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The prospect of raising funds for your business venture through an initial coin offering can sound like a dream. But all of that can quickly turn into a nightmare if the SEC determines that your token is a security.
For anyone looking to launch an ICO, it is crucial to first understand what a security is and whether or not your offering qualifies as one. This could be the difference between having a successful funding round and being put behind bars.
How do you know if your token is a security?
The way to check if a token or other investment product is a security is by running it through the SEC’s Howey Test. This includes four prongs: 1) Investment of Money, 2) Expectation of Profit, 3) From the Efforts of Others, and 4) In a Common Enterprise.
In this article we give you a quick rundown of what securities are, how the SEC assesses token offerings as securities offerings using the Howey Test, and what this all means for your ICO.
This will give you a basic level of understanding on the law, but should not be taken as legal advice with respect to your particular offering. Always consult with a qualified legal professional before raising funds.
What is a Security?
In layman’s terms, a security is an investment product that is bought or sold with the expectation of making a profit but involves some degree of financial risk. The most common examples are stocks and bonds.
In order to protect investors from fraudulent investment vehicles, security offerings are regulated by the US Securities and Exchange Commission. If an investment product is classified as a security, the issuer is required to either (i) register the offering with the SEC, and follow extensive reporting and disclosure requirements, or (ii) fit within a recognized registration exemption.
Given how new ICOs are, it has taken time for SEC regulators to officially opine whether or not cryptocurrencies are securities. But with each new SEC ruling, we are getting closer to regulatory certainty.
As it stands today, Bitcoin and other first generation cryptocurrencies are probably not considered securities, but most, if not all, ICOs are securities offerings. According to SEC chairman Jay Clayton, ICOs fall under the SEC’s broad category of classification known as ‘Investment Contracts’. In his words,
“Replace the dollar, the yen, the euro with Bitcoin. That type of currency is not a security… Where I give you my money and you go off and make a venture… and in return for me giving you my money, you say, ‘You know what, I’m going to give you a return.’ That is a security, and we regulate that. We regulate the offering of that security, and we regulate the trading of that security.”
This means that, according to Mr. Clayton, ICOs should be registered with the SEC. Unfortunately, as anyone familiar with the registration process can attest, it is a legal and bureaucratic headache that can cost the issuer millions in fees to lawyers, accountants and broker dealers.
That said, there are ways to avoid registration. Either by making sure that the product you’re offering is not classified as a security or by seeking a registration exemption for that offering. In order to decide the right approach, the first thing you need to understand is how the SEC determines what qualifies as a security.
How the SEC Determines if a Token is a Security
To determine whether or not a token or any other investment product is a security, the SEC uses what is known as the “Howey test”. This was established by the US Supreme Court in a famous case in Florida (SEC vs. Howey).
In Howey, tourists had been solicited to buy plots of land with orange trees and promised that the oranges would be cultivated and marketed for them by the Howey Company. These tourists were interested in the financial returns the Howey Company promised and it seems the Howey Company delivered as promised, earning its investors between 10% to 20% profits each year.
In the end, the court determined that this land contract and sales service contract together formed an investment contract.
In their words, an investment contract is:
“a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”
This became the basis of the Howey Test, which essentially measures a business or investment offering against these four criteria. In order to qualify as a security all four criteria must be met. Let’s break down each of these parts to see how they apply to crypto projects and ICOs:
Investment of Money
This criteria is pretty straightforward. Somebody must actually invest money for the SEC to get involved. And this makes sense when you consider that one of the SEC’s core goals is to protect investors. For this reason, any crypto project that is looking to raise funds for its activities should take care to see if its token offering can in any way be classified as a security.
Even cloud mining businesses, which purportedly take money in exchange for providing services, have undergone scrutiny for engaging in unregistered securities activity, as we saw with Genesis Mining. The regulators that made the charge eventually reversed their decision; nonetheless, it is always important to err on the side of caution and confirm this with your legal counsel.
Expectation of Profit
With first-generation cryptocurrencies like Bitcoin, the main selling point was arguably the technology that enabled users to make fast, anonymous and trustless transactions. Some may have hoped that the prices would go up, but in essence, the initial buyers of crypto did so more for its utility rather than for speculative purposes. At least that’s the argument.
The situation is significantly different today, with many tokens now offered with the sole purpose of providing buyers with investment returns. Regulators have acknowledged the distinction between these two different offerings of utility tokens and security tokens. They have even explicitly used this language in rulings, as seen with the SEC’s ruling against Titanium’s ICO in mid-2018.
Previously, in the case SEC v. Life Partners, Inc. it was asserted that in order for a product to be deemed an investment contract, it needed to provide a “financial” return. As such, this disqualifies utility token offerings that promise only non-monetary benefits, such as current or future access to the project’s service or network from being considered securities.
From the Efforts of Others
With most ICOs, investors are buying into a project whose team is responsible for developing, managing, and marketing the project. As the investor, the idea is to hand over your money, let the professionals run the business and then receive a return.
This provides us with another key distinction between completely decentralized crypto projects, like Bitcoin, and centralized crypto projects, like Ripple. Centralized crypto projects are no different than other types of companies. They are entrepreneurial ventures with a core team behind them to manage and grow the project.
To be clear, from case law we know that the “efforts of others” must be entrepreneurial or managerial to be considered a security, and that purely administrative, ministerial or clerical activities do not meet this prong of the Howey Test. So if the purpose of the centralized team is to simply administer a project, and the team’s purpose cannot impact the overall value of the enterprise, then this prong can be avoided.
In a Common Enterprise
The primary definition of a common enterprise is one that involves “horizontal commonality”, which essentially means the pooling of money from multiple investors for shared profits, losses, and risk. And this standard is what we commonly think of when buying stock or bonds. All the investors win or lose together.
However, since the Howey Test was first articulated in the 1940’s, this criteria has been defined differently by different courts. The most broadly accepted standard is called the Broad Vertical Approach, which finds a common enterprise if the success of the investors depends on the same promoter’s expertise. Under this standard, its possible for investors to have different gains and losses yet still have participated in a common enterprise.
Recent Cases Against Unregistered Security Token Offerings
The first cases that the SEC launched against unregistered security token offerings were Airfox and Paragon in November 2018.
In the time since, a number of projects across the board have found themselves under fire from the SEC.
The most prominent of these cases are the SEC vs Kik and SEC vs Telegram. As the number of cases builds up, we are starting to get a clearer picture of how the SEC is applying the Howey Test to securities offerings in practice.
That said, there is still significant confusion, as the SEC Chairman has stated that Ethereum’s ETH token cannot be considered a security token. It is possible that Ethereum’s ICO could have been considered a security token offering, but now with time, the project has become sufficiently decentralized so that ETH no longer can be considered a security.
This is unprecedented ground in both crypto law and securities law, so we are keeping a close eye on how things progress in this area.
What does this mean for Crypto Law Insiders?
It should be no surprise to Insiders that the SEC considers ICOs to be securities offerings. We’ve discussed this numerous times before and it’s clear where the trend is heading. Don’t play around here! Violations of securities laws are very serious and can result in heavy fines and even imprisonment.
If you are planning an ICO, it is imperative that you seek experienced legal counsel from a high-quality crypto lawyer to help you structure your ICO or token offering. Securities counsel will be able to guide you either through the registration and compliance process or through an appropriate SEC registration exemption for your securities offering.
Editor’s Note: This article was first published on October 5, 2018, before the SEC began its crackdown on unregistered ICOs.