Those hoping for clear direction were likely disappointed by the long-awaited document
by Rakesh Sharma
Could the SEC finally be warming up to ICOs? Two developments over the last week at least suggest they’re high on the agency’s priority list. But, as with all things crypto, these developments raise just as many questions as they answer.
First, the agency released guidance on its site Friday outlining a framework for startups to help them evaluate their token’s status, a notorious point of contention between crypto entrepreneurs and the SEC. Throughout the short lifespan of ICOs, entrepreneurs have sought investment by marketing their coins as utility tokens. This, they presumed, would allow them to circumvent the high disclosure costs and processes associated with registering securities.
But then the SEC came knocking.
Also on Friday, the SEC issued a no-action letter to TurnKey Jet Inc., a private jet company that intends to issue tokens for use on its platform. The letter greenlights TurnKey’s coin offering of TKJ tokens as long as they adhere to the rules outlined by the agency. These rules include issuing immediately usable tokens and restricting token transfers to TKJ wallets.
What Does the SEC Say?
For those clamoring for a revision to securities laws, the SEC’s 13-page guidance document (read it here) might come as a disappointment. It reiterates the importance of applying the Howey Test to determine the status of a token.
As a refresher, the Howey Test uses four criteria to determine if investment offering — any offering, not just tokens —should be classified as a security:
- presence of an investment contract;
- expectation of profit;
- establishment of a common enterprise; and
- use of a third party to promote and market the initiative
Most self-described “utility tokens” found themselves failing the Howey Test. Many blame this for the dramatic slowdown in the ICO markets since 2017’s heyday.
In the document released last week, the SEC further elaborates on the Howey Test’s context and terms. It also includes a distilled version of the SEC’s observations based on prior crackdowns on suspect offerings.
The agency considers the “economic reality” of a project — meaning, its condition and progress at the time of the offering — to determine its status. A fully functional project with established examples for a token’s utility in its network, for example, should reduce the risk of a token being classified as an investment contract, according to the agency. Any coin being marketed as a utility token should also be promptly usable.
Economic benefits from the coin, such as an appreciation in its price, should also be “incidental” to its utility price, the letter said. In other words, the coin should not become so expensive that its users consider it as a store of value rather than a token for transactions. If there are secondary markets for the coin, then they should exist within the platform instead of outside it.
The agency provides the example of an online retailer with a “rewards” system of coins. The rewards are subsequently utilized by customers to purchase more products from the same platform.
In light of this guidance, developers with ambitions for use cases beyond their own platform may find it difficult to comply. While several chains and services claim to offer cross-chain services, the technology for such transactions is still under development. The “incidental” economic benefit may also be difficult to prove in cases where entrepreneurs actively use funds from offerings to further develop their platforms.
The document also highlights the importance of examining the role of active participants — also known as APs, or promoters — in an offering. The involvement of APs risks creating a governance model where a select group of centralized stakeholders benefit from an appreciation in a coin’s price. The role of participants is especially critical in networks that are still under development, where one would “reasonably expect an AP to further develop the network’s functionality or digital asset (directly or indirectly),” the SEC wrote.
The no-action letter reiterates and elaborates on many of these points. TurnKey Jet is obliged to sell tokens at a face value of one TKJ and provide products and services on its platform at an exchange rate of one USD per TKJ token. The figure creates an artificial limit to the token’s price, ensuring that inflation in TKJ’s price will be a loss-making proposition for TurnKey.
Progress, or More Ambiguity?
Lawyers and crypto experts have chimed in on Twitter and elsewhere about the SEC’s framework guidance. Reactions have run the gamut from enthusiasm to nonchalance to overt criticism.
Anyway. tl;dr, the SEC doc and the no-action letter are, legally speaking, nothingburgers. What these documents tell us is that the Commission understands the issues and is unlikely to be swayed by technobabble.
— Preston Byrne (@prestonjbyrne) April 3, 2019
🚨 THIS IS HUGE: the SEC just released an official statement on “Framework for ‘Investment Contract’ Analysis of Digital Assets” analyzing whether a digital asset is a security or not
READING NOW WILL POST ANALYSIS HERE STAY TUNED
— Katherine Wu (@katherineykwu) April 3, 2019
Some even predicted a “chilling effect” on the crypto ecosystem as a result of the guidance. One senior lawyer who advises crypto firms, and asked not to be named, told Fortune it “feels like an overt war on cryptocurrencies” and predicted that it will result in an exodus of small companies from the US.
Others are more hopeful.
“Getting this sort of guidance from the SEC, even if unofficial and not legally binding, is helpful,” wrote Katherine Wu, former director of business development at Messari Crypto, in a post analyzing the document. But she also pointed out that the SEC’s broad and varied definitions for an active participant, or “AP,” could prove to be problematic later as startup employees struggle to evaluate their role as participants in an offering.
Peter Van Valkenberg, director of research at Coin Center – a non-profit focused on cryptocurrency research and advocacy – is likewise optimistic. “What’s new here are not the conclusions necessarily but that it is being said, more clearly than ever,” he wrote.
One thing is certain: The SEC’s letter does not break any new ground in regulating cryptocurrencies or eliminating risk for offerings. It recycles old, vague statements and is more than anything a distillation of previous pronouncements by senior officials. That the document is legally non-binding and was authored by SEC staff without the blessing of its commissioners further blunts optimism.
While the framework is the first such guidance document from the federal agency, Rep. Warren Davidson (R-Ohio) noted the only truly effective guidance must come from Congress.