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ICO research: Do U.S federal security laws apply to your ICO?


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The U.S Securities and Exchanges Commission or the SEC recently published a framework for market participants in the Initial Coin Offering space. The aim? To enable these players to better assess whether a digital asset being offered is an investment contract or not. And as a result of which would be subject to federal securities laws.

In essence, the new framework is meant to function as a guide to help answer the most perplexing question in the ICO space “do these tokens being sold, traded and offered during an ICO, fall under the category of a security or particularly an investment contract?”.

This new framework is not to be confused with a rule or regulation approved by the commission instead, it represents the views of the Strategic Hub for Innovation and Financial Technology or Finhub, division of the SEC.

What is an Investment Contract, according to regulators?
An economic transaction is treated as an investment contract, which is a type of security, if it satisfies the Howey test, which was created by the U.S supreme court.

While there are several factors to be considered, an investment contract exists “when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others” (source).


The Howey test: explained
The Howey test determines whether a certain economic transaction can be considered as an investment contract and if so is subject to federal securities laws, which ordains certain registration and disclosure agreements.

In 1946, the U.S supreme court heard a case (SEC vs Howey) which involved the leasing back of land. The Howey company was an agri-business based out of Florida, which operated a citrus farm on a large portion of land.

The company had decided to lease out almost 50% of its property in order to finance further growth. The purchasers of the Howey land had little no skill/ experience in this field of business and bought the land in hopes of earning a profit in the future. The Howey company landed in hot water when it failed to register these transactions with the SEC.

An economic transaction will be considered as an investment contract if it satisfies the following criteria-

  • If the transaction is an investment of money.
  • If the investment of money is in a common enterprise.
  • If there is an expectation of earning profits from the work of the third party.

While the regulatory definition paints a broad picture of what an “investment contract” can be considered to be. Umbrella terms like “common enterprise” can include a whole host of organisations, hence it’s important to address these terms by the regulator’s rulebook.

  • Common enterprise: Federal courts mandate there be either "horizontal commonality" or "vertical commonality." be an element of the common enterprise aspect of the Howey test. But the SEC doesn’t require these elements.
  • Investment of money: One of the key aspects of the Howey test is there needs to be an investment of money. This is often satisfied by ICOs, as the digital assets are acquired in exchange of value. Either in the form of fiat currency or another digital asset.
  • Reasonable Expectation of profit: This is often the main hindrance while analysing a digital asset as an investment contract. Determining whether the purchaser of the digital asset has a reasonable expectation of profit derived from the efforts of others.

The inadvertent ramifications in the blockchain space
Arguably one of the most significant use-cases for blockchain technology outside the cryptocurrency space was how it enabled entrepreneurs to raise capital through Initial Coin Offerings.

ICOs enabled startups to break free from the bureaucratic shackles of traditional fundraising methods like an IPO or VC funding, while at the same time enabling them to reach out to a global investor base. But the reign of ICOs quickly came to an end just as quickly as they rose to fame.

A deadly combination of increased regulatory oversight and a profuse number of ICO exit scams initiated the end of ICOs, as the SEC cracked on many ICOs with “cease and desist” orders for violating the law. (according to the SEC, most ICOs are actually security offerings and hence should have registered with the SEC or applied for exemption). The destructive ramifications of these events can be clearly observed in the depreciation of ICO numbers.

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Globally the number of ICOs have fallen by over 61% to just 285 in Q1 2019. And the chances that ICO number will jump back to 2018 highs are very slim, considering the increased regulatory oversight which mandates compliance with federal securities laws.

While the new framework doesn’t create a favorable environment for ICOs to flourish, however, it does help clearly distinguish the economic transactions that are “investment contracts”. Enabling companies to structure their ICOs according to avoid any stints with the SEC.

Therefore in the US, most Initial Coin Offerings are likely to considered as a  security offering despite the fact that these crypto tokens are meant to be as instruments of utility.  Increased regulatory oversight over a nascent market such as the ICO space is likely to be beneficial in the long run by bringing in credibility to the space. But categorizing something as new and advanced as Initial Coin Offerings using laws  created decades ago doesn’t seem like the logical thing to do. That’s analogous to trying to regulate the internet with rules of how the postal service works. But regulators are gradually inching towards a more conducive regulatory environment, the SEC’s new framework on Digital assets is proof these changing perspectives.


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