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The Howey Test: The Fine Line Between a Security Token and a Utility Token – Thought Leaders

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The Howey Test: The Fine Line Between a Security Token and a Utility Token - Thought Leaders

The Securities and Exchange Commission’s recent barrage of crypto-related firms and investments with enforcement actions tells a story that has long been a mystery to many. Two of these prominent cases made headlines in June. The first, a case against a social media platform, Kik, and Kin foundation – the foundation governing the operations of the Kin ecosystem. The second was against Longfin Corp, a fintech company that “offers commodity trading, alternate risk transfer, and carry trade financing services.”

While many expect more of such crackdowns, the back and forth between the SEC and these companies have somewhat opened fresh controversies surrounding the viability of the regulatory framework governing digital securities and tokens. In light of this, it is important to examine the arguments from both sides of the divide to fully acknowledge the critical nature of the situation and its implications on America’s investment landscape. But first, let’s explore the actions/inactions of Kik and Longfin that might have forced the SEC to sue them.

SEC vs Longfin

In April 2018, the SEC froze the trading profits generated from the sales of Longfin’s stock, which the regulator accused of selling unregistered shares after acquiring Zidduu.com (a crypto trading company). In June 2019, SEC filed fraud action against the same company and its CEO, Venkata S. Meenavalli. The released complaint claimed that Meenavali had “conducted a fraudulent public offering of Longfin shares” by misleading investors on the financial standing and mode of operation of its company’s crypto-related business.

SEC vs Kik

On June 4, 2019, the SEC officially took legal action against Kik Interactive Inc. for conducting an illegal $100 million securities offering of digital tokens back in 2017. If you will recall, Kik was one of the many companies that capitalized on 2017’s ICO boom to raise money for its blockchain ecosystem. SEC asserted that Kik’s fundraising campaign was illegal because the company sold $55 million worth of tokens to US investors without registering the offers or sales.

Secondly, the complaint alleged that at the time of the fundraising campaign, none of the products and services that Kik had implied would drive the demand for Kin tokens did not exist. Also, the watchdog claimed that the revenue-sharing clause that featured in the Kin offering campaign established that the Kin token is a security. This is true since the campaign failed the Howey test as it  promised profits “predominantly from the effort of others” to build an ecosystem and drive the value of the token.

And so, SEC based its case on Kik’s failure to comply with the registration requirements under U.S. securities law and the omission of information that would have helped investors make informed decisions. It is worthwhile to note that Kik had released a strong response to SEC’s initial claim.

Although there was no clear framework to guide the conduct of ICOs or digital security offerings in 2017, that has not stopped SEC from litigating companies that had sold digital tokens years before regulators issued guidelines.

 

The Howey Test Controversy

From the details of the highlighted charges, it is clear that funding a business or company through fabrication or manipulation of information is, by the standard of current securities law, a punishable act. This is also true for investments that do not comply with existing required financial disclosures. However, as argued by David Weisberger (co-founder and CEO of CoinRoutes), the current financial disclosure requirements are not effective when it comes to giving investors insights on the viability of the investments.

In its true sense, existing securities laws only require the disclosure of information about the issuer and its finances. As such, Weisberger argues that there is no way investors would use such information to judge the prospect of digital tokens. Using Kik’s travail with the SEC as a case study, he explained that if Kik had followed due process and complied with registration requirements, it still wouldn’t have given investors a hint that the price of the token would today worth far less than what it had sold for in 2017.

Nevertheless, as SEC puts it in the complaints, before the commencement of the Kin promotional campaign, Kik was in dire need of funds, as its expenses had consistently trumped its revenue. If Kik had informed prospective investors about its financial predicament, many would have had a rethink. As such, there is no doubt that such information would have helped investors to make informed decisions.

The Howey Test: The Fine Line Between a Security Token and a Utility Token - Thought Leaders

Also, SEC’s released a clarification on the Howey test, which explains the factors that determine whether a digital asset is a security or not, showed that many of the tokens out there are securities. Perhaps, the most interesting piece of information in the 13-page document is the one that revealed that companies must have working products before embarking on fundraising campaigns.

