Any new SAFTs being entered following Munchee will, at a minimum, need to be structured to address these concerns.

Could you elaborate?

Sure. The SEC in the Munchee order makes an important observation: a “network token” which no one yet actually uses (because it is brand new) has little value. Imagine my hypothetical coffee bar on a dark, untraveled side street with few if any vendors. For such a platform, the “mugs” needed to buy coffee from vendors will likely have very little value as very few people know about the existence of the coffee bar or have any interest in specific vendors. As a result, there will be little demand for the coffee (or the mugs) — the tokens in my analogy. The question that needs to be asked is, how will that change? In the case of the sale of a network token, where token purchasers are told not to worry — that the platform sponsor will be using the funds raised in the token sale to publicize the platform and get people using it, all of a sudden we have a new factor to consider: dependence on the skills and ability of the sponsor to create a network effect resulting in the anticipated exponential increases in usage and therefore also in demand and price for the tokens (given a predetermined limited supply).

So will sales of “network tokens” always look like offerings of securities?

I would say “mostly, but not always”. It depends on the state of the development of the protocol at the time of the token sale and what purchasers reasonably believe will drive development and adoption of the protocol (and therefore value of the token). If the only realistic answer is that it is the promoter of the token platform (e.g., Munchee, Inc., in the case of the MUN token), then I do think that the SEC will likely find that token purchasers have a (1) a reasonable expectation of profit (through the anticipated appreciation of the token) and (2) are relying primarily on the efforts of the token platform sponsor to drive that adoption through marketing and other promotional efforts. This adds the last two pieces of Howey test and, with “investment of money” and “common enterprise” otherwise met, voilà, you have an offering of “securities”. However, this needn’t be the case for all network tokens (and is certainly not the case with other types of tokens, such as those that provide a discount for a service or function as the equivalent of a license). Imagine a network token platform sponsor that has created meaningful and relevant partnerships and — in advance of any token sale — has built interested communities of prospective users so that the success of the platform is not dependent of the efforts of the sponsor, but rather that success will turn on the input and actions of a variety of stakeholders and community members (including the initial token purchasers themselves, who are economically invested in the success of the platform). Another critical factor will be the state of the development of the protocol code itself at the time of the fundraising. The strongest cases for fundraising using network tokens not involving an offering of securities will be those with an already functioning network supported by the strongest partners and communities going into the fundraising. This is because, although the network token may appreciate dramatically, there is no reasonable reliance by token purchasers on the “efforts of others” (that is, the platform sponsor) to generate that appreciation. To my mind, this is a much more relevant test than simple token “functionality”.

Yet it sounds like there is still something about the SEC’s position in Munchee that troubles you.

Yes, there is. I do not dispute that, properly applying current securities law (and assuming all of the SEC’s alleged facts are true), an “investment contract” as defined in Section 2(a)(1) of the Securities Act appears to have been created by Munchee, Inc. To accomplish their objective of shutting down an offering that failed to comply with the relevant law, making a distinction in the cease-and-desist order between the offering and the token itself was not necessary for the SEC. That said, the Munchee order clearly states that the SEC believe that the MUN tokens were themselves the relevant “investment contracts.”

Why does this concern you?

It has to do with where I see the future of the token market going. What many (though not all) token sales in 2017 have had in common is that they were used to “bootstrap” a new blockchain-based business — that is, the proceeds from the sale of the tokens were to be used to develop (or expand) a token platform. Depending on the circumstances, this bootstrapping can cause significant regulatory concern. In the world of physical goods, it is well established that a product can be sold prior to the ability of the seller to deliver the product, without the sale involving an offering of securities (think advance tickets to a Broadway show or the latest all-electric vehicle). This should not change when we move into the world of digital goods, like tokens. However, in the case of some token sales based solely on some loose ideas in a “whitepaper”, many skeptical observers have looked at the complete lack of anything resembling an existing business and concluded that the platform sponsors must be issuing securities. Effectively, this perspective adopts something known as the “risk capital test” — a standard different than that found in the Howey case and first set out in a case from the State of California called Silver Hills Country Club v. Sobieski. This test, which 16 states have adopted in one form or another, is effectively additive to the federal test, since a state attorney general or other authority could theoretically bring an action under that test under state law (if sales of a token occurred in the relevant state), event if no action was undertaken (or could be undertaken) at the federal level. Although we can debate the merits of the risk capital test as an alternative standard for determining whether an arrangement involves a securities offering, we are still left with the more fundamental question of whether the token itself being sold constitutes the relevant “investment contract”.

Well, does it?

