In a personal statement on cryptocurrencies and initial coin offerings issued Monday, Jay Clayton, the chairman of the SEC, reinforced the agency’s messages thus far that whether or not a particular token or cryptocurrency falls afoul of securities laws depends on the facts and circumstances of each case.
“A number of concerns have been raised regarding the cryptocurrency and ICO markets, including that, as they are currently operating, there is substantially less investor protection than in our traditional securities markets, with correspondingly greater opportunities for fraud and manipulation,” he said.
Noting the questions that cryptocurrencies and ICOs present investors, such as “Is the product legal?“ “Is the offering legal?” and “Are the trading markets fair?” he said, “The answers to these and other important questions often require an in-depth analysis, and the answers will differ depending on many factors.”
In keeping with the tone of earlier communications from the SEC, which has a mandate to protect investors but also facilitate capital formation, he did not make blanket statements. However, some of the red flags he noted were promoters who touted the profit potential of their tokens, offerings for networks and other products that had not yet been built, and and issuances that emphasized form over substance.
Joshua Ashley Klayman, chair of the Wall Street Blockchain Alliance's Legal Working Group, wrote via email, "Chairman Clayton urged market participants and others to thoughtfully consider, among other things, the existing 'principles-based securities law framework, which has served us well in the face of new developments for more than 80 years.' In my view, this framing seems to support the idea that the existing facts-and-circumstances-based inquiries -- and not bright-line tests -- will continue to apply to token sales."
Marco Santori, blockchain technology lead at Cooley, wrote via email, “The Chairman clearly believes there is a path forward for both securities and non-securities tokens.”
The chairman of the Commodities Futures Trading Commission, J. Christopher Giancarlo, commended Clayton on his statement. He added, "I want to reiterate my previously stated emphasis that market participants should take note that the relatively nascent underlying cash markets and exchanges for bitcoin remain largely unregulated markets over which the CFTC has limited statutory authority. Investors should be aware of the potentially high level of volatility and risk in these markets.”
One question in the crypto community that Clayton's statement at least partially addressed was the concept of a utility token.
Some ICO operators believed that if their token has utility, it is not a security, because presumably investors would purchase it to use the network it powered, and not necessarily because they expected the value of the token to rise. However, Clayton said of these ICOs trying to claim that because their tokens had utility they were not securities, “Many of these assertions appear to elevate form over substance. Merely calling a token a ‘utility’ token or structuring it to provide some utility does not prevent the token from being a security.” He stated that marketing that emphasized the profits to be made based on the efforts of the token sellers or other parties could give such tokens the “hallmarks” of a security.
Klayman wrote via email that the chairman's message indicated, "Manner of sale matters. If you or your agents are marketing a token in a way that emphasizes a profit potential based on the efforts of others, you may be selling a security -- even if, in the absence of such marketing, your token may otherwise have looked less like a security."
Clayton also contrasted an example of a token that represents participation in a book-of-the-month club that would not be considered a security against “interests in a yet-to-be-built publishing house with the authors, books and distribution networks all to come,” with the latter fitting the definition of a security that the SEC has determined will apply to token sales: an investment where the purchaser expects profits that depend upon the efforts of others.
Santori said the emphasis here on the network and entity that are not yet built and “all to come,” validates a proposal he and one ICO issuer, Protocol Labs, made for how token sales could fit within existing securities laws.
Called the SAFT Project, it relies on the difference between selling to investors before the network launches vs. after. According to this proposal, before the network launches, a sale is a security because the success of the token or investment depends on the issuers, while after the network launches, the purchase of the token is more similar to the purchase of a product. “The Chairman’s statement is in no way an endorsement of the SAFT framework, but we’re delighted to find it in harmony with it,” said Santori. “By and large, this is expected and welcomed clarification. Most token sales to date have been pre-functional, with their promised functionality ‘all to come.’”
Clayton also sent a warning to operators of exchanges and other businesses that promote or offer the sale of coins: they should not do so without first assessing whether or not those tokens are securities. He also emphasized that such operators selling securities would need a license, and that entities accepting payments in cryptocurrencies, allowing customers to purchase securities on margin or otherwise use cryptocurrencies in securities transactions must ensure they are following anti-money laundering and know-your-customer rules.
In a year when the crypto market has ballooned from not quite $18 billion to more than $450 billion and initial coin offerings had raised $3.5 billion, compared to less than $300 million in all the years prior, the SEC has issued several warnings and reports and begun taking enforcement actions to quell the frenzied market and stop bad actors.
So far, it has warned investors against buying tokens based on celebrity endorsements, about potential scams by publicly traded companies trying to boost their stock prices with ICO-related claims, plus taken action against a few ICO issuers, including one that allegedly promised returns of 13x within a month. This statement furthers the agency’s initial indications that whether or not any particular token or offering would be deemed a security depends on the characteristics of the token itself or its sale.
The statement emphasized, for Main Street investors, the need for transparency, disclosure, skepticism and the right to ask questions and obtain clear answers. It also noted that the crypto markets are worldwide, limiting the SEC’s ability to pursue bad actors and recoup funds. Examples of some questions he suggested crypto investors ask issueres include, “Who is issuing and sponsoring the product, what are their backgrounds?” “Where is my money going and what will it be used for?” “Who is promoting or maketing the product?” and “Have they been paid to promote the product?”
Clayton also had a message for what he called “market professionals” as well, acknowledging first that ICOs can be an effective way for entrepreneurs to raise funding for innovative projects. But he again underlined the need to be transparent and comply with securities laws if issuing a security, even if it’s recorded on a blockchain.
