When is a Coin not a Coin? Understanding ICOs and Securities

2017-11-27T17:37:10+00:00November 22nd, 2017|

This year’s hottest investment, the initial coin offering (ICO), would yield an astonishing 1,320% if one invested in every coin offering. For blockchain firms, ICO funding is rapidly outpacing traditional equity funding in 2017. But the new kid on the block has raised some questions, especially on the regulatory front. Since ICOs are unregulated, unlike IPOs and other capital investments, many are wondering about if and when a regulating authority will step in and set some ground rules.

The blockchain community didn’t have to wait long, as the U.S. Securities and Exchange Commission recently released a statement on the DAO, determining, “tokens offered and sold by a ‘virtual’ organization known as ‘The DAO’ were securities and therefore subject to the federal securities laws… issuers of distributed ledger or blockchain technology-based securities must register offers and sales of such securities unless a valid exemption applies.” In essence, the ruling stated that the DAO’s offering fell under the articles of the Securities Act of 1933.

The debate boils down to two things–first, what is a security? The term is thrown around frequently in traditional finance and blockchain circles, but sometimes with different meanings. An clear definition will help determine the answer to the second question, are ICOs securities?

Under the Supreme Court case “SEC v. Howey Co. (1946)”, a security is defined as “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, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.” Succinctly, there are four boxes that must be checked for to make an investment a security–1) the investing of money, 2) investment in a common enterprising (pooling), 3) an expectation of profit, and 4) the profit must result solely from the efforts of a third party.

So, are ICOs securities? According to the SEC, some are. But there are a few ways that companies are able to evade the qualifications of a security listed above, exempting them from federal regulation. One of the more popular methods of avoiding SEC regulation is the SAFT (simple agreement for future tokens) framework. Under this framework, tokens would be sent to investors after a functioning product is in place. The tokens would have to serve a useful purpose on the platform, thereby disqualifying the ICO under the fourth point listed above. Because the tokens can be used by investors for a specific, actionable purpose, the profits from the ICO do not result solely from the profits of others.

Additionally, there are some blockchain platforms that incentivize investors to become a part of the ICOs themselves. There are blockchain platforms that create ICO infrastructures as well as marketplaces for part time jobs to help a company’s core team launch an ICO. Theoretically, if all investors in the ICO were a part of the ICO launching effort in some capacity–marketing, development, implementation, etc.–the fourth component of the Howey case wouldn’t apply.

As an example, Gladius tokens (GLA), once they hit the public market, will not be considered a security. This is because Gladius tokens have utilitarian value–they are the token used on Gladius’ DDoS prevention and content distribution network platform. The fourth component of the security definition isn’t met. In contrast, LAT (Liquid Asset Tokens) issued by LAToken as portions of other investments, would likely qualify as securities, and are therefore being restricted by the ICO for just accredited investors.

Though the SEC hasn’t seriously cracked down on other ICOs as of late, their ruling issued a stern warning to companies and ICO investors alike. In one sense, the blockchain community has seen this coming. Coupled with ICOs growing popularity and the federal government’s love of regulation, this isn’t a surprise. What it will do is force companies to place an even higher priority on compliance. Hopefully, the SEC will issue more guidance to the blockchain community, rather than cracking down all at once. Regardless, token and coin issuers will need to proceed with caution.