CRYPTO ASSETS: THE SEC, SUBPOENAS, AND THE CRACKDOWN

Posted on by Richard Storey

 

On February 28th, the Wall Street Journal reported that the SEC delivered “dozens” of subpoenas to cryptocurrency companies https://www.wsj.com/articles/sec-launches-cryptocurrency-probe-1519856266. Some report that 80 or more such companies were served. The warning signs are over; the gauntlet is thrown. It would be fervently delusional to think indiscriminate crowdfunding of crypto “tokens” will continue without regulator scrutiny—at least in the U.S.. The SEC is on the hunt for unlawful sales of securities and unlawful crypto exchanges. Crypto companies caught in this roundup may face an estimable financing retrofit, if they are permitted to do so.

The SEC is also taking aim at the gatekeepers, the lawyers, who have enabled this process.

In 2017, the words bitcoin, blockchain and crypto anything were the sexiest topics in finance–and around the water cooler. In 2018, those words will likely be among the sexiest topics in law.

It is astonishing that crypto players got away with it as long as they did. Some crypto companies raised millions in minutes, distributing White Papers (purportedly containing all relevant company info) to the online public that are short, grammatically unsound, and rife with spelling errors. That alone is unacceptable. To regulators, however, depending on the nature of the offering, it is more than unacceptable. First a couple of clarifications.

Relevant Terminology Clarification: Most Cryptocurrencies are not Cryptocurrencies

Most so-called “cryptocurrencies” are not cryptocurrencies at all. Most are profit-seeking, blockchain-based, cryptographically protected companies that raise capital by selling “tokens” online though a crowdfunding platform to any and everyone. Legally, all blockchain-based, cryptographically protected digital efforts should be called crypto assets. Under the rubric of crypto assets, three general categories can be identified: cryptocurrencies, utility tokens, and crypto securities. While the legal test that defines a crypto security includes 4 indicia, substantively, the key test is whether the particular crypto asset has income potential. Briefly, the income characteristics of these categories are as follows:

Cryptocurrency: Bitcoin is a digital currency. It largely satisfies the three indicia constituting a currency: medium of exchange; unit of account; and store of value. It is nothing more than a cryptographically protected digital transaction unit. Given existing protocols, you will never receive an income from holding Bitcoin.

Utility Tokens: Like Bitcoin, utility “tokens” will never produce an income. They are a sort of entry fee to play, but you will never earn money from them.

Crypto Security (Profit Producing Token): Here, profit is the motive. If we remove the new-tech language from the definition above we get the following:

“profit-seeking, blockchain-based, cryptographically protected companies that raise capital by selling tokens to the public at large through an online crowdfunding platform.”

This definition should sound familiar if you change the word tokens with shares. In the eyes of regulators, this is nothing more than a public offering of stock; and that requires a prospectus, or an exemption therefrom.

In the Munchee Order,  https://www.sec.gov/litigation/admin/2017/33-10445.pdf  the SEC expanded on the definition of a security. The Howey test talks of “a reasonable expectation of profits”, and that is usually associated with income. The SEC widened the definition of profit by linking it to an expectation of investment or capital gain. This quasi-judicial decision potentially and importantly added to the current jurisprudence as follows: if a company promotes the capital appreciation of its tokens through its white paper, advertising, or use of funds, and this engenders an expectation in token buyers (investors) that the token will appreciate in value, then all else being equal, the regulators may find the token is a security. That is despite no possibility of income from the token. While this notion was anticipated, the fact that it is contained in an SEC order that relates directly to crypto assets is important. Therefore, an otherwise utility token that promotes appreciation in their token, combined with an accompanying expectation from investors, may be found to be a security.

Securities regulators do not have substantive issuance concerns with cryptocurrencies or utility tokens, properly defined, and marketed as such. Though SEC Chair Clayton tends to believe pure utility tokens are tantamount to unicorns. However, those crypto asset companies that promote an expectation of profit (income and/or capital gain) are likely securities, and they fall squarely under the jurisdiction of securities regulators like any other security.

Securities regulators’ raison d’etre is to protect the public from all activities related to securities. It is their job to locate and sanction those entities, issuing,  trading, or exchanging (e.g. NYSE) securities unlawfully.

