A recent ruling by the US Securities Exchange Commission (SEC) is that Distributed Autonomous Organizations (DAOs) putting forward Initial Coin Offerings (ICOs) are to be treated as issuers of securities. I feel strongly this is misguided in the general case and that the SEC already has the precedent to establish that the sale of tokens in an appropriately-designed ICO is not subject to federal securities laws. In addition, there are opportunities for the SEC to embrace blockchain technologies in the overall running of their responsibilities in overseeing such determinations.
In https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_coinofferings the SEC is rightly cautioning candidate investors to be careful in determining the level of risk when participating in an ICO. Prudent guidance is given regarding points to consider and possible limitations for recovery that may be present in a poorly-designed ICO. But by not distinguishing a poorly-designed ICO from a carefully-designed ICO, the SEC is making blanket conclusions that are not applicable at all times.
The US Supreme Court has already established precedent in the far-reaching “Howey Test” regarding determining if a particular transaction qualifies as an investment contract or not. Should it qualify as such a security it would be subject to certain disclosure and registration requirements. Key to the many determinations in the Howey Test is the one issue of the control borne by investors and their active participation in their own investments.
The Howey Test is based on a case that was won by the SEC in the Supreme court against W.J. Howey Co in 1946 for the sale of Citrus groves to inexperienced business people who were not farmers and knew nothing of agriculture.
W. J. Howey owned large tracts of citrus groves in Florida. Howey kept half of the groves for its own use and sold real estate contracts for the other half to finance its future developments. Howey would sell the land for a uniform price per acre (or per fraction of an acre for smaller parcels) and convey to the purchaser a warranty deed upon payment in full of the purchase price. The purchaser of the land could then lease it back to the service company Howey-in-the-Hills, via a service contract, which would tend to the land, and harvest, pool, and market the produce.
The service contract gave Howey-in-the-Hills “full and complete” possession of the land specified in the contract and left no right of entry or any right to the produce harvested.
The finding was that the lack of investor control in the use of the investment dictated the investment to be a security. Thus it was subject to SEC controls. And in 2017, the Howey Test continues to be used to determine whether an investment is considered formally a security or not.
So any given project’s ICO may or may not be considered a security by the way it is designed and the smart contract associated with the tokens executes. What distinguishes a “poorly-designed” ICO from a “carefully-designed” ICO in regard to treating the ICO as being a security or not being a security? A token intended not to be a security but failing the SEC’s sniff test would be poorly-designed. A carefully-designed ICO can readily be seen (or should readily be seen) by the SEC not to be a security by the explicit involvement of token holders in the running of the project.
Blockchain technology can even help in this regard and, in turn, help in other areas of SEC purview. The smart contracts of ICO tokens can have parameters implementing the active participation of token holders, for example, by participatory voting mechanisms. Smart contracts engaged by the SEC can then scan ICO smart contracts for anything that looks like it might be a security characterized by its lack of control by participants. Upon failing such a sniff test, the SEC could automatically blacklist the contract address until an application for a security was filed and approved.
In contrast, the purchaser of the carefully-designed smart contract would be able to prove to the world manifestly that not only are they experienced in the purchase of the product (namely information technology programming smart contracts) on offer, but that they are taking an active role in their participation by exercising their control in the project they’ve obtained from their investment. One way to do this would have the purchaser sending a notice of acknowledgement, (perhaps signing and broadcasting a transaction on an SEC blockchain) to the SEC that they are capable of determining in their own capacity of having applied the Howey Test. In so doing, they declare they are accepting the risks of investment in securities and their responsibility to participate in the project whether or not they actually take the time to do so.
Should a token holder choose not to participate, that is not a failing of the Howey Test where investors were wholly preventing from participating.
And while they are at it, blockchain technology has even more to offer the SEC in their own running of their organization. Examples on page 122 in the https://www.sec.gov/about/secpar/secafr2016.pdf Agency Financial Report for the fiscal year 2016 illuminate hundreds of millions of dollars of unaccounted spending and revenues preventing the report from being audited. This was because of the timing differences between obligations reported in SEC’s financial reporting system and the data transmitted to http://USASpending.gov through the central Federal Procurement Data System.
Blockchain technology offers the SEC the opportunity to connect the procurement systems to their reporting systems, where they are able to stem the tide to ensure that staff operating their systems are not without the appropriate authorizations. SEC staff need to become trust-less and are so empowered by the blockchain. The SEC admits in their report they are seeking ways to ensure their systems are not only secure but also up-to-date, for example, that accounts are deactivated. They further admit that they are in breach of their own policies using the established practices. Something needs to change.
To address this, SEC could apply the answer they give themselves as shown on page 139 of their report, reading “In your statement, you discuss the SEC’s IT requirements-gathering process and management of the SEC’s protective security force contract”. Alternatively, the SEC could secure their systems with a blockchain and by issuing each user with a wallet, the records of authorized expenditure, payments to anonymous third parties and procurement would resolve the need for auditing and would also fix the timing issues on flow of funds, they are currently facing. Perhaps this is a better implementation approach than utilizing a security force contract or whatever they mean by a security force contract.
And so I believe the SEC can have an important role in this new world of tokens and the blockchain, but not as a regulator. The SEC would transition themselves from a regulatory authority to an Oracle of advisory, assisting the traditional fiat leaders as they transition their enterprises to fully compliant, trust-less, self-governing nodes which create value. This is in contrast, rather, than enforcing tests by special protectionist interests and thus significantly altering the costs of performance and risk in non-compliance to external rules. Such are the cause of constraints to US-based innovators, investors and consumers of products and services.
This new world reifies a market that, with an appropriately-designed ICO token, distributes active participation and decision making for not even the cost of $1.00. Such an ICO is an amazing opportunity for investors to take an integral role in the projects in which they are investing to make successful, should they choose to do so. But even should they choose not to participate, it is my opinion that very potential ensures the investment is not a security in light of the SEC’s own sniff test. This demands careful attention to the design of ICO tokens.