Again, this clarification implicates Kik and many of the organizations issuing digital tokens, as it is common practice for startups and established companies to base their ICO campaign on fictional products.

Some history 

To fully appreciate the controversy surrounding the “security” and “utility” conversation, one must take a look at the origin of the Howey test way back in 1946. Back then, a company, the Howey company, introduced an investment scheme that would allow investors to buy a fraction of its orange groves, with the hope of making returns on the profit made from selling the cultivated oranges. 

Following the introduction of this scheme, the SEC, while claiming that the terms of the investment meant that it was security, moved to block the sale. What ensued next was a hard-fought legal battle that dragged to the supreme court. Eventually, the supreme court ruled in favor of the SEC. And so the definition of securities established in this case has since been the de facto framework for defining securities till this very moment. 

The Howey Test: The Fine Line Between a Security Token and a Utility Token - Thought Leaders

No respite for digital (utility) token issuers

The commitment of the SEC to establish a standard and enforce securities laws on firms that had once found a way around regulatory structures will undoubtedly change the outlook of the digital asset markets. While some crypto firms have taken up the defensive stance to fight the imposition of these new directives, others are working closely with regulators to establish clear rules and to guarantee investors protection.

There is no doubt that the present regulation narrative is stifling the growth of the crypto sector in this part of the world, as established companies like Coinbase are yet to find their footings. It does not help that even after complying with the SEC’s regulations, companies have to deal with the various regulatory provisions of each state.

But it is also true that things would have deteriorated had regulators chosen to stay on the sideline. For one, the surge of scams that punctuated the ICO era of 2017 would have continued as investors had no means of ascertaining the legality of tokens. Only now some cases are becoming public, such as notorious ICOBox violating securities laws with its 2017 token sale and further activity promoting other initial coin offerings (ICOs) or an extortion case Nerayoff and Hlady. There are many more cases like this that are yet to become public. The SEC’s primary goal is to protect investors. And as argued by CEO and co-founder of Symbiont, Mark Smith, it is up to firms to look for ways to work with regulators to define the fine line between utility and security. This right here is the step forward, rather than the common practice of bypassing existing laws. 

Nonetheless, if the SEC were to change its stance and introduce new securities laws, creating a subclass of tokens issued to investors to fund for-profit organizations will go a long way to help the watchdog update the 70 years old Howey test. In turn, the establishment of such an asset class will help the SEC to formulate an adequate framework to govern the exchanges and dealers that trade them.

Interestingly enough, the US House of Representatives has taken the initiative to reintroduce a taxonomy act that would exclude digital tokens from the broad definition of securities. To achieve this, the legislators plan on amending the security acts of 1933 and 1934. Having said that, the implication of such a development, which will be treated in a separate article, would kick-start a domino effect. 

Conclusion

SEC’s reinvigorated approach to digital tokens and security laws has not come as a surprise. The ICO abuse of 2017 was just an anomaly brought about by the change of guard in SEC’s leadership after the swearing-in of President Donald Trump. For this reason, digital token issuers must ensure that all their operations fall within the confines of the law, as there are no more free passes. 

We now have 2 great examples of SEC approved Reg A+ compliant offerings: Blockstack and Props

P.S. IT’S OFFICIAL!.Ether is a commodity.

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Constantin is a venture partner at BitBull Capital, CBO at ABOTMI, and has been a cryptocurrency investor since 2012. He has 10+ years experience in corporate leadership, technology and finance. He contributes to the digital asset space, sharing and value economies.

Regulation

HODL Your Hoopla Over SEC Changes For Exempt Offerings – Thought Leaders

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HODL Your Hoopla Over SEC Changes For Exempt Offerings - Thought Leaders

Last week the The U.S. Securities and Exchange Commission released a proposal – that has yet to become regulation – to simplify how exempt offerings are done. Shortly thereafter, a flurry of articles and newsletters made their way through the digital asset industry – many of which suggested their platforms were already being modified to fit the new rules. While the SEC has proposed changes, time will tell whether the proposal is adopted  – and if so, whether there will be changes to the final draft that will be published to the Federal Register.