Few crypto assets are cryptocurrencies or utility tokens; most are profit-seekers as defined above. Therein lies the rub.

Warning Shots and The Subpoenas

Over the past year regulators have fired warning shots at crypto issuers. See a previous post http://www.bsatlaw.com/icos-looking-float-crypto-lawtoday/. The July 25th, 2017 DAO decision should have curtailed crypto security issuers. https://www.sec.gov/news/press-release/2017-131. The DOA release, the Munchee Order, SEC releases, warnings by Jay Clayton etc. were relatively ineffectual. These events and words got industry people talking; but many crypto security sellers ignored the warnings. The frenzy to float an issue and raise vast amounts of capital was seemingly too intoxicating. Sellers were blind, brazen, benighted—pick an adjective. In their defence—which is not a defence–it is hard to choke down significant legal and operational costs to step into the compliant light when everybody else ignores the call to compliance. Avoiding compliance and sticking with the crowd is cheap and quick. Nonetheless, most players in this game knew or ought to have know that a whirlwind crowdfund offering to the public was unlawful. To avoid regulators, many crypto security companies dressed up white papers to masquerade as pure utility tokens, when they clearly were not. And, according to SEC head, Jay Clayton, the securities bar (securities lawyers) in the U.S. are on notice. Inevitably, those law firms that advised crypto companies inappropriately or negligently will be called out and questioned, if not sanctioned.

Regulator intervention was inevitable

If it be not now, ‘tis not to come. If it be not to come, it will be now. If it be not now, yet it will come—the readiness is all.” Hamlet: Act 5, Scene 2

The choice was a subpoena. A subpoena compels attendance to a hearing. The testimony is generally under oath. Failure to respond to a subpoena can result in punishment. Fines and imprisonment for contempt (unlikely) are possible. The point is that this exercise is serious and the SEC will get information. Bloomberg reported that this round of subpoenas were aimed at fraud. https://www.bloomberg.com/news/articles/2018-03-01/sec-is-said-to-issue-subpoenas-in-hunt-for-fraudulent-icos I believe a far wider net is cast.

The SEC, and all securities regulators, are looking for fraudulent issues and instances of misrepresentation. They will be on the prowl for those; but more likely the SEC is prowling for unlawful crypto security issuers posing as cryptocurrency/utility tokens. After all, this is a new exploding area of fund-raising that has avoided all regulator scrutiny. Despite there being an estimated 1,600 crypto assets out there, few, or none, have registered with the SEC. Jay Clayton stated that he has never seen a “utility” crypto. The clear inference: there are crypto assets that are securities and they have avoided lawful registration with regulators. In addition, there are crypto exchanges that may be exchanging crypto securities without proper registration.

The first step is to get information. The paramount goal is to implement a legal structure for the issuance of crypto assets or enterprises that is seamlessly consistent with current securities law and regulation. The subpoenas may relate to charges; there may be hearings, reviews and court cases as we enter this stage of the crypto crucible.

The SEC has telegraphed that they will follow the Howey test to decide if a token issue is de facto a security issue. In a previous article, I outline the legal test. The SEC used the Howey test in evaluating the DAO, supra.

Among other things, it is certain that the SEC will be collecting the following indicia:

1. Was there an investment? In addition, the SEC will look at the characteristics of the individuals or companies investing (friends, family, indiscriminate passive crowdfunding etc.).
2. The business. Is it a business that has the potential to make and distribute profit; and/or is it built on expectation of capital gains?
3. Do the investors substantively contribute to management and decision-making?

It is likely that issues related to money laundering and terrorism funding will be raised. Regulators will be profoundly interested in what issuers are doing to that end. They will want to see due diligence measures that satisfy “know your client” and “suitability” requirements.

Reining in the Beast

Regulators are attempting to rein in the beast. The speculative froth is news-worthy; the proliferation of crypto asset companies and the funds raised in 2017 was spectacular. The rage to create and sell tokens combined with public rage to buy them in an unregulated environment could not last. The comeuppance was inevitable. Profit-seeking technologically abstruse, blockchain-based, cryptographically protected, securities (token/shares) were being sold to the masses who barely understood them. Investor safety and regulatory order is required.

