First Takeaway: The SEC Means Business and is Polishing their Playbook
First, the recent settlement of SEC Registration charges against Paragon and Airfox on November 16, 2018 is likely the first of many civil penalties levied against cryptocurrency businesses. The ruling also represents an important legal precedent where the SEC applied guidance from the 2017 DAO Report of Investigation (Release №81027 / July 25, 2017). The guidance was used to charge both Airfox and Paragon for violating Section 5(a) and 5(c) of the Securities Act by “offering and selling these securities without having a registration statement filed or in effect with the Commission or qualifying exemption from registration with the Commission.” PRG and Airtokens were represented as “Utility Tokens” to present themselves fundamentally as glorified Kickstarter projects rather than securities.
The DAO Report set a framework to predict how the SEC would interpret securities law when applying them to ICOs despite labels as a security or utility token. Below are a few of the foundational principles of securities law from the DAO Report applied to capital raising via cryptocurrency offerings.
1) Determination of whether an investment contract exists. A key item distinguished was that the investment of “money” does not necessarily need to take the form of fiat currency. Using ETH to make investments was specifically cited (such as exchanges involving smart contracts). Tokens that fit the Howey test are determined to be securities.
2) Reasonable expectation of profits. Despite the focus on funding development projects, the tokens were presented and structured in a manner where a reasonable investor would have been motivated by the “prospect of profits on their investment.”
3) Benefit derived from the managerial efforts of others. The responsibility for shepherding the raised capital and generation of profit was assumed to be tied to the efforts of the management team. This increases in importance when considering management teams using cryptocurrencies to compensate employees and contractors.
4) Voting rights are a critical distinguishing factor. Based on the structure of these companies, there are a number of limiting items for the overall control of token holders. In addition, given that token holders are often widely dispersed and lack the ability to communicate with one another, there is an even greater burden placed on management to prove their efforts are not being relied upon for economic gain.
5) Information rights are important. Whether it is an unplanned hard fork or change in monetization strategy, it is important for token holders to have a reasonable amount of information to make an informed decision. This is likely to increase the burden on management teams to effectively communicate their results and general business plans in a more structured manner.
Second Takeaway: No Fraud Charges Levied
The SEC charged the two companies with a $250,000 fine and a cease-and-desist order until they can be properly registered. Notably, no criminal charges were applied in either case. This demonstrates that the SEC is focused on establishing registration requirements and enforcement mechanisms to create a more predictable ICO market. While these rulings may not establish a clear bright line on a number of other securities items pertaining to cryptocurrency markets, the blue prints for ICO compliance seem to be coming together.
Third Takeaway: Labeling it as a “Utility Token” Means Nothing
None of the defenses based on the label of a “utility token” were strong enough to avoid the categorization of each token as a security. A utility token is issued in order to fund development of a cryptocurrency and future marketplace where the token would be exchanged for a particular good or service. The legal defense of a utility token to avoid the label of a security is tantamount to comparing themselves to Kickstarter projects. However, the SEC determined that the promise and hope of asset inflation creates a fundamental point of distinction.
Fourth Takeaway: Investor Relations is Important
The SEC consistently discussed the promotional efforts on social media, email communications, blockchain communities / chat sites, and white papers in applying securities law. Similar to virtually every other asset class, the overall communication of the opportunity was evaluated in a legal vacuum to determine whether the tokens were securities and if they were exempt from registration.
While there are likely much more settlements in the SEC pipeline, we are starting to see the development of clear standards for ICO markets. This positive trend will culminate in more clear standards for asset monetization strategies using blockchain technology. Future guidance on the following topics are likely over the next few years:
· Equity compensation rules around distribution of cryptocurrency
· Trading rules surrounding secondary markets
· Liquidity requirements (for instance, escrow accounts held in ETH)
· Information rights
· Voting rights
· Governance structure
· Distributed ledger technology security
· Industry-specific applications (i.e., gambling, gaming, cannabis, etc.)