The US exempt offering framework includes tools such as Reg D, Reg A, crowdfunding (a.k.a. Reg CF)  – essentially everything that is not a public or retail offering. This framework has seen little in the way of changes or modernization since the Securities Exchange Act of 1934. There has been significant public criticism of the current rules for exempt offerings, largely because they reserve access for only the wealthiest Americans to invest in private funds, companies, and other offerings.

If passed, the proposed changes could allow for the average person to invest in earlier stage deals – such as Uber or WeWork – before they reach their lofty valuations and dumped into the public markets. Enabling SPV (special purpose vehicles) and harmonized reporting (ie combing Reg D and Reg CF into one, not two reports), and increasing the total amount that can be raised would help streamline compliance for issuing firms. Additionally, the changes could also enable crowdfunding to become a viable capital formation tool for investing in such asset classes as real estate.

Currently, US offering exemptions such as Regulation CF (crowdfunding) are quite restrictive, limiting the total amount you can raise to $1.07M USD per 12 month period and includes significant restrictions per investor.  The US SEC appears to be following the lead of other jurisdictions such as Canada where regulators proposed similar changes, or Europe where regulations were updated last year, increasing the limits for the EGP (European Growth Prospectus) to €8M EUR, a little over $9M USD. According to the new proposal, companies would be able to raise up to $5M USD. While $5M is still a relatively small amount of capital, it does allow early stage companies to build their tribe with a broader investor base.

The SEC proposed similar changes to Reg A, increasing the upper limit to $75M USD. This could make Reg A viable for many later stage companies where larger Series B, C, or even D rounds demand more capital than what is currently available in Reg A.. This also opens up these investment opportunities to the retail investor, previously these deals were only available to the wealthiest corporate venture firms, private equity shops, and high net worth individuals.

Further changes include allowing accredited investors to participate in crowdfunding. Previously, if you used a crowdfunding exemption, you could not accept funds from accredited investors and would actually have to use another exemption, such as Reg D, simultaneously. This typically forces companies into more paperwork, legal fees, and an increased risk of getting something wrong – which could result in regulatory or civil actions. The proposed changes would enable companies to combine accredited and retail investors into one offering.

Aside from accredited investors, the changes also open the doors to institutional and corporate investors, including the SPV (Special Purpose Vehicle).

An SPV is a corporate entity created for a specific purpose – usually for reasons such as limiting liability, tax efficiency, investment, or capital formation. For example: In order to tokenize a piece of real estate, you might form an SPV, and transfer the deed to the real estate into this company. The purpose of that company/vehicle is to hold the deed of this real estate and maintain a accurate record of who the owners are, SPVs are commonly used for investment funds as well.

Combined, SPVs, corporate investors, accredited investors, and major institutional investors can move large amounts of capital. However, they weren’t able to invest in crowdfunding offerings in the US. This created an interesting paradox for companies raising capital, if you could get the big fish interested, you would avoid the crowd – but, if your offering didn’t look good enough for professional investors, your last resort may be crowdfunding. The crowdfunding industry as a whole has faced a lot of criticism from professional investors for low returns and low deal quality, this is likely to change when retail investors have access to the same deals as larger institutions.

Finally, the new crowdfunding regulations propose several major changes to how much each investor can put into any one offering. Currently, investors who do not meet the accreditation thresholds were limited on how much they could invest based on the lower of their income or net worth. The new regulations would change this to the greater of those two. These changes are expected to not only fuel innovation, they are likely to bring in a lot of smart money as well.

For example, an investor with a net worth of $750,000 and an income of $150,000 couldn’t qualify as an accredited investor. This person has a Phd in bioscience and finds a startup with a revolutionary innovation in the field of bioscience – they are not qualified as an accredited investor and barred from investing. Ironically, they can be an advisor to any institutional investor on why this particular startup is so hot – but under the current rules, they are not qualified to risk their own money.