Those companies with subpoenas will expose what they have or have not done. That will be juxtaposed with what they should have done to be legally compliant. If these companies are found to have unlawfully issued securities, the SEC will have to right the wrong, level the playing field, and institute a defensible legal structure going forward. It is unlikely that the SEC will forgive issuers or in some way “grandfather” their non-compliance as acceptable. Regulators will, however, balance relevant interests going forward.

As mentioned above, regulators are in the business of protecting investors, but they are also committed to facilitating (not stifling) new methods of finance and new asset classes. Presumably, SEC decisions will adhere to these principles as they collect information on the acts and omissions of crypto security companies. SEC actions or charges will adhere to the law and these principles.

A continuum of misdeeds will emerge. It is conceivable that flagrant, knowing unlawfulness may result in return of investor funds and significant sanctions against the owners of the crypto security company. Some misdeeds may find their way to the courts; some may attract SEC sanctions. Some misdeeds may indeed by criminal. Securities regulators have broad powers and will exercise them.

What may happen, excepting fraud and other egregious misdeeds, is that the SEC will force compliance on unlawful issuers. If, as a finding of fact, the SEC finds a crypto asset is a security, the issuer will have to settle any sanctions or go to court. If there is a settlement, crypto security companies will likely be permitted to go back and fix the unlawful acts or omissions. The unlawful acts or omissions could be a myriad. Fixes will bring out the full panoply of investor protections and funding options under securities law. Here are a couple of general examples.

If the funding was an indiscriminate crowdfunding exercise to the world, that offering is tantamount to a public offering and will therefore require a prospectus through an investment dealer. If the issuer does not want to incur the expense of a prospectus, it may apply for an exemption(s). Exemptions are several, and they all carry specific rules.
Unlawful crypto asset exchanges are also in the line of fire. On March 7, the SEC issued a public statement on  crypto  assets trading on online platforms. https://www.sec.gov/news/public-statement/enforcement-tm-statement-potentially-unlawful-online-platforms-trading These platforms promote the buying and selling of digital assets. The SEC makes clear that if any of the exchange traded crypto assets are “securities” then that exchange is operating unlawfully. They write,

If a platform offers trading of digital assets that are securities and operates as an “exchange,” as defined by the federal securities laws, then the platform must register with the SEC as a national securities exchange or be exempt from registration. The federal regulatory framework governing registered national securities exchanges and exempt markets is designed to protect investors and prevent against fraudulent and manipulative trading practices.
…
To get the protections offered by the federal securities laws and SEC oversight when trading digital assets that are securities, investors should use a platform or entity registered with the SEC, such as a national securities exchange, alternative trading system (“ATS”), or broker-dealer.

If a trading platform (exchange) is registered with the regulators, enforceable protections are necessarily in place.
Again, the regulators are after entities that are selling, dealing, or trading in crypto securities. On February 21, the SEC charged John Mo and Bitfunder with “operating an unregistered securities exchange and defrauding users of that exchange. The SEC also charged the operator with making false and misleading statements in connection with an unregistered offering of securities.” https://www.sec.gov/news/press-release/2018-23

Becoming Lawful is a Retrospective Challenge

If the SEC gives crypto security the opportunity to redress the unlawful acts or omissions, they have a retrospective challenge. The crypto security company has already raised money. It has a list of investors and amounts invested. Normally, companies choose an optimal financing method that aligns with corporate goals. Directors will balance factors such as cost, time delays, timing of a capital raise, existing investors, availability of new investors, desirability of regulator scrutiny etc. From that information, they opt for a financing option that is in the best interests of stakeholders. The reverse is true here: the crypto security company must find lawful financing method(s) to fit an already constituted investor base. A prospectus filed in all relevant jurisdictions may serve to cover most investors (subject to KYC and suitability); exemptions may not. It may be a complicated exercise to ensure all sales to all investors are lawful. And that assumes investors are prepared tie up their money and wait for the company to become all things compliant.

Jurisprudentially, the law must be consistent: “like cases must be treated alike.” Regulators and ultimately law-makers must enact logically defensible rules that are known, promulgated, and fair. We are in early stage clean-up. Crypto security players who persevere in the willful self-deception that they will avoid regulator scrutiny are unwise. The law may take time to evolve; the regulators may take time to enforce the law;  but both are inexorable.

