Security Token Offering – A compelling regulatory opportunity for India (Part II)

For Introduction and conceptual understanding, read Part I, click here.

United States of America – An Investment contract

On April 03, 2019, the US Securities Regulator, SEC published the ‘Framework for “Investment Contract” Analysis of Digital Assets’[1] with a rider that the same is not a rule, regulation, or statement of the Commission, and that the Commission has neither approved nor disapproved its content. SEC surmises this as Additional Guidance for the Commission for scrutinizing whether a digital asset has the physiognomies of one specific type of security – ‘an Investment contract’. The Framework avers that the Federal securities laws require all offer and sales of securities, including those involving digital assets, to either be registered or to fall within the exemptions provided therein. The rationale behind this is that the disclosure norms laid down in Federal Securities Law aim to slash information asymmetry by way of warranting adequate disclosures, to in turn, guard investors.

The Framework relies on Howey’s test to ascertain whether there exists an investment contract. SEC v. Howeys[2] pertained to the application of Section 2(1) of the Securities Act, 1933 which defined the term ‘security’. The definition includes securities of more adaptable features designated by evocative terms, such as open-ended expression ‘investment contract’.

The Court, in this case, discerned that ‘Investment Contract’ in milieu of the Securities Act denotes ‘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 is immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.’ It was perceived as an accommodating principle, capable of adaption to meet the myriad of schemes conceived by those who seek the use of the money of others on the promise of profits.

Thus, the Howeys test is whether the scheme involves, i. investment of money, ii. in a common enterprise, iii. with the expectation of profits solely from the efforts of others.

The Framework remarks that the first prong of Howey’s Test is contented since the digital asset is purchased or otherwise acquired in exchange for value, whether in the form of fiat currency or another digital asset. The second prong is also satisfied, as observed by the SEC, which noted that a common enterprise characteristically exists in these circumstances.

Per the framework, two fragments of the third prong, i.e. the existence of reasonable expectation of profits and reliance on efforts of another, necessitate a comprehension of the transaction in question. Instead of laying a hard and fast principle, it has deliberated situations, the incidence of which would make it more likely that there is a reasonable expectation of profit. It stipulates that transferability or tradability on or through secondary market or platform, reasonable expectation of capital appreciation of the asset are among the listed factors amplifying the likelihood. Fascinatingly, the framework acknowledges economic realities which would signal that the presence of certain traits would reduce the likelihood of meeting the test. These include purely utility tokens, purely currency tokens, tokens where prospects of value appreciation are narrow, tokens limited for intended functionality on a network, etc.

The Framework is overtly an extension to various case laws in this regard, one among which is the DAO case. Howey’s test was applied in the Report of Investigation pursuant to Section 21(a) of the Securities Exchange Act of 1934 – DAO Exchange Act release no. 81, 207, 2017, WL 7184670 (July 25, 2017) (“The Report”). This involved a virtual organization’s usage of distributed ledger technology for the facilitation of offer and sale of tokens to raise capital. The Commission had determined that DAO Tokens are securities under the Securities Act 1933 and the Securities Exchange Act 1934. In light of this, SEC took action against Cyber Unit[3], charging Carrier EQ Inc.[4], Paragon Coin Inc.[5], Gladius Network LLC,[6] Argyle Coin LLC[7] and most recently Kik Interactive Inc.[8] all for sale of tokens to US investors without registering of offer and sale as prescribed by the Federal Securities Laws.

The Report speaks about the notion of Active Participant (“AP”) who is the architect or founder of the project or organization. The Report discusses the pivotal role of AP in reaching the conclusion that the investor Token Holder relies immensely on this role. This includes the central role played by the AP in the direction of the ongoing development of the network or digital asset as well as his continuing managerial role in decision making about the characteristics or rights the digital asset represents. On this line of logic, the Report deduced the typical presence of reliance on AP or the creator issuer.

The Report starts of advising anyone using a DAO, or other distributed ledger or blockchain-enabled channels for capital raising, to take apposite measures to conform to US Federal Securities Laws. It pronounces the applicability of the US Federal Securities laws to virtual organizations or capital raising entities. The Premise behind this is iterated therein as that automation of certain functions through this technology, ‘smart contract’ or ‘computer code’ does not remove conduct from the purview of the US Federal Securities Laws.

SEC dissected the particular DAO ICO and took note of the statements of White Paper which revealed that the DAO tokens would facilitate the participants to vote and entitle them to rewards. DAO was supposed to be decentralized, in that[9], it would allow voting by investors holding DAO Tokens, whereby votes would be administered by the code of DAO.

SEC examined that the Investors used Ethereum to make their investments in DAO evinced by DAO Tokens received in exchange. This was learnt to have constructed an investment contract under Howeys, thus discharging the first prong of Howey’s test. Investors who purchased DAO Tokens were investing in a common enterprise and reasonably expected to earn profits through that enterprise when they sent Ethereum to The DAO’s Ethereum Blockchain address in exchange for DAO Tokens. This was found to satisfy the reasonable profits expectation. It was noted from efforts of DAO’s curators and through their conduct as well as marketing materials, that they led investors to credit that they could be relied on to deliver significant managerial efforts required, to make the DAO a triumph. The Curators exercised sizeable control over the order and frequency of proposals and could impose their own subjective criteria for whether the proposal should be whitelisted for a vote by DAO Token holders. From this, it was established that the managerial efforts of others were vital and relied on. It was noted that the voting rights afforded to DAO Token holders did not provide them with meaningful control over enterprise because firstly token holders ability to vote for contracts was largely perfunctory and secondly DAO token holders were widely dispersed and limited in their ability to communicate with one another.

