The reality is that more regulation, not less, is on the horizon. When it comes to new and disruptive technologies several constants apply. First, regulation tends to lag behind technological breakthroughs. Second, governments like regulations. It gives credence to their existence. Third, at least at the beginning of the application of regulations to a new technology, there is a tendency to over-regulate rather than under-regulate. Over time, regulatory correction often happens, and the regulation is moderated to balance the government’s responsibility to protect the public with the ability of innovative companies to drive the new technology that serves the masses.
The SEC Arrives On The Scene
In many jurisdictions around the world, ICOs remain unregulated, however, the trend worldwide since mid 2017 has been to follow the lead of the Securities and Exchange Commission in the USA. In July2017, the SEC decided that ICO token sales may be considered securities and should be regulated as such. In other words, if you live in the USA, it is going to be more difficult to participate in an ICO. Startups that want to use an ICO to raise funds will need to be extra careful to follow the SEC guidelines. If the startup is based outside the USA, they are probably better off excluding Us-based investors from the ICO offering. China, Russia, and South Korea have officially banned ICOS.
The Howey Test
The Howey Test is used to determine whether a particular offering is a security. Both the Securities Act of 1933 and the Securities Exchange Act of 1934 include a broad definition of the term
security that encompasses a variety of instruments, including an investment contract. The facts and circumstances test set forth by the US Supreme Court in SEC v. W.J. Howey Co. has long been applied to determine whether a particular instrument should be considered an investment contract and therefore a security for purposes of the Securities Act. The elements to be considered in the application of the Howey Test are whether the purchasers of the instrument:
- invested money or valuable goods or services,
- were investing in a common enterprise
- with a reasonable expectation of earning profits
- that were to be derived from the efforts of others.
Seen through the lens of the Howey test, the SEC found a security to exist in the DAO offering; however, the SEC did not state in the report that all tokens will be considered securities. Rather, the SEC stressed the importance of a detailed analysis of the facts and circumstances of the particular offering. The new clarity on the SEC’s view of the appropriate analysis to be applied
may make it easier for token issuers to structure their offerings to avoid characterization as a security. For example, tokens that are linked to the use of a particular product or service, which are not marketed for their investment potential but rather are intended to be used as a medium of exchange, would not seem likely to satisfy the “expectation of profits” element of the test. These tokens would be viewed as utility token” versus security tokens” Conversely, if, based on the Howey analysis, it is likely that a token may be considered a security, issuers of such tokens would need to structure the offering to fit within an exemption from the Securities Act registration requirements. For example, the issuer of a security token may want to limit purchasers of the tokens to accredited investors and meet the other requirements of the safe harbor. That includes I taking reasonable steps to verify that all ultimate purchasers of the tokens are accredited investors if general solicitation is used in offering the tokens to the public for sale.
Security Tokens vs. Utility Tokens
In a subsequent public announcement about ICOs in December of 2017, The SEC made it very clear that its determination whether an ICO’s token is a security may hinge on whether the token is a security token or a utility token. Here is pertinent language from the announcement: A key question for all ICO market participants: “is the coin or token a security?” As securities law practitioners know well, the answer depends on the facts. For example, a token that represents a participation interest in a book-of-the-month club may not implicate US securities laws and
may well be an efficient way for the club’s operators to fund the future acquisition of books and facilitate the distribution of those books to token holders. In contrast, many token offerings appear to have gone beyond this construct and are more analogous to interests in a yet-to-be-built publishing house with the authors, books, and distribution networks all to come. lt is especially troubling when the promoters of these offerings emphasize the secondary market trading potential of these tokens. Prospective purchasers are being sold on the potential for tokens to increase in value – with the ability to lock in those increases by reselling the tokens on a secondary market – or to otherwise profit from the tokens based on the efforts of others. These are key hallmarks of a security and a securities offering.
For purposes of clarity, let’s again define a security token and a utility token.
– Security Token Equity are tokens that represent ownership of an asset, such as debt or company stock. As such, they are to be regulated as a security by the SEC and other governing bodies around the world that view the SEC guide lines as a best practice.
– Utility Tokens, often called app coins or user tokens, provide users with future access to a product or service. The defining characteristic of utility tokens is that they are not designed as investments; if properly structured, this feature exempts utility tokens from federal laws governing securities.
Because of these pronouncements by the SEC in the USA, it is not uncommon for startups wanting to hold COs to base themselves in Switzerland, Estonia, Malta, or Malaysia, where regulations are lax, and they refuse any investor with a US-based IP address. It is not uncommon for someone in the USA who attempts to become involved in an ICO that is advertised on whatever crypto news source.they follow, to see the warning on the website of the CO that, if you are from South Korea, China, Russia, Singapore, or the USA, you cannot participate. Among of the forces that are moving the markets at the beginning of 2018 are the policy announcements or, more accurately, policy intentions announced by the governments of South Korea and China. South Korea and China are both countries that are “market movers” in the way that they deal with regulations. Both of them are tending towards regulation of both COs (which they have prohibited) and cryptocurrency exchanges, where cryptocurrencies are purchased, sold, and traded.
Bitcoin transactions are already banned in countries such as Bolivia, Ecuador, India, Bangladesh, Iceland, Kyrgyzstan, Morocco, Nepal, Malaysia, Indonesia, and Taiwan. At the same time, China – where trading on local cryptocurrency exchanges is banned – and Russia are preparing bills of cryptocurrency regulation, which could come into force in 2018. In the United States, Bitcoin
investors will have to report gains to the Internal Revenue Service and pay tax according to Notice 2014-21. On December 4, 2017, the UK and EU financial regulators declared that they
are planning to pass a law under which cryptocurrency traders and investors, in some cases, would be required to disclose their personal information. Cryptocurrency exchanges would have to provide authorities with access to user information. According to the state financial bodies, these measures are necessary to prevent money laundering activity and terrorism financing.
Harmonization of different approaches to this issue will be completed in early 2018, and the law will come into force by the end of 2019.
So what do you think?
Will further regulations strengthen or hurt cryptocurrency?
Let me know in the comments! And if you’d like to learn more about this topic and others check out Crypto.IQ and use code “jsherm” to get a super discount.
You can also watch an episode about the SEC and Cryptocurrency Regulations in our web series “Mastering Cryptocurrency” right here featuring Bitcoin Legend Charlie Shrem and Serial Entrepreneur Jason Sherman: