Are crypto ‘tokens’ securities by another name?

Ask forgiveness, not permission. That’s the no-holds-barred philosophy in bitcoin-land, where developers tend to write software and entrepreneurs tend to build businesses first, without seeking approval from regulators.

Sometimes this turns out fine, but other times bright-eyed experimenters can find that the legal gray area they thought they were operating in was much more black than white. In other words, just because you’re using cryptocurrency does not mean you’re outside of the reach of law enforcement. As Ripple, Erik Voorhees, Charlie Shrem, Trendon Shavers and many others have found out, the law can still come crashing down on top of you if you’re doing something illegal.

One of the legally murky aspects of the crypto world is the initial coin offering. An ICO is a way for developers and businesspeople to collect money directly from individuals who wish to invest in a new project or venture. Investors usually send bitcoin to the development team behind the new offering in exchange for a new altcoin, appcoin or other type of digital token. The general idea with these digital tokens is that they will be tied to the growth of a specific project or business. As that project grows in popularity, the thinking goes, the token purchased during the initial coin offering will also grow in value. The connection between a platform’s popularity and why that should result in increased value for the related digital token is often hazy.

Questions remain about the legality of the ICO concept. One of the major issues with ICO tokens is that sometimes it’s unclear if a security is being created, which would potentially require registration with the Securities and Exchange Commission. If the authorities decide that the tokens are securities, technologists and entrepreneurs who raised money on the internet through ostensibly unregulated token sales face fines or even jail time under certain circumstances where fraud or similar charges are involved.

At stake is the innovative role blockchain technology — which has gained increasing acceptance from bankers as a multitool of the future, albeit without the tokens — can play in business, especially in raising money from the public. If these digital tokens are regulated like traditional financial assets, then the supposed benefits offered by blockchain technology, such as raising money from a wider range of individuals and lowering the cost of doing so, are dubious at best. It’s not as if blockchain technology works as some sort of cloak that can hide you from regulators.

The largest ICO to date has been the DAO, which was built on top of the Ethereum platform. The DAO (for Distributed Autonomous Organization) was essentially designed to be a venture capital fund with no barrier to entry. While many cryptocurrency projects have failed over the years, the DAO’s implosion was likely the most spectacular. A hacker was able to redistribute funds to himself through a flaw in the DAO’s smart contract. The DAO debacle led the Ethereum community to throw away its “code is law” mantra and fork, or alter, the Ethereum ledger in a way that allowed DAO token holders to reclaim their deposited money.

Nearly all ICOs are launched on top of Ethereum these days. Ethereum’s smart-contracting system makes launching these sorts of projects quite easy for the uninitiated. Ethereum itself was launched in 2014 by way of an ICO, in which investors exchanged their bitcoins for a token known as ether, which currently has a $1.7 billion market capitalization.

A lawyer familiar with bitcoin and Ethereum in the United States has come to the conclusion that the ether token sale was indeed an issuance of a security.

Why some say the ether token is a security

In early 2016, Coin Center, a think tank in Washington, released a report on cryptotokens and when it makes sense for these digital assets to be considered securities. In the report, Coin Center’s director of research, Peter Van Valkenburgh, recommended that the ether token not be considered a security, because those who purchase it are doing so to use the Ethereum network rather than simply for the expectation of profits.

Jason Seibert, a securities lawyer, takes a different view. In a recent episode of his YouTube show “I’m Not Your Lawyer,” Seibert discussed the topic of ether as a security with Paul Sztorc, an economist at Bloq, an enterprise blockchain technology startup. During the show, Seibert and Sztorc noted that many of the individuals who purchased ether in the presale were doing so with the expectation of profit.

There are multiple videos online of Ethereum creator Vitalik Buterin referring to ether as an investment. At least one of the videos was filmed before the presale took place. In an interview in March 2014, Buterin talked about the Ethereum project’s hope that there would be a fivefold increase in ether’s price after the initial presale, which would make more funds available for the development process.

The Ethereum Foundation, a nonprofit that promotes and supports the cryptocurrency, would not comment for this story. Joseph Lubin, who was an Ethereum co-founder and also founded the Ethereum-focused blockchain startup Consensys, said, "From my perspective the Ethereum token launch took place after months of extensive legal diligence."

While this understanding that some people will think of ether as an investment was obvious to anyone paying attention to the Ethereum token presale at the time, such language is not found in the official terms and conditions that came with the sale.

“It’s decentralized and a nonprofit on one hand, but on the other hand, there’s kind of like this reading between the lines of we’re-all-going-to-get-rich kind of stuff,” Sztorc said.

“You don’t give a donation in order to invest and get rich,” Seibert said. “You don’t give a donation with the expectation of a profit.”

While it’s clear that many people viewed the initial ether token offering as an investment opportunity, Van Valkenburgh said that the definition of a security is rather broad and it’s not something that’s easily articulated in plain English. “It’s more if it’s only for investment or speculation use,” he said.