Future article: possible ways out of the mess: prospectus; exemptions; investment dealer; exempt dealer; exchange (marketplace); Alternate Trading Systems etc.

TO HEDGE OR NOT TO HEDGE: DIRECTORS LIABILITY FOR NOT HEDGING MARKET RISK

Posted on by Richard Storey

If a court finds that negligent corporate acts or omissions generate unnecessary and preventable losses what are the potential sanctions? loss of reputation? fines? Jail? The conclusion of this article is that senior management has a positive duty to protect (hedge) the value of the firm against any material risk that it knows or ought to know; or, at a minimum, directors or senior officers (collectively, “Directors”) must provide a fully informed, fully reasoned, reasonably justified, basis for not hedging.

Context: Market Risks and Losses

“If it be not now, yet it will come—the readiness is all.” (Hamlet: Act 5, Scene 2)

Market risks include all risks that attach to production inputs or outputs controlled by world markets; those risks that a company does not control. Material corporate losses can accrue from market moves in interest rates, commodities, or currencies (“risk factors”). These losses are coming; the question is when. How does the law address decision-making when corporate losses are predictably unpredictable? In other words, are Directors legally immune from foreseeable mitigable losses simply because the risk of those losses come from international markets?

Consider moves in the dollar. Importers fear a weak dollar; exporters fear a strong dollar. Directors know which moves are detrimental to earnings. All else being equal, if the dollar takes a 25% unfavourable move the result is a dollar for dollar assault on corporate income. Costs for the importer increase by 25%; sales revenue of the export decreases by 25%. Unless a corporation can pass on the pain, the damage is certain and quantifiable.

Directors know when risks to the company are material. But in many cases market risk is not properly addressed.

Hedging, the Indefensible Position, Speculation and the Leveraged Play

Many corporate decision-makers have, paradoxically, confused hedging with derivatives as gambling with the treasury. Maxims include the following: “doing nothing” to mitigate market risk is the safe course; using hedging instruments is speculative; fluctuations in market risk factors are certain, uncontrollable business risks that even out in the long run. Relevantly and unfortunately, as Lord Keynes explained, “in the long run we are all dead”.

These positions are not defensible.

The indisputable fact is that not hedging market risks is speculating with corporate cash flow. Speculating with cash flow is speculating with income, and speculating with income is speculating with firm value.

A director’s paramount goal is to optimize firm value (E. M. Iacobucci, “Directors’ Duties in Insolvency: Clarifying What Is at Stake” (2003), 39 Can. Bus. L.J. 398, at pp. 400 1). Maximizing firm value is in fact a fiduciary duty owed to the company. However, firm value optimization becomes a roll of the dice if managers roll the dice with risk optimization.

The materiality of firm risk is commensurate with enterprise operational structure. If a company is a pure exporter—all costs in native currency and all revenues in foreign currencies–this is a leveraged play. The higher the risk-associated percentage of revenues or costs to total revenues or costs, the higher the sensitivity to fluctuations in firm value. In other words, for a pure exporter, there is a direct relationship between a corporation’s percentage foreign revenues (100%), its net profit rate, and a percentage change in the relevant foreign exchange rate. That calculable profit sensitivity to market risk can be applied to firm value. Significant changes in exchange rates can result in big losses.

Big Losses: The Certain and Not-So-Certain Reactions

The job of a CFO is difficult. That person often wears many hats: adding the “risk manager” role to those of audit, accounting, staffing, tax, fund-raising etc. may be challenging. While some larger firms employ a Chief Risk Officer (CRO), many who should, have not.

However, when the company takes a 25% stab from international markets the result can be catastrophic depending on the company’s market risk sensitivity to earnings and ultimately firm value. Directors and shareholders may, for over-lapping reasons, express concern.

Director’s general concerns are several, but they all stem from losing money. This is especially so when losses may be preventable. Likewise, stakeholders can be outraged if losses were preventable.

