Among world economies and governments, cryptocurrencies have been a topic of continual debate. Blockchain regulation has emerged as a topic with many different governments and regulatory authorities.
Blockchain Regulation in Europe
The overall approach of the EU towards the blockchain technology is positive and welcoming. The EU appears to be following the path of an innovation-first business philosophy, which could end up supporting development of virtual currencies from two angles:
- encouraging the exploration of use cases to test impact and laws, and
- giving entrepreneurs confidence that their “approved” applications will be more trusted by their target markets.
This approach, combined with the EU’s scope as regulators for a 28-country economic bloc, could not only encourage an ecosystem of thinkers and doers, but could also end up making Europe a prime destination for blockchain development, as businesses choose the continent for their domicile and as talent flocks to the area.
Earlier in 2017, the executive arm of the European Union government revealed that it is working on the blockchain to support distributed ledger-based projects. According to this official press release published on February 7th, the Commission is considering growing its efforts on supporting more projects related to the distributed ledger technology (DLT).
The European Commission is “actively monitoring Blockchain and DLT developments” and is working on exploring “DLT benefits and challenges as well as fields for application in financial services”.
The official press release also clarified that the Commission wants to “pilot projects to foster decentralized innovation ecosystems and help reshape interactions between consumers, producers, creators and among citizens, businesses and administrations to the end benefit of society.”
Switzerland has become one of the main European hubs for cryptocurrency and blockchain development. This has been spearheaded by the Crypto Valley Association, a Swiss non-profit blockchain and cryptographic technology ecosystem, which has started to develop an ICO Code of Conduct considering China’s recent ban of token crowd sales.
Blockchain Regulation in the U.S.
According to the Congressional resolution proposed July 14, 2016 in the U.S., “blockchain technology with the appropriate protections has the potential to fundamentally change the manner in which trust and security are established in online transactions through various potential applications in sectors including financial services, payments, health care, energy, property management, and intellectual property management.”
According to The Columbia Science and Technology Law Review, the regulatory responses to emerging technologies, and to blockchain, range from excitement to suspicion to indifference. The law review states that the U.S. federal government has not exercised its constitutional preemptive power to regulate blockchain to the exclusion of states (as it generally does with financial regulation) or even expressed intention to do so, regardless of the interest of federal agencies.
And so, the states remain free to introduce their own rules and regulations. As an example, although New York did not enact state-wide legislation recognizing blockchain for record-keeping purposes, in June 2015 it became the first state in the U.S. to regulate virtual currency companies through state agency rulemaking.
In 2017, at least eight U.S. States have worked on bills accepting or promoting the use of Bitcoin and blockchain technology, while a couple of them have already passed them into law.
The most important developments for blockchain’s regulation and implementation in the U.S. in a legal evidentiary context occurred in Arizona (recognition of smart contracts), Vermont (blockchain as evidence), Chicago (real estate records), and, most importantly, Delaware – which authorized registration of shares of Delaware companies in blockchain form.
Securities Implications of ICOs
The key that unlocks the regulatory oversight and control by the SEC is the offer, sale, purchase, solicitation or other activity involving “securities.” Although federal laws include definitions of what constitutes a “security”, courts have interpreted the term broadly to encompass a wider variety of investment arrangements.
Importantly, the report confirms the longstanding federal securities law principle that it does not matter what name a promoter of an investment gives to “what” is being offered and sold—what matters are the underlying characteristics of what is being offered.
It is irrelevant whether ICO declares its sale of “tokens” or “coins”, and investors are not offered something explicitly called “shares,” “stock” or “securities”—the label does not control whether the offerings are securities subject to regulation by the SEC and state securities law agencies.
The SEC and courts use a “principles-based” approach to this determination, which, by its very nature, is extremely flexible and enables the regulator to address activity through the characterization of an instrument as a security.
Even if the conclusion is reached that a coin or token offering is not the offering of a security under federal law, it still doesn’t end the regulatory inquisition. The coin or token may still be construed as a security under individual state law and/or may be subject to other state laws and the laws of jurisdictions outside the United States.
SEC Issues ICO Pronouncements
On July 25, 2017, the SEC issued a flurry of ICO-related commentary, including, first and foremost, a “Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934”. The report described an SEC investigation of The DAO and its use of distributed ledger, or blockchain, technology to facilitate the offer and sale of “DAO Tokens” to raise capital. The report was introduced through a news release, which also referenced an investor bulletin describing the SEC’s analysis of ICOs.
For those who hoped that the SEC would allow cryptocurrency and ICO markets to evolve unregulated, their hopes were dashed by the report and the bulletin. The SEC did not outlaw ICOs by any stretch. But it did assert that, depending on the facts and circumstances, an ICO may indeed involve an offering of securities.
In that case, organizations proceeding with an ICO offering of tokens that function as securities without registering with the SEC or that structure the offering in such a manner to qualify for an exemption from registration will violate federal securities laws.