While these changes are welcomed by most market participants, they are not a sure thing. This proposal for a new exempt offering framework is not yet regulation, it still has to make it’s way through the government and be entered into the Federal Register. Looking back at the proposals for crowdfunding in the US we can see how different a proposal can be from the regulation – and there are still a lot of lobbying dollars that want to see the status quo maintained. It is important to not make important business decisions based on this proposal – rather, look at these changes as a larger trend among securities regulators globally.

We’re seeing securities regulators trying to make easier for distributed capital formation. Crowdsales and crowdfunding are actually becoming something that the regulators across around the world are working together to harmonize their frameworks. By combining the crowdfunding regulations from jurisdictions around the world, early stage companies would be able to access global capital and build a global investor base, without being forced to break the rules like most of the ICO and STO issuers are doing today.

Perhaps the most exciting thing about the SEC’s proposed changes is how they demonstrate a very coordinated effort among securities commissions globally. As this new era of capital formation emerges, businesses will be able to combine and leverage the regulatory frameworks of multiple countries. That being said, for US based offerings, we still have to wait for the new regulations before knowing what they will look like, or their impact on the digital securities industry.

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Regulation

Why EU blacklisting the Cayman Islands matters for the STO industry – Thought Leaders

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Why EU blacklisting the Cayman Islands matters for the STO industry - Thought Leaders

On February 18th the European Union added the Cayman Islands to its tax haven blacklist. While this has not made the news in the security token industry, it has had major implications. Due to the strict demands of AML & KYC in many jurisdictions, regulators are focusing more resources on beneficial ownership, tax transparency, and enforcement.

For companies raising capital, the blacklisting means you should not take money from a Cayman fund if you’re a European issuer. In the EU, a lot of the investment in security tokens, real estate, and private equity comes from or through Cayman fund structures. Cayman is also where a large portion of American VC funds are domiciled.

The current tax haven blacklist also includes American Samoa, Fiji, Guam, Oman, Palau, Panama, Samoa, Trinidad and Tobago, US Virgin Islands, Vanuatu, and Seychelles.

Any company taking funds from a Cayman domiciled fund, or working with a platform/issuer/bank in that market should be aware that being associated with a blacklisted country could create significant new risk exposure for your project, and possibly yourself. These changes are effective immediately. Until recently, most firms could fly under the radar but the EU is also rolling out a public registry of corporate ownership. This will not only make non-compliance much easier to spot but also increases the ability for regulators in the EU to investigate and enforce.

The regulation could impact people working at (including directors, officers, or significant shareholders) a company that received funding from a Cayman source after the blacklist date. Enforcement severity changes by country but can include criminal charges, company seizure, and known associates may end up on a variety of sanctions and watch lists. Not to mention the reputational damage.

This is a good example of why a good AML program does not only consist of face matching a document and pinging an API to name match a sanctions list – you are opening up your venture, and most likely yourself, to massive liability. Your legal and regulatory obligation is to take a risk based approach. What that looks like can change by country, transaction value, activity history, etc., so AML program needs to be dynamic, robust, and comprehensive enough to catch things like narrative sanctions.

For example: The most popular security token platforms today only use KYC for digital onboarding of natural persons – not corporate entities. However, when you look at the investors in their previous token issuances you can see that most of the funds are coming from corporate accounts, corporation owned wallets, but the on-chain transaction and KYC is done by an individual. These platforms are missing the technical capabilities to spot transactions coming through blacklisted jurisdictions such as Grand Cayman.

iComply recently helped a virtual asset exchange pass the audits needed to offer their users the ability to spend virtual assets, such as Bitcoin and Ethereum, with a Visa card. This process involved independent audits from Visa, their banks, and regulators – each wanted to see the client demonstrate how they would be able to identify these risks and fulfill the requirements of a whole web of regulations.

Now that they have passed the audit, they are first to market with a very compelling offer compared to their competition who still have months of development on their AML systems before their applications will go through. Using iComply to get ahead of the regulations has also put them ahead of their competition.

