The takeaway: The SEC’s statement acknowledging that Ether is not a security is beneficial for the crypto community because it provides market participants the opportunity to gain valuable insight into how regulators are thinking about token issuances. While BTC and ETH are largely being grandfathered in, the SEC’s stated framework implies that all future token issuances will be subject to securities regulation from inception. The critical question moving forward is determining the point at which a network becomes so “sufficiently decentralized” as to no longer constitute a security. This question is not new — courts and regulators have examined the issue of declining information asymmetry between promoters and investors in other industries, with the results largely being that line-drawing in this area is a futile endeavor due to the fact-specific nature of the analysis. This means regulatory uncertainty will persist for utility token issuances, further rendering them an inferior means to raise capital as compared with tokenized securities.
As I’m sure you heard, the SEC released a statement a little over a week ago confirming that current offers and sales of Ether are not securities transactions. The results post-release were largely as we’ve come to expect from the crypto world — wild price swings with BTC and ETH rising dramatically (ETH by as much as 10%), optimistic crypto proponents announcing a huge win for token proliferation, lawyers decrying the announcement as an abdication of responsibility and a veritable Twitter explosion of pseudo legal analysis (some good, some less than stellar) trying to explain what exactly the SEC’s statement means for the regulatory environment. For all the content out there on the release, I haven’t read anything that adequately captures the full picture. This blog post will attempt to do exactly that. As always, I welcome questions, comments and feedback on everything I write.
Token legal disclaimer…
The information contained in this article is provided for informational purposes only and should not be construed as legal advice on any subject matter. You should not act or refrain from acting on the basis of any content included in this article without seeking legal or other professional advice.
The Precedent
Let’s explore the potentially grimy world of viatical settlements for a moment. The situation is as follows: (1) a terminally ill patient with a life insurance policy would like to financially benefit from that policy prior to dying and (2) investors are willing to purchase interests in the patient’s death benefit at a discount reflecting the time value of money invested plus a profit. This is a transaction in which both parties may benefit — the patient, who wishes to spend today, is able to bring a future cash windfall into the present and the investors, who wish to accumulate additional dollars for tomorrow, are able to earn a percentage on their starting cash balances.
Firms exist that serve as matchmakers in this market — we’ll call them “viatical settlement providers” or “VSPs.” A VSP scours hospitals for the terminally ill, evaluates the patient’s insurance policy, analyzes the patient’s medical records, develops an expected death date, offers the patient a lump sum, sells fractionalized interests in those death benefits to investors, takes over the premium payments and distributes the proceeds to the investor group once the patient kicks the bucket (whew — that’s a lot of work). At the extremes, this transaction has ethical implications, but let’s assume a world of good actors. The patient does not lie about his illness and the VSP pays a fair, time-discounted value of the policy to the patient in order to receive the full death benefit once the patient dies. Has the VSP sold securities to its investors?
This is a Howey analysis! Most of the crypto community has this test memorized by now, but for the uninitiated — a contract is an “investment contract” subject to securities regulation where a person:
1) invests his/her money;
2) in a common enterprise;
3) with the expectation of profits;
4) solely from the efforts of the promoter or a third party.
Analyzed under this standard, the VSP’s investors have certainly (1) provided money, (2) in a common enterprise and (3) with the expectation of profits. But (4) have they really relied solely on the efforts of the promoter or third party?
It is a bit of a funky question because the profits in large part depend on the insured — that is, the more quickly the patient dies, the higher the profit. If the patient lives for a long while after receiving the payment, the investors will earn less money (and potentially lose money) as the death benefit loses value the further into the future receipt of it is pushed. Sure, the VSP does a ton of work in the lead up to the contract, but once the contract is executed, the primary determining factor in value delivered to the investors is the patient. More succinctly, the VSP lays the groundwork and, other than ancillary tasks, the “success” or “failure” of the enterprise depends on something outside anybody’s control (the patient’s death). Interpreting the fourth prong of the Howey test, and in particular determining whether a promoter fading from driving profits causes a contract to fail the Howey test, is something that split the circuit courts in SEC v. Mutual Benefits Corp (11th Circuit) and SEC v. Life Partners (DC Circuit).