I would say in many cases, “no.” Let’s look at another example. Let’s say that I wanted to start a high-end ladies handbag company. I come up with some cool designs and am well-connected in the world of celebrities and social media stars. Let’s also say that, while the first batch of my limited edition handbags are being manufactured, I sell 1,000 bags to individual buyers for $10,000 each, delivery to be made within three months when manufacturing is complete. Few, if any, might suggest that a purchase order made out to an individual buying one of my handbags for their personal and “consumptive” use would be an investment contract. In the example, I am selling a “consumptive good” (the handbags) for delivery at a later date. There is always a risk that I could go out of business during the period between when I am paid and when the bags are available for pick-up, but that should not change the securities law analysis.

Okay — so far, so good.

But, let’s now say that I go to both the general public and to potential financial buyers (for example, folks running an investment fund) with the following proposition: “We have data to show that, over the last 10 years, ladies limited edition high-end handbags have appreciated in value on average by at least 8% year-on-year and even more with select items and those promoted on social media. We are now accepting “purchase orders” for up to 80% of our production run (so that we would raise $8 million). We will agree to keep the purchased bags in a warehouse under ideal conditions and, if you like, we will sell them on your behalf in a year’s time when we believe there will be demand at a price much higher than what you are paying now. Of course, you can count on us to promote the heck out of the 20% of the bags we do initially sell — they’ll be seen on the arms of all the most desirable celebrities! We would expect that you will pocket a return of at least 15% on your investment.” Clearly, on these facts, if we made this offer to the general public over the internet (as most token sellers do) we will have gone a very long way toward meeting the four prongs of the Howey test and almost certainly will have created an “investment contract” — an investment of money in a common enterprise with a reasonable expectation on the part of the “investors” (handbag purchasers) of a profit (through the appreciation of the handbags) as a result of the efforts of others to promote the bags.

I think I am with you.

But are the handbags in my example themselves “securities”?

Ouch! No, I guess not. And don’t bother with the next point — I see it coming. If the handbags are not “securities” in your example, then why should the tokens in Munchee be considered “securities”?

Exactly! This critical distinction has importance, in particular when in the future a platform sponsor wants to register an offering of tokens with the SEC and needs to figure out what exactly it is they are registering. It will also be relevant when we look at the secondary market where tokens are bought and sold. While the distinction may have been mere semantics in the case of the Munchee order, I believe it will take on increasing significance going forward. A 1966 case, SEC vs. Weaver’s Beaver Association (brought to my attention in a blog post by Preston Byrne), helps to illustrate my point. In that case, the SEC obtained an injunction against some bothersome beaver boosters who promoted a scheme in which individuals were offered the opportunity to purchase live beavers with a view toward profiting from their later resale when the beavers had grown and developed.

You are joking, right?

You can’t make this stuff up! According to the court record, purchasers were told to put up their money and then “’sit back and let nature take its course’ or, more precisely, to ‘let things ride while (his) herd builds up and up and up.’” Interestingly, Weaver’s Beaver Association was organized as a non-profit agricultural cooperative, but this did not stop a separate case from proceeding against the principals of the Association, based on an allegation of fraudulent misstatements. Token sellers considering using a “foundation” or similar non-profit entity as the token issuer should bear this in mind. Importantly from my perspective, nowhere in the Weaver case is there the suggestion that it was the beavers that were “securities”. Rather, it was the purchase and sale arrangements for the beavers that constituted the investment contract. Another relevant case is known as Glen-Arden Commodities which involved a scheme similar to my handbag example but involving the offer and sale of warehouse receipts for whiskey held in storage barrels. There was no suggestion in Glen Arden either that the whiskey itself was a “security”, even if the court concluded that the warehouse receipts which facilitated the purchase of the whiskey were. It will be very interesting to see how this plays out in terms of tokens in the coming year.

How are token issuers coping with these uncertainties?

A number of token issuers are looking at bypassing the complexity and concern regarding whether or not their token offering would be considered an offering of securities under the Howey test. Instead, they are considering registering the offering of the tokens under the SEC’s Regulation A which allows for a more streamlined process for offerings of up to $50 million (with a bill recently passed by the House to raise that cap to $75 million). Recently, the target proceeds for most platforms raising funds through token sales has been in the range of $30 million, so this could be a good option. Among other things, the registration of an offering of the tokens to be used on a blockchain platform would ensure disclosure compliance — both at the time of sale and on an on-going basis — by the sponsor with the SEC’s robust standards while at the same time discouraging a wide variety of potential bad practices in connection with the offering as a result of the oversight of the fundraising by the SEC. However, both the SEC and any token issuers considering this approach will need to carefully consider just what the “security” offered is — as you now know, I would argue strongly that it isn’t and should not the token but rather some other “investment contract” of which the token is merely the “object”, like the whiskey in the Glen Arden Commodities case, the beavers in Weaver’s Beaver Association or the handbags in my other example. There is also a thorny question of how the Regulation A requirement for providing a transfer agent will be resolved, though I strongly doubt that will be a long-term impediment to the market. We have been working with clients to develop solutions for both of these issues. File under “more to come” on this topic, for sure.