SEC noted the economic reality and found that on all counts, there was a derivation from the managerial efforts of others. Both by contract and in practicality, the token holders relied on the significant managerial efforts provided by the curator and co-founders. Their efforts and not those of token holders were undeniably significant ones, crucial to the overall success and profitability of any investment into the DAO.

The Report concluded on a high note, accentuating the weight of appreciating the facts and circumstances together with the economic realities of the transaction while ascertaining whether or not a given transaction entails offer and sale of a security. That being said, it is irrespective of (i) the terminology used, (ii) the nature of the issuing entity (traditional or decentralized autonomous organization), (iii) the course of purchase (Dollar or Virtual Currencies) and (iv) the form of issue (traditional certification or through distributed ledger technology)

The SEC’s framework may be more about guiding judges’ analysis in future litigation than postulating tools for an average market participant to evaluate her digital assets.[10]

Token Taxonomy Act of 2019 was  introduced in House of Representatives[11] ‘to amend the Securities Act of 1933 and the Securities Exchange Act of 1934 to exclude digital tokens from the definition of security to direct the Securities and Exchange Commission to enact certain regulatory changes regarding digital units secured through public-key cryptography, to adjust taxation of virtual currencies held in individual retirement accounts, to create a tax exemption for exchanges of one virtual currency for another, to create a de minimis exemption from taxation for gains realized from the sale or exchange of virtual currency for other than cash, and for other purposes.

Notably on July 10, in a first, the SEC approved Blockstack[12], a blockchain startup to launch a USD 28 Million Token public offering under Regulation A +.[13] Regulation A+, which was adopted in 2012 as part of the “Jumpstart Our Business Startups” Act (the JOBS Act). Regulation A+ allows an offering to be open to the general public and the securities being sold are not deemed to be restricted securities.[14] However, Regulation A+ imposes its own limits – notably that the offering is limited to US $50 million being raised in a 12-month period. Regulation A is an exemption from registration for public offerings.[15] It has two offering tiers: Tier 1 for offerings of up to USD 20 Million and USD 50 million each in a 12 months period.[16]

FINMA –Uncertificated Securities

The Swiss Financial Market Supervisory Authority FINMA issued ICO Guidelines on February 16, 2018 to provide information on how it will deal with enquiries apropos the supervisory and regulatory framework for ICO. The Guidelines establish that FINMA aspires to base its assessment on the underlying economic purpose of the ICO, more predominantly where there are hints of an attempt to outwit existing regulations.

The Financial Market Infrastructure Act 2015 (“FMIA”) construes ‘Securities’ as standardized or uncertified securities, derivatives and intermediates securities, which are suitable for mass standardized trading. FMIA defines uncertificated securities as ‘rights which, based on a common legal basis (i.e. association/ issuance conditions), are issued or established in large numbers and are generically identical. Under the Code of Obligations, the lone formal obligation is to keep a book which details of the number and denomination of uncertified securities issued and of creditors are recorded. This, the Guidance notes, can be achieved digitally on a blockchain.

FINMA delineates explicitly and rightly that payment tokens are not securities. Utility tokens are not securities if their sole objective is to bestow digital access rights to an application or service and if the utility token can truly be used in this way at the point of issue. In these cases, the underlying motivating function is to grant the access rights and connection capital markets, which is the atypical feature of securities, is missing. If a utility token is merely utility as an additional feature and mostly for investment purpose, FINMA would treat it as securities. Asset tokens which are tokens backed by real assets are unambiguously treated as securities by FINMA if they represent uncertified security and are standardized and suitable for mass standardized trading.

The issuing of tokens that are analogous to equities or bonds can also ensue prospectus requirements under the Swiss Code of Obligations. FINMA has no direct responsibility in this area but expects ICO organizers to themselves clarify these requirements. According to the draft, Financial Services Act (FinSA) prospectus requirements will become part of supervisory law. (Art. 37 Draft FinSA). The Swiss Code of Obligations and FinSA provide for a number of different exceptions and exemptions.

MANAL SHAH


[1] https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets#_ednref9 (Last visited July 07, 2019).

[2] SEC v. Howeys, 328 U.S. 293 (1946).

[3] https://www.sec.gov/news/press-release/2017-227 (Last visited July 07, 2019).

[4] https://www.sec.gov/news/press-release/2018-264 (Last visited July 07, 2019).

[5] Ibid.

[6] https://www.sec.gov/news/press-release/2019-15 (Last visited July 07, 2019).

[7] https://www.sec.gov/news/press-release/2019-72 (Last visited July 07, 2019).

[8] https://www.sec.gov/news/press-release/2019-87 (Last visited July 07, 2019).

[9] https://www.youtube.com/watch?v=49wHQoJxYPo (Last visited July 07, 2019).

[10] http://harvardlawreview.org/wp-content/uploads/2019/06/2418-2426_Online.pdf (Last visited July 07, 2019).

[11] https://www.congress.gov/bill/116th-congress/house-bill/2144/all-info (Last visited July 07, 2019).

[12] https://blog.blockstack.org/blockstack-token-sale-sec-qualified/ (Last visited on July 31, 2019)

[13] https://www.wsj.com/articles/sec-clears-blockstack-to-hold-first-regulated-token-offering-11562794848?shareToken=stc9d0bf95c1fb4b0d885b4a67673bbbeb

[14] https://www.linklaters.com/en/insights/blogs/fintechlinks/2019/july/us-sec-approves-regulated-token-offering-for-the-first-time

[15] https://www.ecfr.gov/cgi-bin/text-idx?SID=c395f9ef73e021327612e76dda074813&mc=true&node=sg17.3.230_1240.sg2&rgn=div7

[16] https://www.sec.gov/smallbusiness/exemptofferings/rega

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