The Securities and Exchange Commission’s much heralded “plain English” guidance on what makes an ICO a security wasn’t the good news many people thought it was. That is, wrapped in nicer language, the conclusion reached on May 16 by the Wall Street Blockchain Alliance, which has been studying the document for nearly six weeks.
While calling the April 3 guidance document “a welcome attempt on the part of the [SEC] Staff to provide greater clarity as to the applicability of U.S. federal securities regulation to digital assets,” the WSBA’s Legal Working Group determined that it is largely “a consolidation of previously enunciated positions, rather than an expansion of prior guidance.”
The result, the group said, is that “it does not change our view that the Staff is likely to view nearly every initial sale of a digital asset…as the sale of a security.”
Which really shouldn’t come as a surprise to anyone, said Joshua Klayman, founder of Klayman LLC and one of the seven primary authors of the Alliance response.
“I think that people keep asking for clarity from the SEC, and what they’re really asking for is a different result,” said Klayman to Modern Consensus. “The SEC has been saying for a long time that nearly every sale of digital assets is going to be the sale of a security. Why people keep expecting a different answer from them, I don’t know.”
She added, “I think if we want a different result, we need to look to lawmakers.”
That is happening, of course, most notably with the reintroduction of the bipartisan Token Taxonomy Act of 2019 in April. The goal is to “clarify the numerous conflicting state initiatives and regulatory rulings, and patchwork of judicial decisions, that have clouded certainty for entrepreneurs and businesses that use blockchain technology,” said Rep. Warren Davidson (R-OH) the bill’s author, in a statement. “Passing this legislation…would send a powerful message to innovators and investors around the world that the U.S. is the best destination for blockchain technology.”
The proposed law would exclude digital tokens from the definition of a security, direct the SEC to enact new regulations, and clarify jurisdiction between the SEC, Commodity Futures Trading Commission (CFTC) and Federal Trade Commission (FTC). It would also make various tax changes, including an exemption when exchanging one virtual currency for another. And it would preempt state law, overturning regulations like the New York State Department of Financial Services’ BitLicense requirements.
A dialogue not a decree
Although Klayman said she sees the SEC’s release of its guidance document as a positive outcome, she acknowledged that the tone of the Alliance’s response could sound fairly confrontational. She attributed that more to lawyers writing in legalese than to the actual intent of her group.
The two documents should be viewed as an ongoing dialogue, she said.
“This was not in any way meant to be something adversarial to the SEC,” said Klayman. “It’s really just talking about things that we still need to explore. As lawyers in this space, we’re almost like translators. We translate from the technologists to the regulators, we translate back from the regulators to the technologists.”
Which isn’t to say that a group of the size of the one that put the WSBA’s response together—seven lawyers from five firms, along with input from many others and WSBA Chairman Ron Quaranta—has anything like a monolithic view of the issue.
“I think this stuff is really hard, and that we should really appreciate that [the SEC] gave us a framework,” Klayman said, adding that she feels the cryptocurrency industry is very lucky to have senior people at the SEC “who are committed to promoting innovation,” singling out Bill Hinman, director of the Division of Corporation Finance (DCF) and Valerie Szczepanik, senior advisor for digital assets and innovation, as well as SEC Commissioner Hester Peirce.
“It could be very different,” Klayman said. “We could have a whole different set of people there.”
Old answers and new questions
What the SEC guidance—technically the “Framework for ‘Investment Contract’ Analysis of Digital Assets”—does provide is “greater insight concerning the Staff’s approach to analyzing” whether a digital asset sale should be considered an investment contract, and thus a security, the Alliance lawyers concluded.
First off, the SEC staff still thinks that virtually all ICOs are security offerings. Second, the U.S. Supreme Court’s Howey Test will still be used to define digital assets as securities. And third, anyone planning an ICO has to run it by the SEC’s FinHub first.
And even that may not be enough. The guidance makes clear that the actual commissioners haven’t signed off on it. In other words, they might ignore it entirely.
The SEC guidance does raise several questions. And that’s a good thing Klayman said.
Many of these are about interpreting the Howey Test. That is the four-pronged test that determines if a sale is considered a security. Basically, it says that a sale is a security when “a person (1) invests his money in a (2) common enterprise and is led to (3) expect profits solely from the (4) efforts of the promoter or a third party.”
Specifically, it is unclear whether the first prong covers ICO give-aways such as bounty programs which involve an investment of non-cash “value” such as services or other benefits. As to the second prong, the Alliance lawyers conclude that it is unclear if “ownership of a common asset whose value rises and falls depending on market forces,” automatically makes it a common enterprise under Howey.
Another section questions whether the guidance’s creation of the concept that a digital asset’s inclusion of an “active participant,” defined as someone who provides “essential managerial efforts that affect the success of the enterprise,” is enough to meet the third and fourth prongs of the Howey Test. That definition may be too broad, the Alliance’s attorneys argue.
In addition, the attorneys say they believe that comments by Bill Hinman, the SEC’s division of corporation finance director, about how digital assets can transition from securities to non-securities after the ICO are unclear. They make the same point about the definition of virtual currencies.
Finally, the Alliance’s response to the guidance questions the relevance of a FinHub advisory decision released alongside the guidance document. That No-Action Letter recommends against categorizing a token offering by TurnKey Jets as a security, noting among other things that the tokens will always be valued at $1 and will be used only to rent private jets from the issuer, so they won’t have an investment value.
The problem, according to the Alliance response, is that TurnKey Jets’ digital asset sale was so different from the ICOs of the past few years as to be irrelevant to the question of whether an ICO will be found to be a security offering.
Which is precisely the point, Klayman said. “It doesn’t say anything that would make us think that the SEC’s guidance has changed,” she noted.
It’s real importance, some people suspect, is that TurnKey’s first proposed to the SEC was likely very different from the proposal that eventually received a no-action letter, said Klayman.
That would make the point of releasing the no-action letter along with its guidance a not-so-subtle hint by the SEC that promoters of digital assets should be adjusting their proposals to meet the agency’s interpretation of the rules, rather than demanding the rules be changed to fit the promoters’ wants and needs.
Updated 11:55 am ET on 05/21/19 to update number of WSBA attorneys involved in the organization’s response to the SEC guidance.