The Hard Job of Ignoring Both Letter of Law and Equity of Statute
Argumentum a Сontrario: Giving Pre-mint Tokens to Founders is a Securities Fraud Guilty Plea
Leviathan is Waking Up
The US Securities & Exchange Commission (SEC) has never hidden its skepticism about the Initial Coin Offering (ICO) frenzy. Scarcely has the echo of “theDAO” crash died away, and a couple of weeks ago US authorities published the investigation and clearly hinted they will punish anyone who issues or organizes trading of [unregistered] tokens that may be labeled as a security.
We must come, eventually, to the conclusion that the warning applies to all non-US ICOs too. To qualify an ‘alien’ status, one needs to guarantee — with a decent KYC filter in place — that not a single US citizen would be allowed in. Simple ‘not for US residents’ disclaimers won’t do. Visit BTC-e website if you have doubts.
Since real identity checks are way too expensive on an average unregistered ICO scale and many token sale designs make it technically impossible, every ICO is de facto a US one, especially if it is successful.
The ‘security or not’ blood test has long been used by ICO founders to estimate how likely a particular token sale is to fall under US federal law. Although not new, the basic set of parameters is in the spotlight again. As I (and many others) translate the essence:
any token sold in exchange of value in an expectation of profit that would come from the managerial efforts of others is a security.
The wording of the recent SEC report probably hasn’t changed much from the past lawyers’ evaluations, and the scariest thing about the definition of a security remains its breadth, but this is the first time my attention has really been caught by the keywords ‘managerial efforts of others’. A chain of the most unpleasant logic ensued:
- The condition of ‘being sold (for money or other value)’ is met by all ICOs, no exception. There’s no point of an ICO otherwise.
- The ‘expectation of profit’ is also obvious, but at least it gives some room for debate in court. Still, I can’t imagine a sane judge being convinced of the opposite. The concept of API key or ‘access to the economy’ is clear but, considering the state of the crypto space, there’s no one to be fooled at this point.
- Seems that not satisfying the ‘managerial efforts of others’ condition remains the only loophole.
Can Fooling the SEC be a Moral Thing?
Some people beg (and maybe even lobby) the SEC to ‘grant amnesty’ to all past and selected future ICOs. Others have ignored the entire hype and have already built grounds for regulated crypto assets. But the prevailing majority have chosen to run a dog and pony show designing coins so the above test does not detect them.
Blatant scams put aside, I used to feel it was a moral thing to do. Interestingly, there is no embarrassment about open attempts to circumvent regulations in the blockchain startup community. Normally, people intelligent enough to invent and market a new tech don’t get involved in obvious manipulations against the law. In this case though, people act very differently as if some fundamental truth is backing them.
A particular regulation can range anywhere between legitimate consumer protection and creating an artificial scarcity. The latter makes people pay triple price to compensate for efforts of violators and the government employees who go after them. The inaccessibility of IPOs and accredited investor segregation is bad. Security regulations tend to slide to the ‘artificial scarcity’ end of spectrum. That results in the attitude we see across the civilized crypto space.
The cat and mouse game to avoid SEC ruling used to be fair enough.
Once you convince yourself and your investors that the coin ‘is not a security’, this potential regulation antidote was a good enough condition to proceed to other checkpoints within the general investor attractiveness narrative: product and team quality, potential market size, public sentiment, and other things.
Now, with hundreds of ICOs and well over a year into the ultra active phase and their extremely poor average quality, I believe it is not a fair approach any longer.
Fooling ‘Others’ is Fooling Yourself When You Belong to ‘Others’
One consideration which deterred me was that almost all ICO projects, one way or another, grant their founders, development teams, and other supporters some share of initial emission. That is considered normal, and the behavior seems to be acquired from a custom in the legacy equity world. What can be more natural than paying yourself back with a portion of the property that you created in the first place? How could anyone doubt one’s inalienable right to get paid for managerial efforts?
The SEC people might be a burden on the society, but they are pretty good at naming things in bureaucratically correct ways. Following the formal wording, however, we come to an interesting contradiction.
If the SEC is not going to raise charges against a given [decent and truthful] ICO, then what the team behind the ICO sells is not the result of managerial efforts of the team alone. It would otherwise fall under the securities fraud charges.
In other words, value has to be created by everyone involved with equal access to all tools of participation for everyone — for founders, developers, advisors, contributors, and investors. Thus, there must not be a way to tell a ‘founding team member’ from anyone else. Whatever your status within the project is, you may contribute any type of resource as much as you like, but you can’t have any privileges. If you do, your project is a company and your token is a security.
In practical terms, a project should either be a DAO backed by a legal entity (and founders can waste their shares the way they like), or it is a closed loop of aligned incentives for dedicated economy participants (with zero privileges for anyone).
On High Wealth Concentration
Bitcoin may end up in the state of significant wealth concentration. If there’s anyone alive to control the rumored 1.5M BTC of ‘Satoshi funds’, it means that Bitcoin’s ownership concentration may be at least one order of magnitude above the position of the wealthiest people in fiat (more BTC ‘whale’ stats here). It is very hard to tell the actual fiat figure considering the questionable nature of wealth held in form of derivatives, but even if one believes in conspiracies, a well organized group owning up to 5–10% of the world’s assets looks improbable. Even if they exist, their operations are very slow and cumbersome compared to those of someone directly possessing private keys to one-tenth of all the money.
The ratio itself is not necessarily a problem in abstract terms — many well-functioning systems run in this range of concentration parameter. It is rather the ideological contradiction with the general decentralization premise ICO marketing campaigns use to attract investors.
Concentration of wealth or influence is certainly a problem for a distributed application; one need not argue about that. But it is rarely discussed as compared to less important issues that are constantly in the spotlight. Want to hide something? Place it where everyone can see it. It is just amazing how well this trick worked out in the crypto space.
Unpleasant Dilemma for Zero-Stage Startups
The world has many things that are well accepted by one large group of people and considered absolutely absurd by another. Whenever the latent conflict appears to have actual borders of contact, usually the letter of law stands up to prevent the fight. In the course of this particular discussion, a decent ICO must admit founders are not eligible to special treatment and constitute that project team associates are not ‘others’ as opposed to investors.
Therefore, there are only two complementary readings of the problem that cover the entire universe of those refusing to set up a registered legal infrastructure:
- You don’t agree with the SEC’s wording; the whole logic doesn’t apply to you; you work in complete tabula rasa. Then you’re against the letter of the law.
- You accept the definition and squeeze yourself into a legitimate framework. Then you can’t get any of your own coins, pre-arranged. If you do, you are against both letter of the law and the equity of statute.
A pretty wicked dilemma for someone who only has a white paper and the desire to raise funds, isn’t it?