The point is this: blame for losses will search for a home. The board may blame the CFO; the CFO may blame the board; stakeholders of all sorts may blame the company generally. However, eventually all roads lead to one potentially fatal barb to the relevant players:

“Don’t we pay you to protect us from this?”

Shareholders or creditors—anyone with legal standing–can, and do, sue companies and Directors who do not prudently protect corporate earnings. Directors are vulnerable to a variety of career-altering penalties.

Directors, Shareholders and other Stakeholders have Legal Options

Legal actions are available to litigants when senior management take or omit actions that damage the value of the company or the interests of specific stakeholders. These actions can take several forms. Inter alia disgruntled agents can bring “derivative” actions, actions for “oppression”, actions for “breach of fiduciary duty”, or actions for “breach of a duty of care”. These actions can be brought by shareholders, employees, or creditors. In fact, others may be granted standing.

Going back as far as 1994, when I began working in this area, Commissioner J. Carter Beese of the U.S. Securities and Exchange Commission wrote:

But even while some of the press paints derivatives as accidents waiting to happen, some companies are getting hammered if they do not use derivatives to hedge risk. Compaq Computer, which derives over half of its revenues from overseas markets has two shareholder suits currently pending against it in federal and state court. Compaq is being sued for failing to disclose that it did not have sufficient and adequate foreign exchange hedging mechanisms to protect the company from substantial foreign exchange risk.

A much-cited U.S. case is that of Brane v. Roth (590 NE 2d 587 – Ind: Court of Appeals, 1st Dist. 1992). The shareholders sued the directors of a grain co-operative for losses incurred for inadequate hedging in the grain market. The directors authorized the manager to hedge, but the quantum of grain actually hedged was insufficient to protect cash flow. The court found the following breaches by directors:

1. They did not hire a manager experienced in hedging;
2. They did not supervise the manager’s activities;
3. They failed to acquire the requisite knowledge and skills to enable them to direct and supervise the manager adequately.

The court found that Directors’ negligence in protecting grain co-operative profits resulted in $424,000 in losses.

Some commentators seem to minimize the principles and holding of Brane, supra. Their arguments are based in economic theory and are neither supported with experiential data nor common sense. (this may be worthy of an additional post) Any lawyer who counsels a corporation to avoid hedging based on arcane economic theories may find themselves on the business end of a negligence complaint.

These early harbinger opinions and cases matter. In the past 20 years stakeholders have taken a shellacking through the misdeeds of corporate decision-makers. The debacles (Enron, WorldCom, Barings Bank, Orange County, the 2007 meltdown etc.), the academic papers, the media, the new legislation (Dodd Frank etc.), and the movies (The Big Short etc.) conspire to educate stakeholders, regulators and law-makers about risk. In numerous cases the result was criminal and civil proceedings. These days, arguably, stakeholders, regulators, and law-makers have little appetite for questionable corporate acts or omissions. Media headlines support that contention.

“When sorrows come, they come not single spies, But in battalions.” (Hamlet 4.5.78)

The Law 

It is all about Corporate Governance.

“The Crises” of 2007 and 2008 gave birth to a legislative spasm, notably the U.S. Dodd-Frank Act and the European Market Infrastructure Regulation (EMIR). At the heart of this near-calamitous-collapse-inducing-compulsory-reflex is the control of market risk. Regulation backed by legal and moral suasion was aimed decisively at responsible corporate governance. Of course, Dodd-Frank enacted margin rules on OTC derivative just in case corporate actors do not get the message. But what are the legal tests that bring Directors in view of legal sanction.

The Legal Test: Ultimately a Corporation Must Satisfy the “Business Judgment Rule”

“Use every man after his desert, and who shall scape whipping (Hamlet, Act 2, Scene 2)

As mentioned above, stakeholders can take legal action against senior management. Here, however, I will focus on the ubiquitously cited and cross-jurisdictionally agreed upon, “duty of care”.

While Directors have a “duty of loyalty”, a fiduciary duty where they must act honestly and in good faith with a view to the best interests of the corporation, this duty is tangentially relevant to the focus of market risk. We implicitly assume that Directors are acting loyally to the company.