Life Partners answers in the affirmative — where “the value of the promoter’s efforts has already been impounded into the promoter’s fees or into the purchase price of the investment, and if neither the promoter nor anyone else is expected to make further efforts that will affect the outcome of the investment, then the need for federal securities regulation is greatly diminished.” Mutual Benefits rejects this line-drawing exercise completely — there, the court states that “significant pre-purchase managerial activities undertaken to insure the success of the investment may also satisfy Howey.” What’s a company to do? Are they issuing securities or not?
These viatical cases are relevant because they address the key question the SEC is trying to answer in the world of crypto networks — whether the time of sale of the contract represents a line of demarcation after which a promoter’s efforts are required in order to bring the contract within the realm of securities law. Where Life Partners is the standard, there exists a path to a world in which certain tokens are not securities from inception. Where Mutual Benefits is the dominant position, tokens almost certainly fall within the securities regime at issuance due to the heavy lifting done by the entrepreneurs, architects and engineers in the developmental stages.
The next section of this article will analyze whether the SEC has actually drawn this line in their statement, whether they will attempt to do so and whether their statement provides any insight useful for companies to ensure regulatory compliance. Good news is the crux of the statement can be broken down into the three quotes I analyze below.¹
The Breakdown
The starting place is always policy — agencies like the SEC are tools for advancing political objectives, so accurately predicting regulatory outcomes necessarily begins with an analysis of what the relevant regulatory body’s objectives are. I’ve written at length about these objectives in the world of securities regulation. The quick recap is that the rules and regulations exist to protect the little guy — as I wrote earlier, the SEC takes “a protectionist view that mom and pop investors are gullible, ignorant and easily taken advantage of by fast-talking businessmen and bankers.” To protect retail investors, the securities laws impose antifraud liability and mandate disclosure to ensure those retail investors have adequate data (and confidence in that data) to make an informed investment decision. William Hinman, Director in the Division of Corporation Finance and deliverer of the SEC’s statement, however, starts from a corollary to those objectives.
“The impetus of the Securities Act is to remove the information asymmetry between promoters and investors.”
His is an interesting place to begin because it does not really lead to the conclusions he eventually draws. Therefore, I will make a quick distinction between what Director Hinman says and what I think he really means. Removal of information asymmetry is a mechanism for accomplishing an objective of securities law, not the objective itself. To clarify — if we assume Director Hinman is correct about the “impetus” of the Securities Act, then how do we answer the question of whether a promoter can stop disclosing information? The logical conclusion is that the promoter can never stop disclosing! It runs counter to the “goal” of ensuring promoters don’t know anything their investors do not.
I’ll propose a different starting point (hint: see first paragraph in this section above) — the impetus of the Securities Act is to protect retail investors by ensuring they have adequate data to make an informed investment decision and a path to attain remedies if/when they are taken advantage of. A method for ensuring the investors have adequate data is to require disclosure of relevant facts where there are information asymmetries between the investor and a third party who will be responsible for utilizing the investor’s money and managing the risks facing an enterprise. Director Hinman gets to the same point later on:
“…learning material information about the third party — its background, financing, plans, financial stake and so forth — is a prerequisite to making an informed investment decision. Without a regulatory framework that promotes disclosure of what the third party alone knows of these topics and the risks associated with the venture, investors will be uninformed and are at risk.”
According to the SEC, the disclosure requirement follows nicely from the policy objective. 1) Protect investors by enabling them to make informed investment decisions. 2) Enable investors to make informed investment decisions by mandating disclosure.²
Who has to disclose? Any third party on whom the investors are primarily depending to ensure the success of the enterprise. Thus, when there is no third party on whom investors are depending, there is no need for disclosure. From Director Hinman:
“If the network on which the token or coin is to function is sufficiently decentralized — where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts — the assets may not represent an investment contract. Moreover, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede.”
From this the SEC concludes that Ether is not a security because the promoter function does not exist in a sufficiently decentralized enterprise. But notice the qualified language — he uses the phrase “may not represent” above, and the rest of the release is littered with “may no longer represent a security,” “may be other sufficiently decentralized networks…where regulating…them as securities may not be required.” The SEC is not drawing a bright-line rule or creating a safe harbor (and of course they are not dictating policy —recall that this is just a statement). They are certainly not, as others suggested, abdicating their responsibility. Quite the opposite — they are acknowledging that each token issuance is a unique event with unique facts and circumstances that require an independent analysis to determine whether it falls within the realm of securities law. Importantly, this is an accurate representation of the current state of the law as interpreted by the courts!
Pragmatically speaking, how much help is this really for companies trying to issue tokens?
