If you are in the blockchain/token/cryptocurrency space, it is imperative that you keep up to date on publications from the Securities and Exchange Commission (SEC) regarding cryptocurrencies and tokens, more specifically initial coin offerings (ICOs) and how they relate to Federal securities laws. The SEC has been releasing a lot of opinions within the past couple of years in order to build a framework for pursuing enforcement actions against bad actors in the space. When it comes to the SEC, ignorance of the law is not a defense, and they have been giving us plenty of warnings on how cryptocurrencies/tokens can fall under their purview as securities. A part of your required reading should have been the SEC’s release of their opinion regarding ICO’s and how they can be deemed as “investment contracts” under the “Howey Test” requiring registration or qualification under an exemption. There is a lot to unpack here if you are new to Federal securities laws. The goal of this post is to explain how your upcoming ICO could be considered a security by the SEC.
TL; DR at the bottom.
Securities Laws 101
The purpose of this post is to inform you of the newest SEC publication so I will keep this section high level.
Federal securities laws require the offer and sale of securities to either be registered or qualify for an exemption from registration. Registration of a security is akin to an IPO. It takes a lot of time and money. Most crypto/token startups cannot register their cryptocurrency or tokens as securities from the outset because of this. Therefore, most must seek an exemption under the applicable laws for their ICOs or have a token that is not defined as a “security” under the laws.
What it is a security? The SEC has a laundry list of items that are classified as a security. Many are well known; i.e. stock. However, there is a catch all that certain cryptocurrencies/tokens can be classified under. This catch all is an “investment contract”. This most recent publication from the SEC discusses how a cryptocurrency or token can be classified as an “investment contract” under the “Howey Test”.
The Howey Test: If you are an attorney who works with startups like me, you are well versed in Federal securities laws and the pinnacle “Howey Test”. This landmark case laid out a test that can be used to determine if any specific offering is a security. In short, the test states that an investment contract exists when there is 1) an investment of money; 2) in a common enterprise or scheme; 3) with the expectation of profits; 4) derived from the efforts of others.
Now that we have the framework, we will apply each part to cryptocurrencies and tokens.
Investment of Money
This part of the test is typically satisfied when there is an offer or sale of a cryptocurrency or token, as they are exchanged or purchased for value in the form of money.
In a Common Enterprise or Scheme
Typically a common enterprise exists with the offer or sale of cryptocurrencies or tokens because the fortunes of the purchasers are linked to each other or the success of the issuer’s (the startup’s) efforts.
Expectation of Profits
If the cryptocurrency or token appreciates in value from the original investment due to the further development of the business enterprise, then a profit does exist. However, price appreciation solely from external market forces that impact supply and demand is not considered a profit under the “Howey Test”. If this sounds vague, then you are correct. Luckily the SEC listed out a number of scenarios that could satisfy this prong of the test. An important scenario is where the cryptocurrency or token gives the holder rights to share in the income or profits from the cryptocurrency or token. For all the examples, please see the link to the publication in the “Final Thoughts” section of this post.
From the Efforts of Others
If a purchaser of a cryptocurrency or token reasonably expects to rely on the efforts of the promoter (the startup), and if those efforts are essential managerial efforts that determine whether the enterprise succeeds or fails, then this prong of the “Howey Test” may be satisfied. Again, the SEC listed out a few scenarios that could satisfy this prong of the test. One important example is where the promoter has a lead or central role in the direction of the ongoing development of the network or cryptocurrency/token. For all the examples, please see the link to the publication in the “Final Thoughts” section of this post.
Final Thoughts
The SEC has been paying a lot of attention to cryptocurrencies, tokens, and their ICOs.. If you are planning an ICO, it is imperative that you discuss the legal ramifications surrounding your ICO with your attorney. A good startup attorney will be able to assess whether the cryptocurrency or token you want to create is considered an “investment contract” and therefore must either be registered or qualify for an exemption.
If you want a deeper dive, here is a link to the most recent publication from the SEC which was the motivation for this post.
TL; DR: The SEC has determined that cryptocurrencies or tokens offered and sold in an ICO can be classified as an investment contract under the Howey Test. This makes these cryptocurrencies or tokens subject to Federal securities laws; requiring them to either be registered or qualify for an exemption under the law. Consult with an attorney if you are planning an ICO.