The SEC’s Crypto Crackdown — They Can’t Get Here From There, Part 2
Cognoscenti say the shorter the post, the greater the engagement. While not short, this post is at least shorter than the first draft.
Back in the spring, Part 1 described institutional causes for the SEC’s retarding influence on utility token sales, and urged projects to press for sensible legal guidance.
On an annual basis at least, utility token sales have continued apace, but their mix has shifted outside of the US. Some U.S.-based projects punt on token sales entirely. Others sell equity to U.S. accredited investors. Those selling tokens risk the uncertain impact of potential transfer restrictions or geographically bifurcated token networks.
Faced with novelty, the SEC likes to leverage the size of the U.S. capital markets, offer even informal guidance only slowly, and regulate by enforcement. However, if there are competing power centers and a new law and economics paradigm, the bunker of the Howey test could get pretty uncomfortable … and embarrassing.
First, there are competing jurisdictions. The SEC has stumbled in turf battles before. In the early 2000s, U.S. state attorneys general — New York’s Elliot Spitzer in particular — usurped influence by more assertively pressing cases of fraud and conflicts of interest against Wall Street investment banks. Now, a number of jurisdictions have already taken the position that utility token sales should not be treated like securities sales, including Switzerland, Singapore, Hong Kong, Bermuda, the Cayman Islands, and the British Virgin Islands.
Second, there is a new law and economics paradigm afoot, as discussed further below. For now, consider a partial list of all the jurisdictions studying how best to regulate crypto: Netherlands, Switzerland, China, France, and Singapore. The “investment contract” test of Howey, oft-referenced and even lionized by an SEC website, is not followed under analogous securities laws outside the U.S.
The SEC’s first foray into meaningful public guidance for utility token sales was the June 14th speech by its Director of the Division of Corporation Finance, William Hinman.
Spinning the tiller away from the imminent shoals of embarrassment, the speech said a token was not a security per se. If tokens are securities, then Bitcoin and Ether — together roughly 60% of crypto market value — are rife with illegal securities trades, because there is no registration statement covering any of their token sales or mining. The speech floated a novel and vague theory that Ethereum was sufficiently “decentralized” to avoid having ether trades subject to securities law disclosure requirements.
The speech also said a token could be sold as a security and subsequently not as a security. This has lawyers and others again contemplating use of a SAFT structure in the U.S., without having tokens thereby delivered registered (under Reg A+, for example) or bound by transfer restrictions. The speech suggested using a sale of conventional securities to build out a functioning network, whose tokens could then be sold without registration/exemption under the securities laws.
That’s the good news from the speech. The rest showed little correction to the current course toward embarrassment.
First, the SAFT is still on the operating table. The decentralization test is vague with no guidance from precedent. The operational risks from ending up with tokens that might be subject to transfer restrictions are substantial.
Second, the functionality test is no better from Hinman this year than from the SAFT’s creators last year. A token is apparently functional when the buyer would not rely on the seller to do anything to materially affect its value. Alas, even after the launch of a so-called “functional network,” software projects are ongoing and changing, and in crypto, these subsequent changes could have a greater impact on network utility and value than changes prior to reaching functionality.
To put a finer point on it, look at expected changes in transactions per second (tps) on some major blockchains. Take Ethereum, the current epicenter of the utility token universe and one of the instant reasons for the speech. The SEC seems to accept that ETH is “functional” at 15 tps. Reasonable estimates are that in the foreseeable future Ethereum will blast off to 1,000,000 tps. If so, comparatively, is a 15 tps network truly “functional?” My meow says no.
Third, the speech ticks off some token-specific factors to flesh out the Howey test—just more steps to embarrassment. One is when the developers retain enough tokens to give them an incentive to work to improve the token’s utility (and presumably value). Thus, if developers sell all their tokens up front, it might not be a securities offering, but if they hold some back for future sale, it becomes a securities offering. Of course, this puzzle relates to another “Hinman factor” — raising “excess” funds in the token offering: if the developers decide to sell all their tokens in the ICO, generating net proceeds that could be applied to further work on the network, this too is a red flag. Therefore, if a project devises functional tokens that can be built for $10 and sold for $100, the token sale is at risk of being classified as a sale of securities. Wait, what?
As the inconsistencies mount in applying Howey, consider a different paradigm, dubbed for now utility token law and economics. Let’s focus on five points.
First, utility tokens are exclusive to software’s business model, undercutting the presumption than they are a means of financing rather than revenue. Tokens are essential to a revenue model particularly suited to crypto networks. Software tokens predate crypto. The move to cloud computing allowed software licenses to be metered — the user pays only for what it uses. The commercial and legal practices of the software industry are much more relevant to how to apply the securities laws to utility token sales than analogies to other industries (e.g., orange farming). Indeed, with all due irony intended, analogies are like opioids — they ease the pain of thought, at the risk of addiction to the irrelevant. Alas, the Hinman speech did not even include the word “software,” much less the term “open source.”
Second, as we have argued previously, one major crypto innovation is the commodification of utility at scale, creating a distinct method of monetizing access to software networks that incorporates token liquidity. One advantage to allowing tokenized access to the network and its associated computing resources is that it permits market-based pricing of the tokens. Changes in the price of the service to which a utility token provides access are thus different from changes in the price of a security told to capitalize the project. One reason the securities offering paradigm fails for utility token sales is that utility tokens are micropayments for use of software-based networks, and securities are not. Sale of access to a new software application is treated the same, whether the application is novel or a mere upgrade to a prior version. Token sales should be treated as revenue, regardless of whether the sales price of the application access is greater, equal, or less than the expenses incurred in providing that access. The value of a token tends to vary with transaction volume because the token is a market-priced commodity of known quantity, not because the original sale of tokens was a securities offering.
Third, a meaningful share of even the initial buyers of utility tokens should be looking to hold them, not use them. Tokens never age or depreciate. A token’s marginal storage costs are essentially zero. Holding utility tokens — even for long periods of time — helps future-proof their utility from forks.
Fourth, the open source nature of crypto utility tokens inherently reduces the need for securities law disclosures. ICO funds can be tracked in real time. The code of an open source project is publicly available. An open source project is inherently less centralized than a company, regardless of whether there is an influential developer team, especially given the potential for forking. Although, per Satis, ~10% of all ICO fundraising has gone to identified scams, the vast majority of these scams consisted of just three large projects, easily susceptible to one-off investigation, needing no recourse to securities laws.
Fifth, if the primary monetization of a utility token network is through token sales, these sales presumptively constitute revenue. This is the case even for a sale of a pre-functional, novel token. Just as selling a token that is a nano services contract generates revenue, even if there is work to be done in the future to deliver on that contract, so too should sale of such a token for use of a crypto network. The enterprise risk captured by the third and fourth prongs of the Howey test is reduced by the combined impact of open source, decentralization, governance, and token economics of crypto.
Regulators need to adopt the emerging paradigm of the law and economics of utility tokens to constructively apply the securities laws. Utility token sales for open source networks should be presumptively viewed as generating revenue not investor claims on the network akin to equity, debt or some derivative thereof. Even if the SEC does not follow this course, others likely will.
Before crypto, the author’s journey included working as a corporate attorney at McDermott, Will & Emery in Chicago, a securities attorney at the SEC’s Division of Enforcement in Washington DC, and an equity research analyst at Deutsche Bank in New York City and Wedbush Securities in Los Angeles. He has an MBA from the University of Chicago Booth School of Business, a JD from the University of Virginia School of Law, and a BA in Economics from the University of Chicago. He is also a CFA Charterholder.