The Conclusion
Let’s return to viatical settlements (investors trading death benefits) and the Life Partners and Mutual Benefits cases. Recall that Life Partners advocated a bright-line approach to evaluating Howey’s fourth prong — investors must rely on the promoter post-contract sale in order to pass the Howey test and be subject to securities regulation. Mutual Benefits refused to engage in any line-drawing activity, instead stating that both pre- and post-contract sale efforts by the promoter must be taken into account in determining whether a contract qualifies as a security. The SEC is saying the latter, implicitly adopting the Mutual Benefits approach. Note that Director Hinman specifically excludes the initial issuance of Ether from his analysis:
“And putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.” [Emphasis added.]
At the moment of initial issuance, when a network to that point has been entirely dependent on the efforts of a promoter, it is impossible under Mutual Benefits not to label it a security. The SEC acknowledging that Ether is not a security is a good thing, but I think most people already believed it was not. The real takeaway is that adopting the Mutual Benefits analysis means it is practically impossible for an initial token issuance to fall outside the realm of securities regulation…BUT THIS IS NOT A BAD THING!
Let’s take a look at the SAFT approach (by which I mean issuing a security that eventually becomes something else freely tradeable and which the SEC’s statement explicitly acknowledges as a potential outcome). This paper does an excellent job detailing why case law does not really support the SAFT framework and I tend to agree, but for a much simpler reason — policy. The SAFT approach involves an initial issuance of securities with all the attendant rules, regulations and protections that come with it. Practically speaking, these initial issuances will only be available to the wealthy. Only further down the line, once the items in question are no longer securities, will they be available to common investors. Imagine you’re a regulator with a mandate to protect mom- and pop-investors — would you support a scheme in which the wealthy benefit from the protections of securities laws and then are able to dump a product to the masses once those protections no longer apply? Probably not.
The SEC’s statement generated a great deal of excitement around the idea that a path exists for tokens to not be regulated as a security, but that is a Maginot Line. It does not practically address the real issue at stake for issuers: compliantly raising capital. The real problem is that the approach certain legal advocates are promoting is flawed. By aiming to transform a security into something else at an uncertain future date, the SAFT implicates uncomfortable questions for which a facts and circumstances analysis must be applied, guaranteeing a company can never act with regulatory certainty. When is a network “sufficiently decentralized”? Should a governmental agency be the gatekeeper for mass adoption of a product? Is this approach equitable or does it primarily benefit the wealthy? These are the questions that must be answered under the SAFT approach, and they are largely unanswerable in a generalized manner.
There is a better way forward here: issue security tokens under the existing regulatory framework knowing that, as regulations evolve, the smart contract structure of these tokens will enable companies to evolve with them. Security tokens (1) remove regulatory uncertainty for issuers by operating on the well-trodden path of securities issuances, (2) provide both protections AND upside for investors by subjecting promoters to the rules and regulations of the securities regime while directly connecting returns on an investment to a company’s cash flow and (3) enable regulators to advance their policy objectives in a proactive way by coding non-compliance out of existence. No more trying to fit a square peg into a round hole — it is a difficult, unnecessary and uncomfortable exercise. Instead, companies ought to utilize security tokens as a superior financing product, simultaneously realizing value while unlocking liquidity for their investors.
Like what you read? Check out Welcome to the Jungle and The Rube Goldberg Machine for more information on these topics.
Soon to come on this channel: Considering a New Regulatory Framework, Tokenized Airdrops and much more
Footnotes:
¹ A quick aside to preempt some sketchy legal analysis floating around out there — although the Howey standard uses the word “solely,” courts have largely read that language out of the test. The leading case in this area is SEC v. Glenn W. Turner where the 9th Circuit noted that a literal interpretation “could result in a mechanical unduly restrictive view of what is and what is not an investment contract.” For example, what if Howie required purchasers to work the land and pick oranges one day per year? The securities regime could be easily avoided simply by having investors exert a speck of effort. Instead, the “solely” prong is a question that analyzes “whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.” In that way, the answer in Mutual Benefits and Life Partners is not as simple as “the promoter isn’t the only one doing the work.”
² I’ve hinted before that I don’t really believe mandated disclosure is necessary to ensure investors are adequately informed. One of these days I’ll write about the incentive structures facing promoters and why high value firms are adequately incented to disclose material information to their investors as a signal of that value. It is the lemons problem all over. But I digress…
