By Thomas Friis Nielsen
When the United States’ Securities and Exchange Commission (“SEC”) in December 2020 filed a lawsuit against Ripple Labs, Inc. alleging that the company´s $1.3 billion sale of its XRP cryptocurrency was an unregistered sale of securities, the question on everyone’s minds was brought to the fore: Are cryptocurrencies securities or not?
Consequences of Listing an Unregistered Security
During the initial coin offering (“ICO”) craze in 2017, technology companies raised millions (sometimes billions!) of dollars by offering cryptocurrency tokens to the public. Most of these companies did not register their token sale with the SEC as a sale of securities taking the position that their tokens did not constitute a security but rather a commodity and therefore, registration was not required.
Since then, the SEC has filed charges against 27 completed ICOs and this number does not include the number of ongoing investigations by the regulatory agency or the cases that have yet to publicly disclose settlement terms.
Disgorgement, civil fines, and prejudgment interest are the three key monetary penalties at the SEC's disposal to punish companies that conduct unregistered securities offerings.
Disgorgement is the repayment to investors of profits derived from unlawful or unethical conduct, as determined by the SEC. It is more of a rehabilitative rather than a punitive tax.
Civil penalties, on the other hand, are intended to prosecute corruption, with the harshest penalties reserved for cases involving direct proof of fraud and a significant risk of or real investor damage.
Finally, prejudgment interest comprises charges assessed based on the amount of disgorgement and civil damages agreed upon during a trial.
The SEC may also request specific performance through injunctions and limitations on an individual's right to operate in the securities industry or act as an officer or director of a public company in response to a breach of federal securities laws. The SEC, on the other hand, cannot send people to prison, though if there are grounds under the Department of Justice’s jurisdiction, that is a possibility.
How to Avoid Sanctions from the SEC
The SEC uses the so-called “Howey test” – named after the Supreme Court´s ruling in SEC vs. W.J. Howey Co. - to determine if a financial product is a security that requires registration. The Howey test consists of four criteria that are used to determine whether an investment contract exists. An investment contract is:
1. An investment of money
2. In a common enterprise
3. With the expectation of profit
4. To be derived from the efforts of others
From previous SEC enforcement actions in the digital asset space, it appears that the agency tends to focus on (3) and (4), specifically, if there existed an expectation of profits, and if so, whether that expectation was contingent on others' efforts.
The promoter's profit expectation criteria are influenced by whether the digital assets were sold to prospective users for their functionality or to investors for their speculative value. Whether the network was decentralized or completely functional were important factors in evaluating (4) i.e. "the efforts of others" criteria.
A developer's promotion of a token's potential for appreciation makes it appear to be an investment deal, but it is also possible to consider it an innocent desire for the network to thrive and be used by a large number of people. Some blockchain developers have proceeded with digital token offers in the hopes of convincing the SEC that their token is adequately usable and in an attempt to avoid being labeled an investment contract, however, this strategy is a risky one because proving a token's functionality before distributing it to a large number of people for use on the network is difficult in practice.
Concerning the 4th criterion, blockchain developers have been caught in a regulatory dilemma for many years. If the network is not usable or decentralized, distributing tokens to people could violate securities regulation laws. However, unless the tokens are distributed to and freely transferable among potential users and developers on the network, it will practically never evolve into a robust, decentralized network that is not reliant on the managerial and entrepreneurial efforts of a single community.
A token sale promoter’s typical solution to this risk of regulatory challenges is to only distribute the tokens outside the U.S. in jurisdictions that would allow it. The risk here is that the tokens could easily find their way back to the U.S.
SEC´s Global Reach
Simply launching a token sale in a foreign jurisdiction may not be enough to escape the SEC's Cyber Unit's existing dragnet and the far-reaching, aggressive and global scope of US Federal securities laws.
The SEC's authority extends well beyond the United States' boundaries, affecting investment opportunities offered from anywhere at any time. Federal securities laws in the United States are idiosyncratic, and they are written as inclusionary rather than exclusionary rules.
In other words, the Federal securities laws of the United States apply to anyone in the world (as explicitly stated by the SEC), with exceptions available to the degree that the individual or company in question does not directly trade in the United States or with Americans.
Thus, “going offshore” does not provide token issuers with a regulatory escape hatch in the United States, particularly if U.S. persons may purchase tokens in the ICO or if post-issuance selling of ICO tokens to persons in the United States is possible (and difficult to prevent).
Final Thoughts
As it likely appears from this article, simply stated there is still a lot of regulatory uncertainty when it comes to ICOs. One can only hope that the decision in SEC vs Ripple Labs, Inc. will shed more light on how to hold token sales without risking aggressive lawsuits from the SEC. Until there is more clarity, blockchain developers should be careful and meticulous when launching their tokens to the public and seek legal advice from an experienced blockchain law and securities regulation counsel.
