The Known and the Unsaid from the SEC’s Framework

In our previous article, we broke down and summarized the Framework and the No Action letter published by the SEC in April 2019. In this article, we share our takes on securities compliance for blockchain projects and what to expect in the future.

FUNCTIONALITY AND TRANSFERABILITY

In the Framework, we see the SEC’s approach to where they drop the line as to what is a security and what isn’t a security. First and foremost among them, those elements seem deeply focused on the line of functionality and transferability. To avoid being deemed a security by the SEC,

• your network must be fully developed at the time of sale;
• your token must not be transferable outside the platform.

The thinking goes:

• If the network is fully developed, there would be no expectation of profit predominantly based on the token issuer’s continuing efforts to develop the network.
• If there is no transferability, then there is no expectation of profit. Meaning, if you can’t transfer the tokens out of the network, then you can’t trade it on other markets or sell them on exchanges, so the Howey test can’t be satisfied.

Take the recent SEC v. Kik case as an example, the SEC points out that

a) users couldn’t do anything with Kin tokens at the time of sale,

b) Kin token was not integrated into Kik messenger and

c) no one offered goods or services in return for Kin tokens throughout the offering and sale.

Therefore, the SEC concluded that most users bought Kin tokens as an investment and consequently, the offer and sale of Kin tokens was an offer and sale of securities. (It seems that if you want to presell a pre-functional tokens on the market, SAFT framework may be the only available compliance path.)

Now let’s look at the more problematic element — non-transferability. The Framework says that the “expectation of profit” prong is satisfied if there is a secondary market since purchasers would expect to make a profit. This position excludes too much that it omits how tokens actually work and why people use them.

The transferability restriction ignores the scale of purchaser’s motives. It is possible that a purchaser intends to “consume” the token and still expect profits from holding the token. The point is that, to satisfy the “expectation of profit”, the investment motive must be predominant as opposed to consumptive motive.

THE VICTIM OF ITS OWN SUCCESS

Throughout the Framework, we can see that the SEC is taking a very cautious approach towards digital assets where it evaluates not only the intrinsic features of the token but also the economic reality of the transaction. One can argue that the Framework has broadened the pathway for the SEC to take action against consumer utility tokens while it should acknowledge that tokens can be traded on the secondary market and appreciate in value, just like every other consumer good.

On the other hand, the Framework’s approach reflects a perceived need to protect unsophisticated investors and to control the underlying speculative growth. Had the crypto market grown less rapidly (not from $17bn to $630bn global market cap in one year), had there been less get-rich-quick shillings and less lambo-ing or moon-ing sentiments, regulators might have taken a different approach. In a way, crypto industry is the victim of its own ICO success.

Regardlessly, what we are seeing right now is that the technology has finally caught up the 2017 hype. More and more projects are ready to launch tokens that are functional. With the Framework published, will we see the SEC stifles innovations? Or will we see more compliant manner in the industry?

THE LETTER OF THE LAW AND THE SPIRIT OF THE LAW

In crypto space, there is a lot of buzz about the terminology of security tokens and utility tokens. The existence of classification as a security is intended to protect investors, which is also why securities laws exist. And here, the SEC plays

a critical role to achieve their three-part mission:

1) protect investors;

2) maintain fair, orderly, and efficient markets; and

3) facilitate capital formation.

Accordingly, companies offering securities must disclose certain information about their business, what securities they are selling, and the risks involved in the investment. However, when applying the disclosure requirement under securities law to blockchain projects, it doesn’t tell investors much about how the token network works and how risky the investment is. Under the spirit of the law of investor protection, have the Federal Securities Laws in the United States done a good job?

Under the letter of the law, we see a number of utility tokens proactively classified themselves as securities out of fear of regulations by enforcement. They started treating their tokens like securities, dealing with required disclosures and in exchange, their tokens are traded in restricted transferability regime under the securities laws. This is a troubling phenomenon since classification as security doesn’t yield meaningful investor protection, because these tokens are not like equities. On the other hand, we also see to-the-moon tokens classified themselves as utility tokens to avoid falling under securities laws scrutiny. The majority of existing digital assets are yet to be classified by regulators and still operating in a legal gray area. It is unclear if they have broken the law or what penalties they might face.

For a large part of this regulatory unclarity is because most of the security laws are written in the 30s, long before token network ever existed, including the SEC’s go-to, the Howey Test.

Other jurisdictions don’t have Howey test and they are taking advantage of that. In general, regulators in other jurisdictions often come up with much more favorable laws toward innovation. Why is that? Because they don’t have the Howey Test. They don’t have the investment contract analysis.

The current situation is much muddled, which is concerning because it plays startups and the development of blockchain technology a disadvantage. The SEC promised a framework that would aid entrepreneurs in determining what tokens are securities, but later published the Framework pretty much says, “if it makes sense to use a token, it’s probably a security.”

THE CONCLUSION

Some say the Framework is a big step toward cleaning up the ICO mess and helping to clarify how the Howey Test applies to digital assets. But from a crypto exchange’s perspective, it has muddied the waters rather than clearing them.

The Framework effectively replaces the DAO Report as the SEC’s go-to explanation for whether and when digital assets would be qualified as regulated securities, by including a list of crypto-specific characteristics relevant to the Howey analysis. In this sense, the Framework is much more helpful than the DAO Report.

Conversely, the Framework is a cumulation of the cautionary statements that the SEC has said publicly in their enforcement actions, especially around promotional and marketing efforts. It primarily summarized “additional considerations for the industry” in terms of evaluating token offerings, providing additional clarity but still but it does not give the industry all the answers.

While the guidance from the Framework is not necessarily new, the fact that the SEC is “saying it more clearly than ever” is still significant. It is critical from a policy perspective that regulatory finds ways to incentivize actors seeking to be compliant, rather than just punishing those who are not. Ultimately, clarity like this is just the beginning of the path towards favorable legislative reformation, a much-needed development for crypto space.

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