Cryptocurrency has entered the mainstream — and now the high volume of activity, including the many failures, has attracted the attention of the Securities and Exchange Commission.
Up until very recently, the SEC has seemed reluctant to make a definitive statement regarding whether tokens represent securities or some other interest. However, on Feb. 28, the SEC took a decidedly different approach, issuing numerous subpoenas and information requests to companies with both pending and completed initial coin offerings and pre-sales.
Days earlier, on Feb. 21, the agency charged the former bitcoin exchange BitFunder and its founder as an “unregistered securities exchange,” stating that “platforms that engage in the activity of a national securities exchange, regardless of whether that activity involves digital asset, tokens, or coins, must register with the SEC or operate pursuant to an exemption.” This puts nearly all unregistered crypto exchanges at risk.
The crypto world is reluctant to either court regulation or self-regulate. Part of this is the inherently subversive nature of the crypto culture: It developed primarily to circumvent the centralized, highly regulated banking and fiat industries.
But as crypto activities spread, it is clear that nonaccredited U.S. investors are also seeking to take part, often illegally, and many are succeeding. To be accredited, U.S. citizens must have a net worth of at least $1 million independent of their primary residences, or have earned an income of at least $200,000 per year for each of the past two years ($300,000 when combined with a spouse), with the expectation of earning at least that in the current year. U.S. citizens who are nonaccredited are largely prohibited from investing in unregistered or exempted securities offerings if subject to the U.S. federal securities regulations.
This brings up a serious regulatory conflict. While regulation of this industry is currently under review at a number of agencies, securities issues related to crypto transactions and offerings seem to be inducing the greatest amount of confusion. And those are governed by the SEC.
The lack of clarity in this market has resulted in the U.S. largely being shut out of these offerings — and in other cases, investors are illegally entering investment syndicates, breaking securities exemptions for issuers and acting without access to legally mandated disclosure documents. Nonaccredited investors are joining private offering syndicates, hiding behind an accredited lead, and U.S. investors are joining overseas offerings by hiding behind foreign investor-led syndicates. Neither situation is good for the crypto market or for U.S. investors in general.
It should be noted that some form of regulation has been imposed on nearly every industry and it has yet to destroy any industry that has inherent merit. Of course, what exactly any future regulation coming out of the SEC might look like is yet unclear. The agency has issued a variety of statements and informal opinions, but very little that is determinative.
Interestingly, Chairman Jay Clayton showed his leanings when he said in November that he “has yet to see an ICO that doesn’t have a sufficient number of hallmarks of a security.” He added that “apart from bitcoin or ether, [all other forms of crypto] have attributes of securities.”
The SEC has stated that distributed ledger transactions are not exempt from the securities acts, but the agency has indicated that an investment contract test should be applied to all crypto offerings and transactions. This test, known commonly as the Howey Test, generally states that transactions involving investments of money with an expectation of passively made profit from a common enterprise are deemed “investment contracts” and subject to the federal securities regulations. When transactions are subject to the federal securities regulations, they must either be registered with the SEC or else subject to an exemption from registration.
Blockchain platforms are run by cryptocurrency tokens, either a common primary token, such as bitcoin or ether, or a newly created, specific, secondary token that works specifically for a specific platform, such as Ripple or Refereum. These newly created secondary tokens are what companies typically use when undergoing an initial coin offering — this is the first distribution of these secondary tokens, with funds raised going to the company to further develop the platform.
There’s a popular assumption that these secondary tokens can be exempt from federal securities regulations if it has some level of utility on a blockchain platform or distributed application, known as DApps. Yet that appears to be wrong: Unless the token has no life outside of the platform. That is to say, if the token is not listed or traded on an exchange and merely functions entirely within the platform for in-app or in-platform use (like tools purchased for World of Warcraft or other game), the token is likely not a security. Otherwise, the token is likely purchased for some form of speculative value — the token is very likely a security and subject to the securities regulations. All related transactions should be conducted with this in mind.
Accordingly, the assumption must currently be that crypto tokens are deemed securities, and any crypto transaction must either be registered with the SEC or conducted pursuant to an exemption. Unless and until the SEC is willing and able to develop a more tailored exemption or registration process for this new asset class, the crypto industry should accept the current registration or exemption disclosure process. Failure to do so could result in anything from inquiry to prosecution from the SEC for securities violations, as well as possible rescission requirements and additional civil or criminal penalties. Companies have already started to experience these. In addition, the SEC has formed a task force to address crypto issues, which will ensure that enforcement and oversight will only continue to grow.
Operating under a simple disclosure system available now is far more lenient than an alternative system the SEC and governing bodies may enforce, such as the much stricter regime mutual funds face under the Investment Company Act of 1940, or the even more limited, heavily regulated environment of banks.
In addition, the use of disclosure documents will offer a measure of protection for crypto companies and their officers and directors, allowing them to be subject only to the business judgment rule — a legal presumption that executives acted in good faith — rather than be held liable for any misinterpretation or accidental exclusion of information, failure to succeed or earn a profit, or for changes in their business model or other reasonable pivots.
Regulation clearly needs to be involved and enforced, if for no other reason than to weed out the fraud and malfeasance value-rich systems always attract. If nothing else, it will mitigate some of the fear, uncertainty and doubt that has reduced investor access to this market, as well as the illegal activity currently occurring to allow precluded investors to participate in the crypto ecosystem.
