In recent weeks, the US Securities & Exchange Commission (SEC) has taken significant public steps in the regulation of token sales (popularly known as initial coin offerings, or ICOs) relating to blockchain. These steps followed the issuance by the SEC of the Decentralized Autonomous Organization Report on July 25, 2017 (the DAO Report). On December 4, 2017, and December 11, 2017, the SEC announced enforcement actions relating to the PlexCoin and Munchee token launches, respectively, (Enforcement Actions). On December 11, 2017, SEC Chairman Jay Clayton published a public statement entitled Cryptocurrencies and Initial Coin Offerings (the Public Statement, further referenced together with the Enforcement Actions as the Recent SEC Guidance). The SEC has made a concerted effort to monitor the ICO market and address—first through the DAO Report and now the SEC Guidance—transactions and behaviors it believes are both inconsistent with and in violation of US securities laws.
The SEC Guidance moves further in the direction of much-needed clarity on the SEC’s thinking about token sales, which should help the various constituencies participating in blockchain and ICOs. Highlighted below are critical points that are addressed in the Recent SEC Guidance and several other points that have not yet been directly addressed.
Points of Clarity about the SEC’s View:
- Manner of Sale. While the Howey test (SEC v. W. J. Howey Co., 328 US 293 (1946)) provides the basis of the analysis as to whether a token is an investment contract, concepts from other Supreme Court precedent (cited in Munchee) inform the application of the factors described in Howey. For example, the manner in which a token is sold, including the defining characteristics of the target purchasers, can create an expectation of profit, as can statements about intended project improvements through the use of ICO proceeds, which can increase the likelihood that the token will be considered to be a security.
- Touting. Any “touting” of the possibility of appreciation (return on investment) of a token’s value through anticipated platform development, additional functionality or an increase in secondary market price, whether on a cryptocurrency exchange or from peer-to-peer trading, can impact whether a token will be considered to be a security.
- Token Liquidity – Secondary Market Trading. Engaging in activities that seek to ensure token liquidity might also form the basis for a view that purchasers have an expectation of profits from the efforts of others. In other words, engaging in these activities, even in respect of a token that could be considered to be a “utility” token, could cause the token to be considered by the SEC to be a security. These activities might include arranging for a cryptocurrency exchange to “list” the token, selling efforts geared exclusively to “investors” in tokens rather than users of the platform, and publicity aimed at creating interest among traders.
- Other Market Participants. The Public Statement emphasizes that market participants, other than token issuers, should independently consider the Howey test and whether a token may be a security prior to promoting a token as an advisor, listing the tokens on an exchange or otherwise engaging in behavior that is regulated by the SEC in respect of securities offerings, sales and market-making. Operating as an unregistered broker-dealer or exchange is a separate violation of the securities laws.
- Prior Bad Acts. In Plexcoin, the SEC emphasizes that prior bad acts by senior members of a token issuer, especially in the securities industry (in the United States or in other jurisdictions), will draw additional scrutiny by the SEC.
Points for Which Additional Clarification is Needed:
- Each Enforcement Action asserts that the token at issue is a security without considering an interpretation to the effect that the manner of sale created an investment contract with respect to the sale itself, rather than the underlying token. We consider this distinction important and in line with Howey, where the Supreme Court found that the contract concerning the profits from the sale of oranges was a security, not the oranges themselves. The blockchain ecosystem has developed several “investment contract” instruments for selling tokens in the initial sale that seek to maintain the utility nature of the underlying token. Utility tokens not subject to the securities laws seek to create the kind of network adoption that a project needs for their cryptoeconomy to succeed. SEC clarification of this point would be beneficial.
- Clarification that a utility token that represents a digital good (e.g., cigars, coffee cups) or service (e.g., software as a service, storage, processing power) is not a security, would also be helpful. If someone selling such a token makes statements about appreciation, will the token be a security? We do not think so.
- Additional guidance is needed about whether the stage of a platform’s development at the time of the token sale matters to the securities law analysis of the related token. This question poses significant issues because like any technology, blockchain projects will seek to make continuous improvements.
- Further understanding on the touting prohibition would be helpful. If a market participant does the touting at the request of the token sponsor, that is the equivalent of the project itself touting its token. However, it remains uncertain whether the SEC will take into consideration the touting of a token by independent actors.
We believe it is important to view blockchain as a technology usable in many industries. As a result, “contextual regulation” remains a cornerstone of our advice to clients; the industry in which the blockchain is adopted will tell us a lot about how it should be regulated. In the Recent SEC Guidance, the SEC has adopted a contextual approach that appears to focus on promissory statements and actions, as well as the history of those behind the blockchain project. In other words, if the project creates an investment-like context, the SEC will scrutinize the sale of the token very carefully to protect market participants from sales of securities without adherence to applicable laws and regulations.