On September 28, 2018, a coalition of U.S. Congressmen sent a letter to the U.S. Securities and Exchange Commission (“SEC”) seeking clarification regarding the current regulation of cryptocurrencies (“cryptos” or “tokens”). Specifically, the elected representatives asked for an answer to one of the most looming questions in the Blockchain and Cryptocurrency industry…which digital tokens are securities under the Securities Act of 1933 (the “Act”).
Co-signer of the letter, Ted Budd (R-NC) stated 15 lawmakers from both political parties signed the letter directed to the Chairman of the SEC, Jay Clayton. The group’s letter stressed the need for “guidelines and FAQs to crypto investors,” which would allow stakeholders within the industry to navigate the regulatory process.
Current uncertainty surrounding the treatment of offers and sales of digital tokens is hindering innovation in the United States and will ultimately drive business elsewhere. We believe that the SEC could do more to clarify its position, lawmakers wrote.
Separately, Representatives Doris Matsui and Brett Guthrie introduced a bipartisan bill, H.R. 6913, to the U.S. House of Representatives allocating funding for Congressional staffers to create a “consensus-based definition of blockchain.”
These congressional actions seek clarification of how governmental agencies, e.g., the SEC, the Financial Crimes Enforcement Network (“FinCEN”), the Commodity Futures Trading Commission (“CFTC”), and/or the Internal Revenue Service (“IRS”) will apply traditional regulatory frameworks towards the Blockchain and Cryptocurrency industry. In fact, the congressional letter goes so far to suggest representatives may be considering constructing legislation directly addressing the uncertainty facing the majority of businesses and individuals operating within the industry.
Congress is not alone in wanting clearer regulatory paths, e.g., there is scant precedent regarding how tokens are categorized as securities compared to traditional industries. However, as an attorney with a blockchain/crypto specific legal practice, I can unequivocally say that the fear of regulatory uncertainty in the space is very real, but somewhat misguided. Indeed, on the one hand, industry actors, stakeholders, and contributors are hesitant to launch an exchange, create a token, or simply advertise their project. This uncertainty stems from the plethora of recent regulatory actions towards actors in the space for violating securities, banking, and anti-fraud laws. While these actions help provide clarity, a by-product is industry actors feeling regulatory compliance is an insurmountable task…it’s not.
For example, the regulatory framework for whether certain tokens are securities is quite old, but its application to tokens is in its infancy. With that said, there are several regulatory actions taken by the SEC (e.g., the DAO, Munchee, and Tomahawk decisions) that explain how those creating and issuing tokens are able to seek regulatory compliance through either an exemption filing, e.g., Regulation D, A+, CF, or S, or actual security registration.
The Decentralized Autonomous Organization (“DAO”) case, where the SEC relied on Section 21(a) of the Securities Exchange Act of 1934 to categorize the DAO token as a security. DAO’s ICO offered and sold 1.15 billion tokens in exchange for approximately 12 million Ether Tokens (“ETH”), the equivalent of $150 million. After the DAO tokens were sold, but before DAO was able to commence funding projects, a user of the platform used a flaw in the DAO’s code to steal approximately one-third of the DAO’s assets. More importantly, beyond the immediate applicability to the DAO ICO participants, the SEC report affirmed that a cryptocurrency can be a security pursuant to U.S. securities laws.
Shortly thereafter, on December 11, 2017, the SEC targeted an ICO launched by the company Munchee Inc., which raised $15 million to develop an App that used blockchain technology to allow users to write restaurant reviews. The team stated it would both pay food reviewers and allow restaurant owners to purchase advertising in MUN tokens. By attracting more people to use the token, it would appreciate in value.
The Cease-and-Desist Order issued by the SEC applied the factors outlined in the Supreme Court case SEC v. W. J. Howey, Co., 328 U.S. 293 (1946) to determine whether the MUN token was in fact a security. Specifically, it asked: (1) whether the token holders made an investment of money, (2) in a common enterprise; (3) from which they expected to profit; (4) due to the efforts of others. The SEC determined that the MUN tokens qualified as securities since the tokens were sold to the general public and investors reasonably expected a profit from the rise in value of the token derived from the efforts of Munchee and its agents. Munchee promised a rise in value due to the coin becoming listed on an exchange and due to its promotion of the coin. Notably, the SEC stated its analysis would not have been altered even if the MUN tokens had a practical use at the time of its release.
Indeed, these two regulatory actions set solid precedent for practitioners to determine whether certain tokens are securities. However, the actions also caused businesses to leave the U.S., and deterred international businesses from issuing tokens in the U.S. This, of course, is an expected result of regulatory action in any field, but the lack of judicial and congressional clarity to support these regulatory actions leaves a lot to be desired, which is precisely why there is so much uncertainty in the space. In fact, solely relying on administrative decisions from regulatory bodies leads lawyers such as myself to assume almost any token could potentially be a security.
