- How does the U.S. SEC use the Howey test to determine whether a token is a security or not?
- How did the DAO Report from 2017 affected the SEC’s view on ICOs?
- Telegram relied on a SAFT Framework from 2017 but failed spectacularly
- Why does the whole world seem to fall under the SEC’s jurisdiction?
The United States Securities and Exchange Commission’s crackdown on initial coin offerings (ICOs), has become a major challenge to new blockchain projects looking for funding anywhere in the world. As we learned from the case of the Telegram ICO, the SEC prohibits the distribution of security tokens that could end up in the hands of U.S. investors. As a result, Telegram ended up abandoning its Telegram open network (TON) project, which raised an eye-watering $1.7 billion in funding. The crypto community members are now asking themselves: “Have we witnessed the death of the ICO?”
Why does the SEC deems some tokens as securities?
The U.S. Securities and Exchange Commission has substantial power over the sale of securities – a broad category of investments that generally entail either stake in an entity or debt to it. Their basic rule is simple – anyone offering securities to the U.S. public must register that offering with the SEC.
SEC Registration requires a company to disclose a lot of financial information and introduces compliance costs, therefore many companies try to avoid registration if possible. Not that long ago, the general opinion was that SEC registration had nothing to do with crypto, but this has changed in the past three years.
The SEC started classifying certain cryptocurrencies and tokens as securities, claiming that they fall into the category of “investment contracts.” What exactly falls into this category is determined by the Howey Test, a critical result of the ruling in SEC v. W.J. Howey Co. (1946) that remains the basis of the definition of a security today:
“For purposes of the Securities Act, an investment contract (undefined by the 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.”
The argument behind the stricter regulation and a demand for higher transparency is that publicly traded companies get access to a lot more capital. Understandably, the SEC’s interest in crypto started increasing during the 2017 ICO fever.
The DAO Report changed things forever
The issue of ICOs remained unresolved until the DAO’s 2016 meltdown happened and changed things forever. The event, in which users invested ETH in exchange for DAO tokens, resulted in two important developments: Ethereum Classic and the SEC’s DAO Report issued on July 25, 2017. The report states that the SEC would refrain from prosecuting Slock.it, the firm largely responsible for the DAO. Nevertheless, the report also determined that the DAO was indeed an unregistered securities offering and warns that next time, the SEC would not be so merciful.
“Anybody who had been touting [a new token] before the DAO report was ok”, commented attorney John Berry, who left the SEC’s enforcement division in 2019.
EOS raises $4 billion without lifting much dust
The EOS ICO, which raised an astounding $4 billion without much resistance from the SEC, is an interesting case study. The ICO, which remains the largest ever, started just one month before the DAO Report and lasted a whole year. In response to the DAO report, Block.one, the company behind the EOS ICO, put up an advisory on the site for its ICO against U.S.-based investors participating.
Although the SEC later started an investigation of the EOS ICO, it ended up settling with block.one for only $24 million. Whether it was just timing with the DAO report, or that the EOS Tokens were non-transferrable after the purchase period or the fact that the purchase agreement’s explicit prohibitions on investors from the U.S. or China, remains unclear.
Anyway, the fact that they settled for $24 million, which is next to nothing relative to the capital raised in the ICO, indicates that the SEC didn’t seem to think it had a strong case. Nevertheless, the EOS case didn’t change things for projects to come. Philip Moustakis, Former Member of SEC’s Cyber Unit, commented on block.one’s case:
“I would caution those in the industry against modeling their ICOs after Block.one’s. To me there’s no clear message to take away from Block.one. At best, we’re reading tea leaves.”
Crypto community sets up the SAFT framework
Over the course of 2017, lawyers in the space worked to conceptualize a new framework, dubbed a “Simple Agreement for Future Tokens” (SAFT). Like the approach taken by the EOS project, the SAFT Framework conceptualized a distinction between the initial sale of rights to tokens and the distributions of the tokens themselves.
The former would be considered securities, sold only to “Accredited Investors” using the SEC’s Regulation D to exempt the firm from full registration as a publicly-traded company. The early accredited buyers would be later able to sell their tokens to the general public, even in America, as freely as they can Bitcoin.
Even though the SEC never formally endorsed the SAFT Framework, the statements from Chairman Jay Clayton near the end of 2018 indicated support for the concept.
Telegram relies on the SAFT framework and fails
Since then, project looking to raise capital through ICOs have relied on the SAFT framework. Some have managed to stay under the SEC’s radar and conduct ICOs, while some, Kik for example, have gotten in trouble even though they have followed all the SAFT recommendations. However, the most high-profile project to ever use the SAFT Framework, Telegram, has become the most spectacular failure and could very well be the last.
Telegram made every effort to keep the SEC involved and get everything done the legal way from the very beginning. The firm tried to follow the SAFT Framework by registering its purchase agreements, and not the Gram tokens, under a Reg. D exemption, hoping that the SEC would accept that the Gram itself was not a security. The SEC argued that Grams were still securities, largely because Telegram failed to convince the commission or the judge that the network, TON, was actually complete. SEC proceeded by filing an emergency action stopping the distribution of Grams in October and Telegram ended up announcing that it is backing out of its planned Telegram Open Network, which raised $1.7 billion, last week.
Here’s what Kristin Smith of the Blockchain Association had to say on the topic:
“The Judge basically presumes there would be a crime before there was a crime and is therefore intervening in a way that sends a bad signal to other projects. From our perspective at the Blockchain Association, this is why we need to have an additional regulator and/or legislative solution that provides a legal pathway.”
Why does the whole world fall under the U.S. SEC’s jurisdiction?
Telegram tried to argue with the U.S. SEC that they would only distribute Grams to tnon-U.S. investors, but the U.S. regulator slammed the doors on the global distribution of the tokens. Why is that so, and how does the U.S. SEC have the power to do this?
The U.S. SEC plays a major role in global financial regulations, largely due to the size of the country’s economy and investment market. When it comes to cryptocurrencies, the SEC has claimed potential jurisdiction over any token that could make its way to U.S. investors, and one of the key characteristics of digital assets is their ability to cross borders freely.
EOS tried geo-blocking but the fact that many investors in the crypto world are technologically savvy makes this a very difficult task. Telegram also tried. They even offered to “configure the TON digital wallet to preclude U.S.-based addresses”, but the SEC was not satisfied.
The future without ICOs
To answer the question in the title of the article – yes, we have in fact witnessed the death of the ICO concept. This is, however, not the end of new tokens nor is it the end of new blockchain projects. But, until laws change comprehensively, the massive capital raise that leads to a token that trades freely seems like a thing of the past. It is even harder to imagine something like the 2017’s ICO boom happening again.
Projects will continue to form, and if they are not looking for public funding they don’t have to worry about the SEC’s interference. After all good projects can sometimes be developed with very minimal funds. As put by Coin Center’s Peter Van Valkenburgh:
“Since the beginning of our advocacy in this space, we usually have at least one sentence saying, ‘if you really want to build good decentralized networks, Satoshi was able to build one without a pre-sale.’”
Projects seeking funding, however, will have to look for different forms of raising capital, as raising it through an ICO becomes mission impossible.