Promoters,  in order to raise money to develop networks on which digital assets will operate, often sell the tokens or coins rather than sell shares, issue notes or obtain bank financing. But, in many cases, the economic substance is the same as a conventional securities offering. Funds are raised with the expectation that the promoters will build their system and investors can earn a return on the instrument — usually by selling their tokens in the secondary market once the promoters create something of value with the proceeds and the value of the digital enterprise increases.
And it is important to reflect on the facts of Howey. A hotel operator sold interests in a citrus grove to its guests and claimed it was selling real estate, not securities. While the transaction was recorded as a real estate sale, it also included a service contract to cultivate and harvest the oranges. The purchasers could have arranged to service the grove themselves but, in fact, most were passive, relying on the efforts of Howey-in-the-Hills Service, Inc.
Just as in the Howey case, tokens and coins are often touted as assets that have a use in their own right, coupled with a promise that the assets will be cultivated in a way that will cause them to grow in value, to be sold later at a profit. And, as in Howey — where interests in the groves were sold to hotel guests, not farmers — tokens and coins typically are sold to a wide audience rather than to persons who are likely to use them on the network.
In the ICOs I have seen, overwhelmingly, promoters tout their ability to create an innovative application of blockchain technology. Like in Howey , the investors are passive. Marketing efforts are rarely narrowly targeted to token users.
And typically at the outset, the business model and very viability of the application is still uncertain. The purchaser usually has no choice but to rely on the efforts of the promoter to build the network and make the enterprise a success. At that stage, the purchase of a token looks a lot like a bet on the success of the enterprise and not the purchase of something used to exchange for goods or services on the network.
As an aside, you might ask, given that these token sales often look like securities offerings, why are the promoters choosing to package the investment as a coin or token offering? This is an especially good question if the network on which the token or coin will function is not yet operational. I think there can be a number of reasons. For a while, some believed such labeling might, by itself, remove the transaction from the securities laws. I think people now realize labeling an investment opportunity as a coin or token does not achieve that result.
That might still work to some extent, but the track record of ICOs is still being sorted out and some of that sizzle may now be more of a potential warning flare for investors. Some may be attracted to a blockchain-mediated crowdfunding process. Digital assets can represent an efficient way to reach a global audience where initial purchasers have a stake in the success of the network and become part of a network where their participation adds value beyond their investment contributions.
The digital assets are then exchanged — for some, to help find the market price for the new application; for others, to speculate on the venture. As I will discuss, whether a transaction in a coin or token on the secondary market amounts to an offer or sale of a security requires a careful and fact-sensitive legal analysis. I believe some industry participants are beginning to realize that, in some circumstances, it might be easier to start a blockchain-based enterprise in a more conventional way.
In other words, conduct the initial funding through a registered or exempt equity or debt offering and, once the network is up and running, distribute or offer blockchain-based tokens or coins to participants who need the functionality the network and the digital assets offer.
This allows the tokens or coins to be structured and offered in a way where it is evident that purchasers are not making an investment in the development of the enterprise. Returning to the ICOs I am seeing, strictly speaking, the token — or coin or whatever the digital information packet is called — all by itself is not a security, just as the orange groves in Howey were not. Central to determining whether a security is being sold is how it is being sold and the reasonable expectations of purchasers.
When someone buys a housing unit to live in, it is probably not a security. For example, if the housing unit is offered with a management contract or other services, it can be a security. The same reasoning applies to digital assets. The digital asset itself is simply code.
But the way it is sold — as part of an investment; to non-users; by promoters to develop the enterprise — can be, and, in that context, most often is, a security — because it evidences an investment contract. And regulating these transactions as securities transactions makes sense. The impetus of the Securities Act is to remove the information asymmetry between promoters and investors. In a public distribution, the Securities Act prescribes the information investors need to make an informed investment decision, and the promoter is liable for material misstatements in the offering materials.
These are important safeguards, and they are appropriate for most ICOs. The disclosures required under the federal securities laws nicely complement the Howey investment contract element about the efforts of others. As an investor, the success of the enterprise — and the ability to realize a profit on the investment — turns on the efforts of the third party. So 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. But this also points the way to when a digital asset transaction may no longer represent a security offering.
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. As a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful. And so, when I look at Bitcoin today, I do not see a central third party whose efforts are a key determining factor in the enterprise.
The network on which Bitcoin functions is operational and appears to have been decentralized for some time, perhaps from inception. Applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value. And, as with Bitcoin, applying the disclosure regime of the federal securities laws to current transactions in Ether would seem to add little value.
Over time, there may be other sufficiently decentralized networks and systems where regulating the tokens or coins that function on them as securities may not be required. And of course there will continue to be systems that rely on central actors whose efforts are a key to the success of the enterprise. In those cases, application of the securities laws protects the investors who purchase the tokens or coins. I would like to emphasize that the analysis of whether something is a security is not static and does not strictly inhere to the instrument.
If a promoter were to place Bitcoin in a fund or trust and sell interests, it would create a new security. Or in my favorite example, the Commission warned in the late s about investment contracts sold in the form of whisky warehouse receipts. The whisky was real — and, for some, had exquisite utility. The billionaire has previously been in hot water with the SEC over his tweets, and insulted politicians for threatening to tax his billions.
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U.S. securities law requires disclosure within 10 days of acquiring 5% of a company, and in Musk's case, the day deadline was March SEC Chair Gary Gensler again avoided answering whether or not Ethereum is a security but added that crypto investors need more protection. The first, foundational book on blockchain technology, from the bestselling author of Wikinomics, Don Tapscott and blockchain expert.