The so-called Howey Test, created by the Supreme Court in 1946, is what’s generally used in the United States to determine whether something is a security. Seibert says there is no doubt that the initial sale of ether tokens was the issuance of a security. It was a situation where people put money under the management and control of Ethereum with the expectation of a profit.

“Once you go to the public, you’re not in the business of being in business; you’re in the business of making and raising money,” Seibert said. “The moment you’re in the business of raising money from the public, regulatory nets come down over the top of you. That’s the line that you cross.”

Van Valkenburgh said the key differentiator is that people can also use ether as “fuel” for smart contracts on the Ethereum platform as opposed to simply an investment. In other words, users must pay for the execution of smart contracts on the Ethereum blockchain through the native ether token.

Still, Van Valkenburgh said, “It could go either way, and I wouldn’t go one way or another.”

There is precedent for Van Valkenburgh’s argument that something that is not purely used for speculative purposes may not be a security. “A line of cases stemming from Howey supports this analysis,” he wrote in his report. “In cases dealing with investments made in housing cooperatives, courts have found no expectation of profits when the investor wishes to live in or rent out the property.”

During his YouTube show, Seibert responded to the argument that ether is a useful commodity and not just a speculative investment. “If it was a software license, it wouldn’t change its value on a daily basis,” he said. “It would be an annual subscription rate that gave you use of the network for a year.”

Shouldn’t bitcoin be considered a security as well?

If ether can be considered a security, then some may ask why bitcoin cannot be considered a security as well.

“There’s no real pooling of resources with the expectation of a profit” in bitcoin, Seibert said. “There’s no management and control. It’s this thing that exists.”

Bitcoin creator Satoshi Nakamoto once wrote, “The nature of bitcoin is such that once version 0.1 was released, the core design was set in stone for the rest of its lifetime.” Some people have tried to change or manage bitcoin with the use of hard forks, or radical changes to the software that require all users to upgrade, but thus far none of them have been successful. Bitcoin’s mechanism for upgrades up to this point has been soft forks, which are backward-compatible. Users are not forced to upgrade when these sorts of patches are made.

There was no expectation of profit when Nakamoto released bitcoin. It was simply something he turned on and people started using. The project was already completed when it was announced, and there was no presale of tokens on the network.

“The difference between bitcoin and Ethereum is that with bitcoin, when it came out, people had it and it was already set,” Seibert said. “Ethereum hadn’t been developed yet. They didn’t even have code created yet, and they were saying, ‘Give us your money, so we can develop this thing.’ ”

Some early code had been written before the Ethereum crowd sale, but the platform was far from finished at the time. As Sztorc has pointed out, it could be argued that the platform is still not complete as the final monetary policy and a change in the security model from proof-of-work to proof-of-stake are still in the works.

“They were doing this token sale in order to raise money to be able to finish developing their platform,” Seibert said in discussing a Techcrunch interview in late 2015 in which Buterin said the Ethereum token sale was a more efficient model for funding development of the platform.

Sztorc says the only real difference between Ethereum and the bitcoin testnet (an alternative blockchain for experimentation) is that there is no expectation of profit with the latter. In the past, Sztorc has referred to altcoins — the hundreds of cryptocurrencies that were created in bitcoin’s wake – as “testnet scams” for this very reason.

Seibert was the lawyer for Trendon Shavers in the infamous “pirateat40” case where Shavers was convicted of running a Ponzi scheme on the Bitcointalk.org forum in the early days of bitcoin’s development. During the case, it was ruled that bitcoin is not a security.

So why haven’t the regulators gone after Ethereum?

Ether’s being a security and the regulators’ actually clamping down on this sort of activity are two different things. Also, whom the regulators decide to target can be rather arbitrary.

According to Seibert, the regulators may not have gone after Ethereum yet because it takes time to figure this sort of thing out. “There are a lot of people who think silence from the regulators means consent,” he said. “That’s not the case.”

Seibert pointed to the Glenn Turner case from the 1980s as another incident where it took a fair amount of time for regulators to figure out whether a security had been issued. The Turner case involved the sale of motivational cassette tapes in a pyramid scheme, and the court found, “It is apparent that defendants' pyramid promotion contains the same evils which the Securities Acts are intended to suppress.”

In Van Valkenburgh’s view, it wouldn’t make sense to go after Ethereum when there are much more obviously nefarious actors out there.

“If you’re the SEC and you want to create new precedent here, do you go after the obvious scammer or a vibrant technology?” he asked. “You go after the guy who no one is sympathetic for.”

On the other hand, the SEC also fined SatoshiDice founder Voorhees even though no one was defrauded by his investment offering. In that case, Voorhees was simply charged for publicly offering shares in two websites without registering them.

The organizers of Ethereum "were doing the right thing. I don’t think they were trying to scam anyone,” Van Valkenburgh said. “Trade-offs need to be made with token issuances. Do we want to impose costs on that system?”