Moreover, this token categorization question stems from a larger debate of how regulators (domestic and international) should categorize cryptocurrencies to best facilitate a balance between consumer protection and technology innovation. As early as 2010, regulators grappled with how cryptos fit into traditional regulatory frameworks. There remains substantial uncertainty regarding how the Bank Secrecy Act or Securities Exchange Act of 1934 apply to different virtual currency operations, although regulators have offered some guidance for discrete activities. A recent ruling by the SEC against a decentralized exchange called EtherDelta showed that agencies such as the SEC focus on the reality of how the tokens are transferred, rather than how decentralized the underlying tech is. However, many businesses are struggling to determine whether they are a money transmitter, or whether they’re an exchange.
We are at a tipping point. Congressional and judicial clarification is needed because unelected administrative officials are currently at the forefront of developing precedent. While these regulatory actions do not carry much weight outside of the regulatory authority of the agency issuing the ruling (this is not to imply someone should avoid regulatory compliance), the rulings do dictate actions taken by those operating within the space. The other branches of government are there for a specific purpose, checks and balances. As a result, I anticipate future judicial decisions regarding whether the SEC and other agencies are correct about their assessment of certain crypto and blockchain based projects.
Of course, there are many bad-actors in this space. Fraudsters, scammers, phishers, and hackers are all waiting to take advantage of a newly developed exchange or the user just learning how to acquire Bitcoin. These bad-actors should be removed from the industry, and governmental agencies in the U.S. have done a great job at targeting these specific actors. In fact, the underpinning for Congress seeking further clarification hinges on their desire to make the industry more legitimate.
[…] It is important that all policymakers work toward developing clearer guidelines between those digital tokens that are securities, and those that are not, through better articulation of SEC policy, and, ultimately, through formal guidance or legislation.
“current uncertainty surrounding the treatment of offers and sales of digital tokens is hindering innovation in the United States and will ultimately drive business elsewhere. We believe that the SEC could do more to clarify its position, lawmakers wrote.
Furthermore, the lawmakers also urged for a clear SEC position on tokens issued during the Initial Coin Offering (ICO) process. So far, the Commission’s boss, Chairman Clayton, has reiterated several times that he thinks most, if not all, ICO tokens are securities. However, in June, William Hinman, the Director of the SEC Corporate Finance Division explained not all cryptos fall under security definition
“Do you agree that a token originally sold in an investment contract can, nonetheless, be a non-security as Mr. Hinman stated? Can the resultant token be analyzed separately from the original purchase agreement, which may clearly be an investment contract? And, if so, could the resultant token, nonetheless be a non-security,” the Congressmen wrote.
While this question highlights a need for clarity, administrative precedent lends support to the general notion that certain tokens are in fact not securities. In fact, while the SEC does not necessarily consider the underlying technology in its consideration of whether a token is a security, the fact that certain blockchains, e.g., Bitcoin, are fully decentralized, meaning no central authority or business controls the technology, shows that no single actor is in control of the token, and thus cannot satisfy certain prongs of the Howey Test.
The issue with this line of thought is that many blockchain based businesses are not fully decentralized as well as the general notion that, at least in the exchange context, decentralization can have substantial inefficiencies. However, instead of diving into the decentralization debate, I think it’s better to simply note that businesses should not assume their “decentralized” platforms are exempt from certain regulatory compliance.
Going back to the current exemption solutions for projects, Regulation D, Section 506(c) is the most commonly used for compliance with the Act, and thus should be a starting point for those issuing tokens. However, the issuance of any token under this exemption can only be for accredited investors. In the alternative, Regulation CF allows crowdfunding for smaller projects looking to raise up to $1 million.
Also, a quick note on Regulation A+. I’ve had clients and others in the industry tell me law firms are offering this regulatory exemption to those operating in the space. To be clear, the SEC has yet to approval a single Reg A+ offering for a blockchain business. The application process is expensive, and there is no guarantee the project will receive approval. This is not to say that certain projects should not seek this application, but know any firm advocating they can get approval has the odds stacked heavily against them. Having gone through the process, the largest expense is the multiple rounds of questions the SEC sends to the company, which can sometimes be in the hundreds. Regardless of the exemption sought, token-based projects should certainly determine their compliance before generating or issuing a token.
Overall, the industry should expect to see more regulatory action over the coming months. Those operating in the space should also advocate, in line with congressional representatives, for a clearer regulatory framework from the SEC so that our elected representatives are able to pass legislation that balances technological development with the need to root out bad-actors.