So far, you’ve been focusing mostly on the state of play in the U.S. What is your take on what other jurisdictions have been doing?

My “pre-blockchain” background involved working extensively on cross-border capital markets transactions, so this is a subject of great interest to me. I mentioned earlier that, in many jurisdictions, the definition of “security” is somewhat more formalistic and does not provide for a substance over form catch-all in the way that the U.S. definition (which includes “investment contract”) does. I would argue that one reason for this is that a very broad statutory definition can place a burden on the court system of the jurisdiction to provide numerous nuanced interpretations of edge cases in either direction. In jurisdictions such as the U.S. and England that have a “common law” system, judge-made law through binding precedent decisions can aid the market in avoiding numerous re-litigations of similar fact patterns. Civil law jurisdictions such as the member states of the European Union and most emerging markets do not contemplate judge-made law in the same way. As a result, these jurisdictions can have a harder time addressing situations like token sales in which a multitude of subtle factual variations can produce a wide variety of legal results. One jurisdiction I would highlight as making important strides forward in this regard is Singapore. In November of last year, the Monetary Authority of Singapore issued some of the most helpful guidance in terms of the regulatory treatment of token sales. Unfortunately, it is applicable only to sales of tokens to Singaporean persons and, therefore, is of limited impact. Nevertheless, I really like the idea of providing “case studies” for the market as this approach can make up for the lack of interpretive jurisprudence in these jurisdictions. More recently, the Swiss markets regulator, FINMA issued more detailed guidance on distinguishing tokens that should properly be regarded as “securities” and those that should not.

What is the relevance here of common law vs civil law to the debate around token sales?

The U.S. has almost 70 years of jurisprudence (dozens of cases, hundreds of regulatory interpretations, vast amounts of scholarly work) on the Howey test and its applicability to many, many factual variants, which gives private parties and regulators alike very fertile material to provide interpretive guidance on the crucial question of whether or not the offering of a particular token constitutes an offering of “securities.” Other jurisdictions simply don’t have this rich resource. Accordingly, I believe those of us trained in U.S. securities law have a special responsibility to help to sensibly shape the global regulatory discussion for token sales by drawing on this history. Interestingly, numerous jurisdictions, including Canada and Brazil have explicitly adopted the four-pronged Howey test, giving the U.S. interpretive guidance developed around these elements all the more global significance.

So you’re out to save the world?

Not exactly. But I do think that the most critical issue from a capital markets perspective facing the blockchain space for 2018 will be providing a reliable and globally consistent “perimeter” to allow market participants efficiently to ascertain whether or not a given token offering needs to comply with the securities regimes in jurisdictions around the world. A corollary point is that where a given token sale will be treated as an offering of securities, in most jurisdictions, additional guidance will be needed to allow sensible compliance with disclosure rules that were written long before token sales were ever imagined. Interestingly, early in my career I faced similar issues working on some of the very first issuances of asset-backed securities. Although these early ABS offerings were unequivocally sales of securities, most of the disclosure rules in effect for companies at the time simply made no sense when applied to a special purpose entity whose sole purpose was to hold a pool of mortgages, auto loans or the like. We face a similar situation with tokens that do not themselves constitute “securities” (even if their “manner of sale” may mean that the offering of these tokens would be required to be registered — think the coffee mugs, handbags, beavers, or whiskey). Private market participants will need to work closely with regulators to develop disclosure regimes that make sense in the context of securities offerings involving digital assets. In the U.S., it took about 20 years from the first issuances of asset-backed securities in the mid-1980s to the promulgation of the original Regulation AB in 2004 which provided a specialized disclosure framework for ABS. Then, following the financial crisis in 2008–09, Regulation AB was substantially revised to reflect the many lessons learned over that unfortunate period. I look forward to the development of a disclosure framework for securities offerings involving tokens and other digital assets that are treated as securities that will stand the test of time.

We have not touched on any of the private litigation that has arisen around token sales — some of it has been pretty high-profile.

