Can tokens be securities? The SEC just weighed in.
As a decentralized ledger, blockchain enables users to exchange digital assets — called tokens — without a middleman. The earliest tokens functioned as currency. No entity issued this currency; instead, the algorithm underlying blockchain dispersed tokens to miners, compensating them for processing blocks. As cryptocurrencies have proliferated, tokens have found broader uses. Now entities issue tokens to fund projects.
Many businesses have launched “token sales,” “token launches,” “initial coin offerings,” or “ICOs” to quickly and cheaply raise money. ICOs have become so popular that they are “surpassing traditional early-stage VC funding.” The Decentralized Autonomous Organization (DAO), for example, raised $150 million by selling DAO Tokens; the organization avoided both the expense and delay of complying with the SEC’s reporting requirements for selling securities. But the DAO ran into trouble. Hackers stole the equivalent of $50 million from the organization shortly after the financing’s launch. Though the funds were recovered, this loss prompted the SEC to investigate. On July 25th, 2017, the SEC issued a report. The “Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The Dao” addresses the status of ICO tokens.
Securities? SEC says “It Depends”:
The report disclosed when the SEC will consider ICO tokens securities and where they can be traded. According to the report, the SEC will consider the tokens offered in ICOs securities if the ICOs constitute investment contracts under the Howey test. Under Howey, an investment contract involves the “(1) investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived solely from the entrepreneurial or managerial efforts of others.” The SEC will determine whether an ICO token fulfills these elements based on the facts and circumstances of each case. Issuers of tokens that the SEC qualifies as securities must comply with regulations or be subject to various fines and penalties, including criminal prosecution.
The DAO and most ICOs clearly fulfill the first three elements: token buyers invest money in the common enterprise of the ICO with an expectation of profits from trading the token in the future. But on its face, the fourth element does not seem to apply to most ICOs. Given blockchain’s decentralized nature and ability to integrate self-executing contracts, ICOs can be and often are run by the token-holders themselves. For example, both token-holders and managers called curators ran the DAO, and therefore the entity’s profits derived from both of their efforts. Nevertheless, the SEC has expanded Howey, declaring that ICOs with decentralized or mixed management can fulfill the fourth element.
Because the SEC could determine that almost any ICO is an investment contract, those who plan to purchase an ICO’s tokens should be cautious until the SEC makes a determination on that ICO’s status. Furthermore, creators of an ICO can minimize the risk of the ICO’s tokens being classified as securities by limiting managerial or entrepreneurial involvement to token-holders.
Trading Token Securities:
If an ICO’s tokens fulfill Howey’s four elements and are therefore securities, they may be traded in two ways. First, the issuing entity may register the tokens on a national securities exchange. Second, the entity may trade its tokens on an alternative trading system (ATS), a venue that matches potential buyers and sellers of securities. Announced this week, Overstock’s subsidiary Medici is partnering with RenGen and Argon Group to launch the first regulated token ATS. This exchange will reduce transactional costs by 80 to 90% compared to traditional national securities exchanges. Both of these three methods of trading provides liquidity to the token market. Alternatively, issuers may bypass securities exchange regulations altogether. They can do so by selling the tokens outside of the United States to non-citizens or structuring the securities so as to fall under an exemption, like Regulation D or S.
Blockchain users will invent more kinds of tokens and more methods for exchanging them. Will the SEC give the nascent industry room to grow? Let’s hope so.