ICOs have fundraised billions to date, but there is a lack of legal clarity, especially for ICOs based in US or in which US citizens participate. Even if an ICO goes according to plan and everyone is happy, there is uncertainty about taxes and whether the SEC and/or the CFTC and FinCEN will get involved. Then there are cases when ICOs don’t go according to plan, and the disgruntled investors are almost certain to attract attention from the SEC and/or some other consumer protection agency.
The SEC has warned in July of 2017 that “the DAO” tokens of the infamous 2016 debacle should have been registered as securities and that current and future ICOs “might be” securities, “depending on the facts and circumstances” of each case.
If the coin or token is a security, its “offer or sale” in the US needs to be registered with the SEC, with some exceptions, such as when the “offer and sale of a security” is limited to accredited investors and/or is in amounts limited by SEC’s crowdfunding rules.
So what “facts and circumstances” would the SEC use to decide whether an ICO is a security?
The most well-known of those facts and circumstances is the Howie test, dating back to a 1946 case dealing with orange groves in Florida. However, the Howie test itself is subject to interpretation, as discussed below, especially when it comes to a brand new industry such as decentralized crowdfunding.
A little more up-to-date clarification from the SEC or congress about ICOs would go a long way to head off what some fear will become an assembly line of legal actions. Meanwhile, the crypto community is trying to guess if and how the SEC and other agencies will react, and preempt heavy-handed regulation by avoiding certain practices.
The SAFT and the Howey test
One attempt to get in front of the regulatory uncertainty and start developing best practices is the SAFT project. SAFT stands for Simple Agreement for Future Tokens, (a twist on Y-combinator’s Simple Agreement for Future Equity, or SAFE). SAFT’s 20-page white paper, “towards a compliant token sales framework” is a fairly easy, non-legaleese read. It describes what currently happens with ICOs and makes suggestions and legal arguments on minimizing SEC’s jurisdiction of ICOs.
The crux of SAFT whitepaper’s suggestions is dividing an ICO into two stages. First, an offering to early-stage accredited investors as a full-fledged investment contract, with all its SEC / securities implications. Then, only after the network is up and running, a sale of its functional utility tokens to the rest of us.
The whitepaper does not claim to provide a magic legal formula, nor does it call for radical changes to how ICOs have been happening; most of the early-stage ICO investors already happen to be “accredited”, it says.
It does make a legal argument about how the (re)sale of “genuinely functional utility tokens” ought to not pass SEC’s Howey test, and hence be exempt from US securities laws.
The whitepaper breaks up the Howey test into four parts, all of which must be true at once for the offering to be a security:
- Investment of money
- in a common enterprise, with
- expectation of profits,
- from the efforts of others
and argues how a post-SAFT functional utility token is unlikely to meet all four, especially both 3 and 4, since by the time of a general token sale, the expectation of profits is more dependent on market factors, as opposed to the future efforts of others (developers) who already put in their effort to launch the network and its token.
The whitepaper also claims says that following the SAFT framework may reduce tax burdens on the developers by spreading out their taxable gains over several years, rather than, say, trying to pass of the funds as a donation to a non-profit. It also argues for reducing the scope of FinCEN and “money service business” regulations on exchanges and other resellers of post-SAFT utility tokens.
Not so simple
The whitepaper anticipates much of the criticism it has been met with.
It acknowledges that the developers can have a bigger influence on the price of a token than market forces when they make grandiose promises to make the already-sold token much more functional than it currently is, or if the network is built in a way to allow the devs to retain control of the tokens after they are sold.
It also acknowledges that even functional utility tokens may still be deemed a security if they are sold primarily to those that can’t use them, except to speculate on their price, or even if they can use the tokens but still buy them primarily to speculate.
In a subsequent debate, Marco Santori, a co-author of the SAFT whitepaper, argued that functional tokens are like gold bars delivered after the ‘enterprise risk’ of investing in a gold mining operation pays off - that the produced commodity is no longer a security. However, other lawyers argued back that the analogy between gold or oil and ICO tokens breaks down. Not everyone who buys a token intends to use it or is even able use it right away. The token’s designated purpose often requires technical expertise, or is simply unclear, or changes as soon as the dev team pivots. Not so with centuries-old commodities like gold and oil. Their miners and wholesalers often don’t do anything else besides deal in one commodity in which they are experts. Moreover, any profits in dealing with physical gold and oil are made on large volumes of moving inventory, not buy-and-hold. Physical commodity mining and wholesaling is often boring and barely profitable while ICOs have been anything but.
Another lawyer pointed out that a SAFT investment contract might not conform to legal jurisdictions outside the US, say, Swiss privacy laws
This time, it's different
There is lots of hot money sloshing around in the crypto space, especially from those who made fortunes on the price rise of Bitcoin and Ethereum - hot money willing to take big risks, on the hope the current obscure coin or token will become the next Bitcoin or the next Ethereum. Even the accredited investors often invest without understanding how the utility is supposed to work. Meanwhile, fundraising too much money too fast can put a strain on a dev team’s work ethic and cohesiveness.
There is lots of similarities between the ICO space and the dotcom bubble, circa 2000. It was the beginning of the Internet revolution, but the vast majority of the companies did not succeed to come up with a sustainable business model, or were just too early for the market. Likewise, there is lots of creative destruction in the ICO space, with tokens trying to solve problems we didn’t know we had. Some will prove viable, others will not. The “me too” companies will go bankrupt or get acquired.
Moreover, not every project actually needs to become a decentralized network or fundraise as an ICO. Yet once the founders go the ICO route, they are under pressure to deliver price performance, often at the expense of delivering the actual utility the token is supposed to provide. Hence there are bound to be some investors who get burnt and run to the regulators with their ICO issue, security or not. That is, if all the hype and excitement doesn’t attract the regulators’ attention sooner.
CoinCenter's simplified take
Meanwhile, Peter Van Valkenburgh of CoinCenter made a similar distinction between utility tokens and securities in his 10-minute presentation at Ethereum Devcon 3 in early November 2017. He placed some examples on a graph. The graph was a spectrum of Network vs Issuer on one axis, and Utility vs Investment on the other axis. He expects the SEC to assert itself at least in the Issuer / Investment quadrant, and probably at least in some of the nearby areas as well, although CoinCenter is lobbying for clear limits on SEC’s jurisdiction.
Lots of regulatory gray areas remain as cryptos and ICOs go mainstream and perhaps revolutionize finance. As Adam B Levine pointed out in a podcast, we are still in a time of “first practices”, not necessarily “best practices”.