We can expect the same for the security token market. Token issuers need to pay close attention to their AML compliance – Telegram had to refund over $1B USD over AML, has spent millions in court with the SEC, and the OCC has not even started with them yet…after that, how many of their “not investors” will be ready to jump onto an investor class action lawsuit? We have already seen this with the recent OCC case against MYSB in New York, or with the SEC and AirFox in Boston.

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Regulated Digital Assets Take Over in 2020 – Thought Leaders

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Regulated Digital Assets Take Over in 2020 - Thought Leaders

2018 was the highwater mark for initial coin offerings (ICOs), when 1,253 new coins raised $7.8 billion. In 2019, this “Wild West” market went from boom to bust. Dollars raised in ICOs plummeted 95% compared to 2018, and the Securities and Exchange Commission (SEC) continues to announce new actions against various ICO players for fraud and unregistered issuances. The sheriff has come to town.

Regulation, my old friend

It’s no consolation to investors who lost millions in ICO scams, but they were part of a natural market evolution. The laws governing traditional securities were also originally inspired by bad actors like “bucket shops” that emerged as another new technology, the telegraph, was changing financial markets. The SEC’s decision to crack down on digital assets and apply those same laws to blockchain securities is good news for market participants.

Blockchain securities have the potential to increase efficiency, lower costs, provide greater transparency and mitigate risk. However, the financial industry can’t fully realize the potential of blockchain securities without a public market and regulated ecosystem to support their full lifecycle. That means fully compliant issuing, investing, trading, settlement and custody.

Governments around the globe are working to establish the necessary frameworks in their own jurisdictions. This is lowering the risk of investing in blockchain securities by introducing investor protections associated with traditional markets. Although different jurisdictions have different requirements for regulated entities, investors, traders and users, there are four common areas being addressed:

  • Distribution – how are security tokens created and why, and how are they delivered to their owners?
  • Custody – where is the ultimate record of ownership kept and by whom?
  • Reporting and Record Keeping – what additional regulatory requirements are placed on participants such as transfer agent services?
  • Specific Processes – what additional processes are required, for example, in order to move security tokens between personal and master wallets?

The SEC and the Financial Industry Regulatory Authority (FINRA) have established guidance in all four areas through a series of communications including the report on The DAO and a joint statement on broker-dealer custody of digital assets. The necessary U.S. framework is finally in place to allow regulated, public trading of blockchain securities to blossom.

If the juice don’t look like this

In parallel with these regulatory developments, companies have rushed to create the necessary market infrastructure. Critical components are in place and more are coming this year. The question for those considering whether to participate: is the juice from this 2.0 version of digital assets worth the squeeze? The answer will be yes if the blockchain securities market looks like an upgrade of traditional markets, which would require that it offers two key benefits to investors and companies looking to raise money.

The first is efficiency. Blockchain securities need to eliminate the cumbersome data systems and manual paper-based processes of traditional securities trading. The potential is there but execution is everything as the saying goes. Implemented correctly, blockchain can efficiently support the entire lifecycle of digital assets from issuance and investing through trading, settlement and custody.

The second benefit is smart oversight. To be viable over the long term, the blockchain securities market needs to be fully compliant not only to satisfy regulators, but to create liquidity. It needs to supply investors with convenient access to transparency, account safeguards, and regulated trading. This will require integration with traditional brokerage accounts as well as intuitive user interfaces.

I’ve become so numb

I was hoping to get through this article without using “disruption” because I know we are all numb to the concept. Unfortunately, I keep hearing that blockchain securities will disrupt financial markets. I’ve said it myself! But the reality is that blockchain securities are an evolution not a revolution. The same year that ICOs peaked at $7.8 billion, the traditional US securities industry raised $2.4 trillion. For blockchain securities to become a mainstream asset class, they can’t remain on the island of personal wallets. They need to be bought, held and sold by retail investors, institutions, and advisors through traditional trading systems and brokerage accounts. That could happen as early as this year.

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