How the SEC Approaches Crypto Tokens: What you Need to Know
“Not all regulations are effective or achieve their purposes. Some are too restrictive, while others are weak or improperly implemented. But that does not mean that all regulation is harmful.”
~ Michael Lipsky
Chair of the International Budget Partnership
Not All Regulation is Bad Regulation
If you’re a regulator, one of the foremost challenges of your job is to avoid stifling new innovation before it can properly get its bearings. Historically, regulation lags behind innovation.
Over the past few months, regulators around the world have begun to take note of the nascent crypto economy. Regulatory postures have ranged widely. China banned ICOs in September, Abu Dhabi regulates on a case-by-case-basis, Switzerland’s FINMA has begun looking into ICO regulation, and Dubai intends to put all of its government documents on a blockchain by 2020.
Here are a few goals that cryptocurrency regulators need to balance:
- Protect consumers from scams.
- Reduce the degree to which new technologies empower malicious actors (e.g. prevent terrorist organizations from laundering money).
- Allow as much freedom as possible for new industries to grow, so that your country can share in the economic benefits of the new industries.
- In the meantime, provide clear enough regulatory posture to allow innovators to proceed with new ideas (e.g. make it clear that you won’t suddenly ban all cryptocurrencies forever).
History shows that smart regulation is better than too much or too little regulation. The relatively stable regulatory environment within the United States has contributed to the country becoming the largest recipient of foreign direct investment (“FDI”) over the last decade, with over $1.5 trillion in FDI flowing into the country since 2006. Investors want to know that their rights are enforceable and external risks are as mitigated as possible. The 88% drop in Venezuela’s FDI inflows in 2014 provides an excellent case study on investor interests for an unregulated and unstable market.
The total market capitalization for cryptocurrencies has jumped to over $200 billion in 2017. Smart, clear regulation from the SEC may continue to drive this trend upward as more certainty is introduced into the marketplace.
Smart Regulation is Coming
The SEC appears to be taking a cautious, “wait and see” approach to regulating token sales. Over the past year, the commission has only targeted a few companies whose operations drew special attention, using each opportunity to send their intended signals to the community. A few of these actions (and non-actions) are highlighted below:
- The DAO — In one of the most well known SEC non-enforcement actions, the SEC’s approach can be interpreted as a shot across the bow. The commission didn’t end up pursuing charges, but used the announcement to lay down some initial ground rules for token sales. They reached the conclusion that the offering and sale of digital tokens may be subject to the requirements of the federal securities law. They settled on a cautious “facts and circumstances” approach; if another DAO-like token emerged, they would consider the individual economic organization of the specific project before making a conclusion about the general nature of a token.
- Protostarr — In an effort to use tokens as a way to invest in internet celebrities and receive dividends from advertising royalties, Protostarr was contacted by the SEC and subsequently cancelled its ICO. When the commission informed the company that it was beginning an investigation into potential securities violations, Protostarr acknowledged that they hadn’t hired attorneys to review their sale and didn’t want to challenge the decision.
- REcoin and Diamond Reserve Club — The SEC brought fraud charges against Maksim Zaslavskiy and his companies for selling unregistered securities. Both companies issued tokens that were purportedly linked to the value of the underlying assets. Unfortunately for the token investors, Mr. Zaslavkiy’s companies didn’t actually own any underlying assets.
A Rough Framework is Already Developing
The current regulatory framework that the SEC uses to determine whether an offering is a “security” is commonly known as the Howey Test. Before the blockchain industry, this term would likely have garnered blank stares if mentioned to a group of startup founders. Today, I probably don’t even have to explain it to you (but if you’d like a detailed explanation of the test, feel free to dive in here, here, or most importantly here.)
Peter Van Valkenburgh, Coin Center’s Research Director, reduces the Howey Test to two simple questions:
- Is the thing being sold as an investment?
- Is there a person upon whom investors rely for the profits of their investment?
If the answer to both of these questions is YES, then the SEC will likely consider the “thing” to be a security. When an prospective purchaser is “attracted solely by the prospects of a return” [1] on the investment, the thing being sold is most likely an investment. However, when the prospective purchaser is attracted to product being offered by a desire to use or consume the item purchased — “to occupy the land or to develop it themselves,” as the Howey Court put it, the securities laws do not apply. [2]
With tokens, Coin Center created a helpful chart to break down four different token characteristics to assist us in deciding whether or not a particular token might be regulated by the SEC as a security. Peter asks:
- Why is the token desirable? (Is there actual utility provided? Or, is it simply an investment?)
- What backs up that value? (Is it a network of individuals? Or, is it a centralized issuer?)
Assets like Apple stock and commodity futures are easily seen as securities. These assets are being purchased as an investment with expected future profits and they are managed by a centralized issuer.
Other assets, such as admission tickets, apartment buildings, bars of gold, and interests in member-owned organizations are more likely to be purchased by individuals for the underlying utility of the assets. Once purchased, the value of these assets is generally provided by a more decentralized network of people.
If you’re issuing a token, here’s how to consider if it will be classified as a security:
- Coin Center argues that only tokens that more closely align themselves with traditional investment opportunities should be regulated by the SEC (shaded in red below).
- Conversely, tokens that grant holders usage rights to the underlying assets and allow holders to directly participate in the management of the assets should not be regulated by the SEC as securities. These tokens may fall under the jurisdiction of the Federal Trade Commission or necessitate their issuers to register with FinCEN as a money service provider.
Here’s what to expect from SEC in the future:
The SEC may decide to cast a wide net and take an overly aggressive stance. However, we believe the community at large can help the SEC promulgate smart regulation by developing the crypto ecosystem in a transparent and responsible way to protect token purchasers from fraud.
How will TrustToken help users with securities tokens?
Within this regulatory landscape, TrustToken is designing templated SmartTrusts and smart contracts that will help our users successfully create SEC compliant asset tokens. The details of this endeavor will be explained in our next blog post.
Footnotes
[1] Howey, supra, at 300, 66 S.Ct., at 1103
[2] United Housing Foundation, Inc. v. Forman, 421 U.S. 837 at 852–53 (1975).
Want to Learn More?
DISCLAIMER: In consultation with legal counsel, TrustToken reserves the right to change the distribution schedule and/or impose additional restrictions on transfer and resale if necessary to comply with securities laws. You should also review our most recent FAQs and PPM for a more complete discussion of these factors and other risks, particularly under the PPM heading “Risk Factors.”