The “duty of care” imposes a legal obligation upon directors and officers to diligently supervise and manage corporate affairs. Generally, Directors should identify all material company risks (legally, those risks that are known or ought to be known), inform themselves of all material information reasonably available to them, and do their best to mitigate those risks; or, justify them. Therefore, where risks are material, corporate decision makers must act on a “fully informed” basis. In most jurisdictions the duty of care is legislated (see Peoples Department Stores Inc. (Trustee of) v. Wise, 2004 SCC 68 (CanLII); Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985).

Under the common law (judge made law) Directors must avoid “grossly negligence” with respect to the affairs of the corporation. Decision makers were judged according to their own personal skills, knowledge, abilities and capacities. In most jurisdictions, however, statutory requirements have tended to stiffen these standards and consequently put pressure on corporations to improve the quality of board decisions.

Differences in the legal test across jurisdictions are only gradients of the similarities. In other words, the elements that satisfy the duty of standard of care are largely the same everywhere; it is only the legal interpretation of the respective elements that may make a difference. For example, a couple of differences may be found in the following elements:

The Standard of Care. Where on the standard of care continuum does the skill test fall: “professional person”, “average person”, or “reasonable person”?

The Test of Negligence. Where on the standard of negligence continuum does this legal test fall: “gross negligence (U.S.) or ordinary negligence (Canada)? And does the level of negligence dictate the sanction by the courts?

Courts do not impugn all bad corporate decision-making. In fact, courts have developed a rule of deference to business decisions called the “business judgment rule”. Decisions, whose ex post facto results turn out to be detrimental to the company, will not attract legal reparations if the ex ante reasons for taking such action was reasonably defensible. Again, according to the standard of care test, Directors must employ a standard of skill, make fully informed decisions considering all circumstances Directors knew or ought to have known, in the best interests of the company.

To fall within the defensible protections of the business judgment rule a decision-maker must perform the requisite due diligence. Upper management actually must make a fully informed judgment based on a proper analysis of the relevant risk Kerr v. Danier Leather Inc., [2007] 3 S.C.R. 331, 2007 SCC 44 (CanLII). A fair corollary axiom would be the following: the more material an identified risk is to the company the deeper the duty to be fully informed.

In evaluating business decisions according to the duty of care and the business judgment rule, the courts will fairly address industry standards. Industries exhibit particular best practices. There are spectra of skill, spectra of available information, and, to some extent, spectra of expectations. It should be noted that the trend is toward uniformity across industries when assessing risk (see ISO 31000 from the International Organization for Standardization in Geneva; adopted as the national risk management standard in most developed countries).

For plaintiff stakeholders to succeed in challenging business decisions they must establish that the Directors acted as follows:

(i) in breach of the duty of care and
(ii) in a way that caused injury to the plaintiff.
(for a relevant discussion see W. T. Allen, J. B. Jacobs and L. E. Strine, Jr., “Function Over Form: A Reassessment of Standards of Review in Delaware Corporation Law” (2001), 26 Del. J. Corp. L. 859, at p. 892).

“And where the offence is let the great axe fall.” (Hamlet 4.5.219)

Do Directors have a Duty to Mitigate Market Risks?

If market risks are material, Directors must undertake responsible due diligence relating to those risks.

The duty of care decidedly burdens Directors with a duty to make market risk decisions on a fully informed basis. As discussed above, an exporter with 100% domestic costs, and 100% foreign currency revenues, has a large income and valuation risk; Directors know the risk exists (or legally ought to know). The process of being fully informed and making an informed decision must flow from that knowledge. The exposure to market risk and its potential to reduce firm value induces and drives of the duty of care. Quick-changing production functions of a firm ensconced in an increasingly standardized global environment, make reliance on out-dated industry standards a flimsy defence.

Hedging is tantamount to insurance. Insurance hedges against unlikely events, protecting at least in part, the value of a company. Imagine the folly of a company not insuring its buildings or equipment (part of the value of the firm) against the vicissitudes of fate. Analogously, in finance, not insuring a company’s future cash flows when it is possible to do so, must be tantamount to a measured (or foolish) dice roll. Hedging insures cash flows. Logically therefore, hedging insures against losses in firm value. The duty of care to protect firm value must be commensurate with the sensitivity of firm value to market risk.

