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.
Richard Storey is a British Columbia based lawyer who specializes in securities and related structures. He has an MBA and a law degree from Cambridge University. For 12 years he worked in the world of financial derivatives (futures, forwards, options, swaps etc.) managing risk for large Canadian and U.S. companies.