The SEC just issued another warning over Initial Coin Offerings (ICOs) but the test of a utility versus a security token is still murky. Here’s what I believe the 5 Actions the SEC will take against ICOs in the next 6 months.
SEC Chairman Jay Clayton says, “I have yet to see an ICO that doesn’t have a sufficient number of hallmarks of a security.” Of course! But are you applying this standard fairly Mr. Clayton?
Beanie Babies, baseball cards, and virtual goods in video games all have the same hallmarks of a security, but where are the regulations?
The expectation of future profit? Check. Asset sellers promoting their future value? Check. A current product or service in a common enterprise? Check. Profits derived from the efforts of a third party? Maybe not.
And therein lies the rub.
I wanted to condemn the SEC for hypocrisy, but unlike other government bodies, found them exercising patience and reason.
Referring to an SEC investigation report published this month Clayton discussed how to distinguish whether a token is a security:
Specifically, we concluded that the token offering represented an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.
By the way, that’s not new. The Supreme court stated nearly the same thing 71 years ago.
But does a 71-year-old opinion still apply to today’s world?
Golf Club Memberships and Crypto Kitties
If you haven’t been following the CryptoKitties craze you’re missing an important Pokemon moment in the crypto community. Like Pokemon did for augmented reality last year, CryptoKitties have broken through an important threshold for cryptocurrencies. CryptoKitties is a game for breeding, collecting and selling digital cats for real currency. Think Beanie Babies that breed.
Players of CryptoKitties have spent over $10 million on these digital felines and some sell for as much as $100,000. They meet all the “hallmarks of a security” so why hasn’t the SEC neutered them yet? Ostensibly the digital kitty owner takes “possession” of it, but not really. Axiom Zen, the site owner also has “possession” by setting the rules and control of the marketplace. So if Axiom is still providing a service to increase the value of the CryptoKitty, doesn’t that mean it’s an SEC violation? The situation is littered with contradictions.
Still not getting it? Let’s look at something that SEC regulators and all the other fat cats on Capitol Hill can relate to: golf memberships. One of the charges the SEC laid on the now-defunct Munchee ICO was a claim that there was not an immediate use for the token. Back to golf memberships. A lot of golf memberships are sold to fund new golf courses and many of them are re-saleable prior to the golf course’s grand opening. Moreover, the membership owner neither has possession nor controls the golf course. So why is the SEC handicapped in this situation?
5 Actions the SEC Could Take Regarding ICOs
These aren’t easy questions to answer but after reviewing several SEC documents and Mr. Clayton’s statements, I am going to lay out 5 actions I believe the SEC will take in the next 6 months.
The SEC will accept ICOs as a legitimate fund-raising vehicle. I know there have been a lot of noise in the crypto community about shutting down legitimate ICOs, but I am confident this will not happen. Clayton’s comment on this reinforces my belief:
It is possible to conduct an ICO without triggering the SEC’s registration requirements. For example, just as with a Regulation D exempt offering to raise capital for the manufacturing of a physical product, an initial coin offering that is a security can be structured so that it qualifies for an applicable exemption from the registration requirements.
The SEC will shut down hundreds of past, current and future ICOs in one big sweep. In may not be a midnight raid, but I suspect they will send hundreds of cease and desist letters within the next 6 months.
The SEC will develop an update to the Howey test to help guide future ICOs on whether they should be classified as a security or a utility token. Clayton recently hinted at this a few times and most recently:
When advising clients, designing products and engaging in transactions, market participants and their advisers should thoughtfully consider our laws, regulations and guidance, as well as our principles-based securities law framework, which has served us well in the face of new developments for more than 80 years. I also encourage market participants and their advisers to engage with the SEC staff to aid in their analysis under the securities laws.
The SEC will come down extremely hard on companies that are actively promoting the future value of utility tokens. Incidentally, if you’re thinking about doing an ICO, one way to protect yourself is to email the SEC staff at FinTech@sec.gov and ask for guidance.
The SEC will fine or shut down the worst offending platforms, brokers, and dealers and provide guidance to those that appear to be acting in good faith. Clayton warned about this action in his memo:
Similarly, I also caution those who operate systems and platforms that effect or facilitate transactions in these products that they may be operating unregistered exchanges or broker-dealers that are in violation of the Securities Exchange Act of 1934.
— Crypto Ruling (@CryptoRuling) December 17, 2017
Summing It All Up
So far, the SEC has played a measured and positive role in helping manage this complexity. What it should not do is constrain the actions of this developing market by being overzealous. Judging by Clayton’s opinions on the matter, it appears the SEC is supportive:
We at the SEC are committed to promoting capital formation. The technology on which cryptocurrencies and ICOs are based may prove to be disruptive, transformative and efficiency enhancing. I am confident that developments in Fintech will help facilitate capital formation and provide promising investment opportunities for institutional and Main Street investors alike.
In the final analysis, the SEC appears to be on board with change and they are stepping in to protect main street investors. ICOs are reaching a dangerous frenzy on the scale that we haven’t witnessed since the Dotcom Bubble, driven by inexperienced investors trying to make a quick buck. If the SEC provides clear guidance and drains out the “pump and dump” schemes, we’ll have a healthy, entrepreneurial alternative to Wall Street and venture capitalists.
Note: Bitcoinist has reached out to the SEC for further comments, however, they have yet to respond.
Do you think that the SEC will ever accept ICOs as a fund-raising vehicle? How will such acceptance impact the cryptocurrency market?
Images courtesy of CryptoKitties, Pixabay, Reuters