Conclusion

“If it be not now, yet it will come—the readiness is all.” (Hamlet: Act 5, Scene 2)

Where a market risk exists, senior management must be fully informed on the extent of those risks to income and firm value. They then must explore the methods and costs of risk mitigation; or at the very least, they must provide a fully informed, fully reasoned, reasonably justified, basis of a decision not to hedge. This is fundamental to a defence under the business judgment rule.

ICOs: LOOKING TO FLOAT A CRYPTO? THE LAW…TODAY

Posted on by Richard Storey

At least in the U.S. and Canada the five-minute Initial Coin Offering (“ICO”) on a crowdfunding portal is in jeopardy. This was expected. Regulators step in when actors, to effect a quick and cheap collection of cash, make an offering of securities to the citizenry and call it something else. I will briefly discuss the current the law as it applies to blockchain based ICOs. The term ICO is something of a misnomer; blockchain crypto offering would be an improvement. For the purposes of this article, however, nothing is lost using that term.

Estimates are many, but it is fair to say around USD 5 billion found its way into ICOs in 2017. It was a banner year, raising many times that raised in 2016. Most of that money was raised through crowdsales. In fact, most players in the space associate ICOs with crowdfunding.

Crowdfunding is an indiscriminate offer of something to the world. It provides a means of raising funds for a spectrum of purposes. A point of purpose under the continuum of crowdfunding includes raising money for someone who is sick; another point, in the case of an ICO, includes raising money for a blockchain-based-profit-seeking enterprise. Contemplating an ICO via crowdsale to avoid regulators, where there is an expectation of profit for investors, is unwise. Securities regulators are now in the game, they are making noise, and they are looking to enforce the relevant law.

The Legal Framework

While ICOs are relatively new, the law governing offerings to the public is not.

Legal issues are generally governed by a relevant body of law. Rounds of legislation and caselaw forge legal tests. The elements or indicia constituting legal tests are efficiently deconstructed and hammered with legal arguments. For example, the elements of murder are: unlawful killing; through criminal act or omission; of a human; by another human; with malice aforethought. Each element was, and continues to be, thoroughly litigated. Often every word in a statute or appellate judgement is tested for its meaning (e.g. unlawful, act, omission, human (foetus or “in being”) etc.). Notwithstanding appellate court disagreements or general jurisprudential uncertainties there is most often a governing body of law relating to an issue at any point in time. Where disagreements on a legal issue are few, we tend to dub that as “settled” law. Settled law is settled until something new forces courts to rethink settled positions. The legal test governing ICO distributions sits close to the settled end of juridical spectrum.

Only one legal question must be answered: is an ICO a “security” as that term is legally defined in the law?

If the answer is no, then it does not, at this moment in time, fall under the purview of securities regulators; if the answer is yes, and the intent is to sell it to the public, then this ICO falls squarely within the jurisdiction and regulatory teeth of securities commissions.

Answering the Question: the Howey Test

In 1946, the U.S. Supreme Court in SEC v. Howey Co., 328 U.S. 293 (1946)https://supreme.justia.com/cases/federal/us/328/293/case.html defined the issue as whether

“an offering of an “investment contract” within the meaning of that term as used in the provision of s. 2(1) of the Securities Act of 1933 defining “security” as including an “investment contract,” and was therefore subject to the registration requirements of the Act…”

The Court held, with what became the Howey test, that a “security” exists if there is

An investment of money;
In a common enterprise;
With an expectation of profits predominantly from the efforts of others.

All indicia must be satisfied.

No matter what you call an offering: an ICO, a coin, altcoin, crypto currency, token etc., if it satisfies the Howey test for a security, it is a security, in the full sense and meaning of the 1933 Securities Act.

In other words, if a person or entity heaves an idea indiscriminately at the passive public at large, and the passive public injects money into it, and in return the passive public gets something representing a “bundle of rights that includes profit” that person or entity is unequivocally a security issuer that must register with regulators; or that person must find an exemption. Dressing up an public offering in obfuscating language, like blockchain, utility, crypto, ICO, etc. will not work. An ICO that satisfies the Howey test is an IPO.

