The Duck Test & the Howey Test
Over 100 years ago, poet James Whitcomb Riley wrote: “When I see a bird that walks like a duck and swims like a duck and quacks like a duck, I call that bird a duck.”
When investing in any form of financing, whether an ICO, or in traditional forms, such as stocks or bonds, the public benefits from full and fair disclosure.
The investing public benefits from prohibitions against fraud and manipulation.
Such investor protections are embodied in US securities laws regardless of the form of investment.
An important early test of this definition relates to the Florida orange groves of William Howey.
His company sold land and gave the buyers an option to lease the land to an affiliated service company and participate in the profits of the crop.
Even though not stocks or bonds, the US Supreme Court in 1946 ruled that Howey’s land sale agreements satisfied the definition of "investment contracts" under the 1933 Securities Act.
The so-called "Howey Test" from this case states that: “an investment contract for purposes of the Securities Act means a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”
In 2004, the Supreme Court similarly ruled in SEC v. Edwards, adding: “The profits this Court was speaking of in Howey are profits—in the sense of the income or return—that investors seek on their investment, not the profits of the scheme in which they invest, and may include, for example, dividends, other periodic payments, or the increased value of the investment.”
The SEC has now repeatedly spoken out about the application of securities laws to ICOs, including in the a) “DAO Report”; b) “Munchee Order”; and c) “Centra Complaint”.
Sounding like poet Riley, SEC Chairman Clayton stated in February that "I believe every ICO I've seen is a security… You can call it a coin but if it functions as a security, it is a security."
I agree with the Chairman, except if one were to consider CryptoKitties an ICO.
The Question now is: How?
Thus, in the US, it is no longer a question of "if."
It is no longer a question of “when.”
ICOs and other tokens must comply with securities, commodities, and derivatives laws.
The common-sense duck test, the economics, the law, and the SEC Chair are all suggesting that the answers to those questions are: yes, and now.
The path forward and the pressing question now is, "how?"
Lessons from the Internet
We’ve seen this before, in the 1990s with the broad adoption of the Internet.
The SEC introduced Regulation ATS in 1998 to address new trading protocols emerging on the Internet.
In the name of promoting innovation, though, some actions came back to haunt the public.
New means of trading swaps electronically emerged and along with them exemptions for trading platforms—which came to be known as the "Enron loophole."
The Path Forward
So, how do the markets, this new technology and regulators go forward?
Let’s review a set of four general considerations and a set of four specific ICO considerations.
First, how might regulators bring over 1,000 past ICOs into compliance?
Might retroactive registration along with rescission rights work?
Some requirements will be difficult for these past ICOs. For instance, what solutions might there be to satisfy beneficial ownership records for each token?
Selling unregistered securities now, though, would be a current violation, regardless of when a token initially started.
Second, how might regulators and the courts help investors recover losses on unregistered, non-compliant ICOs?
US securities laws provide rescission rights along with private rights of action, but in many circumstances the funds might be gone.
Compliance and Possible Tailoring of Crypto Regulations
Third, going forward how might ICOs and other crypto-tokens comply with existing laws?
Might the law be tailored to take into account the novel circumstances of this new technology, while still protecting consumer and investor interests?
Tools in Regulatory Toolkit
Fourth, which tools might regulators use in their toolkit?
They’ve used public advisory statements, speeches, testimony, and enforcement actions, but might they issue rules and interpretations specific to the crypto space?
This will presume that some tailored crypto regulations are deemed appropriate.
It also will take significant time.
Let’s now turn to four specific ICO considerations.
Review of All Tokens, Including Large Cap Tokens
First, with over 1,000 past ICOs and other likely non-compliant tokens, which of the current crypto assets might not be securities?
To bring clarity to these markets a review of all large-cap tokens is appropriate.
For illustration, what about the top five tokens?
Bitcoin is generally not considered to be a security by global regulators.
Bitcoin came into existence as mining began as an incentive in validating the distributed platform, with no initial token offering or pre-mined coins.
Litecoin and Bitcoin Cash, both forks off of Bitcoin, do not appear to trigger the Howey Test either.
What about Ether and Ripple? Might they each have been investment contracts, or non-compliant securities offerings, when sold?
Laws and regulations are best applied consistently. A digital token having some consumable utility does not preclude it from being subject to US securities laws.
It is not an either-or proposition.
There is a strong case that one or both of ETH and XRP are noncompliant securities.
Token Design for Non-Securities
Second, how might tokens be designed going forward essentially for consumption such that their sale will be devoid of the investment characteristics embodied in the Howey Test?
As the SEC stated in the Munchee Order, it will take more than semantics and more than a token being functional on a network.
Multi-Stage Offerings such as SAFTs (Simple Agreements for Future Tokens)
Third, how should contracts for multi-stage arrangements such as SAFTs for future delivery of tokens be considered?
Last September, Filecoin raised $257 million, then the largest ICO to date, through a SAFT. Telegram’s recent $1.7 billion offering, which used a purchase agreement, may raise similar questions.
Can the future token be sufficiently separated from the initial investment contract such that when the token becomes usable it will not be considered a security?
Security Token Transformation?
Fourth, how should the law treat tokens evolve over time?
A group of venture capital firms are advocating for a safe harbor under which many tokens would transform over time to become unregulated.
Such a safe harbor allowing for a security to transform into an unregulated contract, though, would be unprecedented under current law.
In conclusion, blockchain technology has a real potential to transform the world of finance.
It could lower costs, risks, and economic rents in the financial system.
For broad adoption—both as a technology solution and as part of the capital markets—the technology and its various applications need to come within existing public policy frameworks.
Basic norms and principles to protect investors and market integrity, while promoting innovation, should consistently guide public policy.
Clear rules of the road also will allow firms—both incumbents and start-ups—to more fully explore investing in crypto assets or blockchain technology.
No doubt, bringing clarity and compliance will have its challenges.
There are likely over 1000 ICOs launched tokens in significant non-compliance. Add to this the possibility of some noncompliant large-cap tokens.
Suffice it to say, 2018 should be an interesting year.
Market participants, the investing public, entrepreneurs, technology developers, regulators and political leaders should all play a role.
In particular, ICO issuers and crypto-exchange operators should now seek to comply with the law to fullest extent possible.
The public, blockchain technology, and the financial system will all reap the benefits.
Delivered at the Business of Blockchain event held April 23, 2018. Follow #bizofblockchain on Twitter for more.