How To Ensure your ICO Avoids Being Labeled a Security
In a nutshell, if you’re investing money planning on profiting from someone else’s efforts, you’re buying a security. That sounds an awful lot like buying a token and hoping it succeeds.
THE HOWEY TEST: WHAT IT IS AND HOW TO AVOID IT
The crypto world has been a tad bit on edge since the SEC infamously ruled The Dao tokens were considered securities for investment purposes. The tokens failed to pass the Howey test, an important court precedent. We’ll break down what the Howey test is, why it matters, and how to avoid it.
First know that a a transaction will be considered a security if all of the following requirements are met:
1. There is an investment of money
2. There is an expectation of profits
3. The investment of money is in a common enterprise
4. Any profit comes from the efforts of a promoter or third party
THE CONNECTION BETWEEN A CITRUS FARM AND ICOs
1946. The scene was sunny southern Florida, where the Howey Company was leasing part of their citrus farms to finance other ventures. The buyers of the land were expecting to profit through the work of the Howey Company, essentially making the plots of land investment contracts. The SEC moved to block the sale. The case bounced back and forth up to the US Supreme court, who ruled in favor of the SEC. The case influenced the SEC’s definition of “securities” forever.
Justice Murphy stated in the original court ruling: “If that test be satisfied, it is immaterial whether the enterprise is speculative or nonspeculative, or whether there is a sale of property with or without intrinsic value.” In a nutshell, if you’re investing money planning on profiting from someone else’s efforts, you’re buying a security. That sounds an awful lot like buying a token and hoping it succeeds.
WHEN YOU BUY A TOKEN WITH THE HOPES IT SUCCEEDS ARE YOU BUYING A SECURITY?
Fast forward to 2016. Ethereum was growing like wildfire and The Dao was one of the hottest new projects on the platform. At the time, DAO was the largest crowdfunded cryptocurrency in history. Even in 2017’s year explosive ICO’s, DAO’s 150m+ raised is still jaw-dropping. Some investors expressed worries about the code being hackable. One of DAO’s founders, Stephan Tual, explicitly stated “no DAO funds [were] at risk.” Famous last words. As you probably know, hackers made off with $50m and the price of Ethereum dropped almost 50%. This made a lot of investors very grumpy and caught the eyes of the SEC.
SEC SENT SHOCKWAVES THROUGH ICO WORLD
The SEC’s subsequent report sent shockwaves through the crypto community. In their own words, “This report reiterates these fundamental principles of the U.S. federal securities laws and describes their applicability to a new paradigm—virtual organizations or capital raising entities that use distributed ledger or blockchain technology to facilitate capital raising and/or investment and the related offer and sale of securities. The automation of certain functions through this technology, “smart contracts,” or computer code, does not remove conduct from the purview of the U.S. federal securities laws.” Cryptocurrencies would no longer exist in a utopia without government regulation. Another DAO founder, Christopher Jentzsch, explicitly compared the rewards DAO holders would earn to dividends. Little surprise the SEC declared DAO a security. The DAO is the most prominent token to get the security tag, but we’ll break down others that could be in trouble, as well as the steps teams have taken to avoid being labeled securities.
PROJECTS THAT HAVE “SHARE-LIKE QUALITIES”
NEO is one of 2017’s biggest winners. Frequently dubbed “Chinese Ethereum,” the team’s coin went from 50 cents to almost $50 a token. NEO fueled their 10,000% growth with a slick marketing campaign and the goal of creating a cryptocurrency that could be a stable store of value. In the process, they also hit the SEC’s definition of a security to a T. The NEO coin gives an owner shares in the company.
The white paper originally explicitly used the term “shares.” NEO holders will also have voting rights, similar to stockholders of a company. It bears reminding that NEO is a Chinese company and not subject to the SEC, but this could be an issue down the line for American users of NEO.
Another coin we’ve profiled extensively, TenX is a potential contender to be dubbed a security. TenX holders receive rewards as more and more people use TenX. That’s awfully similar to dividends. TenX is based in Singapore, so the SEC presumably isn’t a huge concern for the team, but it’s still something they might want to be mindful of in the future. However, companies using in-app tokens will likely argue that this reward-based feature is what makes tokens so innovative. Users, for the first time, are not excluded from the value they create. For the first time, users are able to tie themselves into the success of a project. Imagine Facebook took such an approach. Instead of advertising deals being brokered between FaceBook and advertisers, users like you and I (who actually create the value on the platform), could be compensated for the value we add.
A third coin that might run into trouble down the road is Aragon. Holders of Aragon’s ANT tokens have voting rights, some of which relate to distribution of profits and assets. Again, this sounds awfully like voting stock. Aragon shares many similarities with the DAO, so there’s clear precedent. Like the other coins we’ve touched on in this section, Aragon is based outside of the United States.
However, it should be mentioned, that just because a token has some share like qualities, it often has many other features or built in utility to complicate the matter from a legal standpoint. The truth is, this is new territory for everyone including the SEC.
HOW TO PASS THE HOWEY TEST
Now that we’ve examined what can make a coin a security, let’s touch on how many other currencies have passed the Howey test. The first and simplest way is to make a decentralized cryptocurrency that’s equivalent to cash with no central owner. Holders of Bitcoin use it as a currency; there is no development team or expectation a company will profit. Thus, no worries about the Howey test. Litecoin, Bitcoin Cash, and Dash are all similar currencies that are likely safe and sound.
Ethereum, 2017’s biggest winner, is known for its smart contracts. We’ve written entire articles about how coins implement functionality to avoid being labeled securities. Ethereum has utility, and holders aren’t expecting Vitalik Buterin and co to make a killing for them. Ethereum should be fine.
In-app functionality is something many teams have created specifically to dodge the security tag. Functions within the token and uses in a platform are just a few ways teams make tokens more than securities. Basic Attention Token, for instance, uses its BAT token as a store of value in its Brave browser.
CONCLUSION: DON’T CREATE A CRYTOGRAPHIC STOCK
The Howey case has already pivoted the future of cryptocurrencies forever. To avoid the long arm of the SEC, teams will continue to create functional tokens that aren’t merely cryptographic stocks. Regulation of cryptocurrency is still up in the air, but for now, the path to avoid being labeled a security is relatively clear.
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