On July 25, 2017, the SEC released an analysis of the DAO token offering. The SEC applied the Howey test and found the DAO to be a security. https://www.sec.gov/news/press-release/2017-131 

The SEC wrote at the time:

“…the Commission deems it appropriate and in the public interest to issue this Report in order to stress that the U.S. Federal securities law may apply to various activities, including distributed ledger technology, depending on the particular facts and circumstances, without regard to the form of the organization or technology used to effectuate a particular offer or sale.”

Howey is the law. It has been litigated many times in the last 72 years. The indicia have been argued in the courts. Most entities sold through an ICO satisfy the Howey test, and therefore, are securities. According to SEC Chairman Jay Clayton, none have been registered according to the law.

The Current SEC Position

The head of the SEC, Jay Clayton, has taken an aggressive position toward ICOs. He is clear that it is unlawful to market “securities” without SEC oversight. Speaking on January 21, 2018, Clayton made the following remarks,

First, and most disturbing to me, there are ICOs where the lawyers involved appear to be, on the one hand, assisting promoters in structuring offerings of products that have many of the key features of a securities offering, but call it an “ICO,” which sounds pretty close to an “IPO”.
…
Second are the ICOs where the lawyers appear to have taken a step back from the key issues–including whether the “coin” is a security and whether the offering qualifies for an exemption from registration –even in circumstances where registration would likely be warranted. These lawyers appear to provide the “it depends” equivocal advice, rather than counseling their clients that the product they are promoting likely is a security. Their clients then proceed with the ICO without complying with the securities laws because those clients are willing to take the risk.

With respect to these two scenarios, I have instructed the SEC staff to be on high alert for approaches to ICOs that may be contrary to the spirit of our securities law and the professional obligations of the U.S. securities bar.

There are two obvious conclusions from Clayton’s statements. First, the SEC will not condone the flogging of ICO securities through unregulated means; and second, lawyers who aid and abet in structuring such distributions are flirting with trouble.

On Tuesday, February 6, at a Senate Hearing on ICOs, Clayton reiterated these sentiments. He stated, “I believe every ICO I’ve seen is a security”. In response to questions by Senator Elizabeth Warren, he stated that no ICO has been subject to SEC registration. Specifically. Senator Warren asked about the legality of avoiding proper registration requirements,

“I understand you to say it is a violation of the law?”
“Yes,” Clayton responded.

In an exchange with Senator John Kennedy, Clayton stated,

“I’m not very happy that people are conducting ICOs when they should know they should follow the private placement rules.”

He then went on to conclude:

“I want to go back to separating ICOs and cryptocurrencies. ICOs that are securities offerings…we should regulate them like we regulate securities offerings. End of story.”

While ultimately a judge applying the Howey test determines whether an ICO is an IPO, that is only if the matter goes to court. In the first instance, the SEC makes the determination; therefore, distributors of ICOs should never doubt the signal strength invested in the Chairman of the SEC.

It is worth noting that not knowing the law is not a defence. The law engaging the definition of “security” has been around a long time. That law is known. It was in force when many of the ICO crowdsales were blown out to the public. It is self-evident that unlawful acts are past acts. An issuer is not in the clear just because the ICO issuance happened in the past. SEC Chairman Clayton is aware that in many cases backers of ICOs know better. The law and securities regulators have broad powers to retrospectively level the playing field. Among other penalties, broad powers include, injunctions, bars from association with the securities industry, monetary penalties, disgorgement…

Summary

Securities regulators in the U.S. and elsewhere are scrutinizing crowdsale ICOs. A reckoning is inevitable. If the Howey test is satisfied you have a security, no matter what you want to call it. Conclusions and a proper course of action fall from that determination. As noted above, the SEC found the DAO tokens were securities under U.S. law, but they declined to pursue any enforcement action related to that crowdsale. Letting the DAO issuers off the hook was a matter of discretion. Given the SEC Chairman’s sharp focus on improperly distributed securities, that act of discretion may well be the exception. Favourable acts of discretion are neither tantamount to condonation nor are they legally precedential.

Distributed ledger technology may revolutionize information processing; it may be the next disrupter of our wealth creation system. And innovators with crackling ideas may participate in this potential revolution. However, those who want to participate should think twice about taking short term distribution risks.