You’re right. The class action suits against Tezos have drawn quite a lot of market attention. More recently, another class action suit was launched against Giga Watt, Inc. over their token sale. Look — I strongly support a vibrant dialogue on this space. The blockchain community will never get anywhere living inside a self-imposed bubble. Cryptographers and security specialists spend tremendous amount of time looking at various “attack vectors”, right? Well, private lawsuits such as class actions can be viewed as simply another attack vector. A well-structured token sale should be able to withstand these claims, but everyone — particularly aggrieved token purchasers — deserves a day in court. That is an essential element when we talk about the rule of law. While I don’t want to comment expressly about any on-going litigation here, I would urge anyone in this space to read the Tezos and Giga Watt complaints carefully. There are certainly plenty of lessons to be learned from both. One particular observation concerning the Giga Watt litigation is that, although in one place the Giga Watt complaint claims that the Giga Watt tokens constitute “investment contracts”, other parts of the complaint appear to suggest that it is not the tokens but the terms of the Giga Watt token sale that constituted the security. Very interesting.

How about the topic of the “self-regulation” of token sales?

It is an intriguing idea. I believe that the blockchain community has a huge role to play in setting standards for best practices and demanding a high level of transparency from market participants. Ideally, this process itself would be decentralized. It makes little sense to have a centralized system (regardless of how well intended) in which a few individuals or organizations decide what is “best” for the entire decentralized blockchain community. I run screaming from those seeking to do this — very often it is a transparent grab at becoming a toll-seeking gatekeeper (“Pay me a fee to let me tell you which tokens are ‘good’ and which are ‘bad.’”). However, I do believe that thought leaders in the blockchain space should contribute to an open dialogue on best practices by acting as catalysts for the development of a community-accepted consensus around these best practices. One idea that has been suggested is the use of token-curated registries — a decentralized system for maintaining community-supported lists. There are also some other very notable efforts out there on this front, particularly in Europe. I expect that we will see more discussions with securities regulators around the world as well, both through the International Organization of Securities Commissions (IOSCO) and directly with the relevant bodies in various jurisdictions, since they are important stakeholders and very much equal members of the community. Contrary to the view expressed from time to time in various online forums, regulators are not the enemy. They should properly be viewed as fellow stakeholders and our collaborators in the standard-setting process. This coming year will be the time where we explore what the best practices should be for token sales, and I consider myself very fortunate to be involved in many of these efforts.

Our main focus today has been on fundraising through the sale of digital tokens in a manner not properly treated as a securities offering. Aren’t we leaving something out?

Absolutely. While blockchain technology has opened the door for this important new fundraising tool, the possibilities for traditional securities implementing blockchain are even more far reaching. Unfortunately, not nearly as much headway was made in this area in 2017. I am looking forward to big things for so-called “securities tokens” and other blockchain-based securities offerings in 2018.

Could you give us a quick sense of what this may be?

I would start with one of my favorite areas — asset-backed securities. There is a tremendous amount that blockchain can do for this area. For those interested, the Structured Finance Industry Group together with The Chamber of Digital Commerce commissioned Deloitte to prepare a terrific report on the topic, which I was very pleased to have contributed to. Recommended reading for sure. But mainstream capital markets will be impacted as well. Smart contracts will allow us to start to create programmable investment instruments (referred to by key innovator Symbiont.io as “smart securities”) in which the terms of the securities can be automated and can among many other things tie into the financial reporting of an issuer, enhancing both transparency and certainty, while also reducing cost. Moreover, with the intersection of devices connected to the Internet of Things we can imagine, for example, real estate investment trusts (REITs) providing data feeds on the status and activity from properties (like shopping malls, for example) to investors in real-time. REITs may even choose to “tokenize” their properties under management, allowing investors to select among them, just as today investors can choose among various mutual funds managed by a single fund manager. Revenue-sharing securities may also become more popular. These are similar to non-voting preferred shares in that they allow holders to access specified cash flows after current debt payments have been made, but before any distributions are made to holders of common equity. Such structures might be of particular interest to early stage ventures that are starting to generate revenue, but are expecting significant growth and so are concerned about diluting their equity at a relatively low valuation. The bottom line here is that we are only at the earliest stages of exploring what blockchain and smart contracts can do for the structuring, ownership and trading of traditional securities. We will also almost certainly see greater competition in related services for the capital markets as infrastructure built initially for digital “utility tokens” can be ported over to security tokens as well. This includes of course exchanges but also fund management, market research, ratings and even legal and accounting services.

Quite a lot to digest there, but we are just about out of time. Any closing thoughts?

I’ll just conclude where I began, which is that 2017 was the year legacy players started to recognize that something fundamental is changing in the capital markets. Now is the time for all those heavily invested in the systems, processes and institutions in the capital markets to start to actively explore this new decentralized blockchain community.

Lewis Cohen would like to thank his good friends and colleagues, Mark D’Agostino, Susan Joseph, Joshua Ashley Klayman, Peter Ku, Gabriel Shapiro, and Andrea Tinianow, for their invaluable assistance in assembling the above.