Saturday, July 14, 2018

Not All ICOs are Securities Offerings

William Hinman, Director for the Division of Corporation Finance of the U.S. Securities and Exchange Commission (the “SEC”), delivered a speech on June 14, 2018, that is helpful in defining the U.S. regulatory framework surrounding digital assets. For promoters, investors, and other market participants in the blockchain and cryptocurrency space, Director Hinman's speech comes as a breath of fresh air after the SEC Chairman, Jay Clayton, stated that “every ICO I’ve seen is a security” just months ago. For others, like the legal practitioners active in the crypto assets field, this speech may be seen as creating more questions than answers.

Director Hinman directly addressed the question that has already been hinted at by other SEC (and the CFTC officials): whether a digital asset that was originally offered as a security be later sold as something other than a security.  In particular, everyone had wondered whether the current sales and offers of Ether, the underlying token powering the Ethereum blockchain, were sales and offers of securities. We can all agree that Ethereum’s initial coin offering would undoubtedly be considered as a securities offering in the eyes of the SEC. Considering that Ethereum is one of the most popular platforms for tokens to run on, this is an essential issue for many in the space.

Acknowledging the possibility that a digital asset that was initially offered as a security can later be sold as a non-security, Director Hinman gave examples that would tip the scale in favor of a digital asset being a non-security. Based on Director Hinman’s examples, if the enterprise that is being invested in has become decentralized, or if the digital asset is being sold only to be used to make purchases “through the network on which it was created,” it is likely that the digital asset will not be considered a security. As to Ether, Director Hinman stated: “…the present state of Ether, the Ethereum network, and its decentralized structure, current offers, and sales of Ether are not securities transactions.”

So, it seems like the “once a security, always a security” may no longer be true in certain circumstances, once you have a “decentralized” network where the digital asset is used to make purchases on, or obtain access to, the network. It is unclear, however, how one determines the precise point in time when the security metamorphoses into just a token, and how one "transitions" out of the securities law framework.

A more general issue, of whether all ICOs constitute securities offerings, was answered with a resounding NO. However, Director Hinman made it clear that the label given to a particular digital asset, such as a “utility token,” is inconsequential as to whether it is a security or not. “Whether a transaction in a coin or token on the secondary market amounts to an offer or sale of a security requires a careful and fact-sensitive legal analysis,” Director Hinman stated.

While Director Hinman acknowledges that digital assets are “simply code,” and not inherently securities, he looks towards Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 756 F.2d 230 (2d Cir. 1985) that says that “an instrument can be part of an investment contract that is a security,” regardless of the nature of the instrument itself. There are cases where even whiskey warehouse receipts and chinchillas were deemed to be “securities.” Consequently, we must look closely at the nature of the digital asset and the parties that are involved in the transaction.

Director Hinman reiterated the SEC's determination to apply the “Howey Test,” the current test for determining whether an “investment contract” constitutes a security set forth in SEC v. W.J. Howey Co., 328 U.S. 293 (1946), to each offering of digital assets. For the “Howey Test” to be satisfied (which means that the instrument is a security), there must be: 1) an investment of money; 2) in a common enterprise; 3) with an expectation of profit, and 4) the profit is derived from the efforts of others.

The application of the Howey Test to any particular offering of digital assets requires analysis of each particular set of facts and circumstances. No two offerings are alike, and the promoters and their counsel should carefully assess each offering to determine whether the U.S. federal securities laws apply. It is possible to structure a digital asset offering more or less like a securities offering, and Director Hinman offered a list of possible features and questions that could influence the outcome:

1. Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?

2. Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading?

3. Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent?

4. Are the tokens distributed in ways to meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?

5. Is the asset marketed and distributed to potential users or the general public?

6. Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?

7. Is the application fully functioning or in early stages of development?

Overall, Director Hinman’s statements brought much needed clarity and guidance to the issues surrounding the offering and sale of digital assets; however, they do reflect his own views. It is unclear whether legal practitioners may rely on these statements, and if yes, then to what extent.  It is helpful, though, that the SEC is now open to receiving no-action letter requests, a response to which would provide an official SEC decision.  Given how policies and interpretations tend to change over time, it would be particularly helpful for those legal practitioners who are advising ICO issuers to have clear rules and bright-line tests to apply rather than statements by officials from different agencies that sometimes express conflicting views.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its authors, Brad Klingener and Arina Shulga.  Mr. Klingener is a second-year law school student at Brooklyn Law School and is a summer intern at Ross & Shulga PLLC.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

Should All Accredited Investors Be Wealthy?

            Instead of undergoing the expensive process of conducting a public offering of securities, companies have continually relied upon Regulation D to conduct private placements of securities. Among other requirements of Regulation D, companies are limited to selling their securities only to the “accredited investors” (with some exceptions).

            Rule 501 of Regulation D defines an accredited investor (as it pertains to individuals) as any one of the following: (i) a director, executive officer, or general partner of the issuer of the securities being offered; (ii) a natural person whose individual net worth, or joint net worth with that person's spouse, exceeds $1,000,000 (excluding the value of the primary residence); or (iii) a natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.

Accredited investors are presumed to have a higher level of financial sophistication and financial wealth that enables them to conduct proper due diligence and withstand a total loss of their investment. Also, it is presumed that, if accredited investors are lacking financial savvy, they can afford to hire financial advisers.  Indeed, often the most relevant parts of the definition of an accredited investor are in determining the investor’s net worth or annual individual or joint income. But the idea that wealth alone is some measure of financial sophistication is misleading.

Consider a successful doctor or a wealthy actor. It would be reasonable to assume that these individuals do not necessarily possess the financial sophistication needed to make smart financial investments.  On the other side, consider financial analysts or investment advisers who, while working daily with securities and investments, do not meet the “accredited investor” minimums.  Yet, it will be the doctors and the actors who, in our hypothetical, will be accredited investors.

There have been suggestions for reform. Pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act, the U.S. Securities and Exchange Commission (“SEC”) is required to review the accredited investor definition as it relates to natural persons every four years to determine whether the definition should be modified or adjusted. The last review occurred in December 2015, which means we are still one year away from the second report. But that has not stopped the U.S. House of Representatives from proposing legislation to expand the definition in December 2016, and SEC Chairman Michael Piwowar from speaking on the need for reform of the definition in February 2017. The most common suggestion is to expand the definition of accredited investor to include individuals with a securities license and those who have passed a securities examination.

In our opinion, expanding the definition of accredited investor would increase the pool of potential investors and help facilitate the flow of capital into the startup economy.  It would lead to an increase in jobs and the growth of the U.S. private sector.  On the other hand, the need to protect investors is paramount, and the criteria for accredited investors need to remain simple and straight-forward to apply.  Given these considerations, it would be desirable to expand the definition to include non-financial criteria, such as knowledge in the securities and investment areas, as evidenced by the passing of Series 7, Series 65, 82 and CFA examinations and equivalents.  The definition should also be expanded to include individuals who work in finance-related fields and who obtain a letter or certification regarding their financial acumen from their direct superiors.  However, the amount of investment by such individuals should be limited to no more than 25% of their annual income. 

All we can do is wait another year until the next review of the accredited investor definition in the hope that the definition will include those who have the qualifications needed to knowingly participate in the investments in the early-stage companies.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its authors, Andrew Silvia and Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.