The remedies for such a violation include rescission of the offering, cease-and-desist orders, fines and penalties, bans from participating in the securities industry, bans on serving as an officer or director of a public company, and, in the most egregious cases, referral to the local U.S. Attorney for possible criminal prosecution.
So, whether an offering involves a “security” is a very important initial determination for projects considering a token sale.
Obviously, neither SEC registration nor an exempt offering provides the same freedom of action and limited expense and time to completion as compared to an unregulated ICO. After July 25, 2017, an ICO will not be subject to securities offering regulation only if the tokens being offered and sold are not “securities.” The key is to determine the characteristics causing an ICO to involve a “security.”
The DAO was a digital decentralized autonomous organization and a form of investor-directed venture capital fund.
The DAO had an objective to provide a new decentralized business model for organizing both commercial and non-profit enterprises. It was instantiated on the Ethereum blockchain, and had no conventional management structure or board of directors. The code of the DAO is open source.
The DAO was stateless, and not tied to any particular nation state. As a result, many questions of how government regulators would deal with a stateless fund were yet to be dealt with.
The DAO was crowdfunded via a token sale in May 2016. It set the record for the largest crowdfunding campaign in history generating approximately $150 million of proceeds.
In June 2016, users exploited a vulnerability in the DAO code to enable them to siphon off one third of The DAO’s funds to a subsidiary account. On 20 July 2016, the Ethereum community decided to hard-fork the Ethereum blockchain to restore virtually all funds to the original contract.
This was controversial, and led to a fork in Ethereum, where the original un-forked blockchain was maintained as Ethereum Classic, thus breaking Ethereum into two, separate active blockchains, each with its own cryptocurrency.
The DAO was subsequently delisted from trading on major cryptocurrency trading exchanges such as Poloniex and Kraken in late 2016.
The SEC concluded that the tokens offered and sold by The DAO in its ICO were securities that were required to be registered with the SEC, and, as they were not registered, they were issued in violation of the federal securities laws. The SEC report makes clear that the SEC believes, depending on the specific facts and circumstances, that blockchain tokens can constitute “securities,” and, when they are, they are subject to regulation.
The DAO vs. The Howey Test
The SEC found that DAO Tokens were securities based on the “investment contract” definitions articulated in the 1946 U.S. Supreme decision of SEC v. W. J. Howey Co., now referred to as the “Howey Test”.
Under the Howey Test, a financial arrangement will be characterized as an “investment contract” and treated as a security if it involves an investment of money, or other tangible or definable consideration, in a common enterprise with a reasonable expectation of profit to be derived primarily from the entrepreneurial or managerial efforts of others. The vehicle (whether there is a certificate, voting rights, defined equity participation, etc.) is irrelevant. The principles set forth by Howey are seminal and instructive.
Purchasers of DAO Tokens did not acquire interests in a traditional company in the conventional sense. However, the SEC concluded The DAO was an “issuer.” Although there was no legal entity formed under jurisdictional state law, such as a corporation or partnership, that had acted as the issuer, the SEC determined that The DAO, as an unincorporated organization, and its founders and others that participated in the ICO, constituted an “issuer” under securities law.
The purchase of tokens with payment of Ether cryptocurrency satisfied the “investment of money” prong of the Howey Test. The fact that The DAO promised investors a share of profits earned on projects in which the collective funds of The DAO were invested satisfied the “common enterprise” and “reasonable expectation of profits” prongs of the Howey test. The “investment of money,” “common enterprise” and “reasonable expectation of profits” prongs are likely to be satisfied in many, but certainly not all, ICOs.
“Managerial Efforts of Others”
The passing of the Howey Test for ICOs is whether the potential future profits would be “derived from the entrepreneurial or managerial efforts of others.” The DAO described itself as autonomous, which implied that The DAO included no entrepreneurial or managerial efforts of others.
In the report, the SEC did not accept that conclusion – determining that the organization and people that created The DAO also actively marketed The DAO (including operating a website that promoted The DAO and operating online forums discussing The DAO), selected the “curators” (who vetted proposals before they were voted on by DAO Token holders), monitored The DAO’s operation, and took public actions when The DAO’s operations encountered difficulties.
While the DAO curators did not have the full power of a conventional corporate board, by selecting and crafting proposals for votes by DAO Token holders, they exerted significant managerial control over The DAO.
Since the curators were selected by the creators of The DAO, who also directly expressed their ongoing views though postings made available on public forums, it is reasonable to say that, in addition to overtly promoting The DAO as an investment (including arranging in advance of the ICO for a secondary trading market for DAO Tokens), The DAO’s creators also exerted considerable managerial control.
The managerial power and influence of The DAO’s creators severely undercut the argument that The DAO was autonomous and led the SEC to conclude that potential future profits of DAO Token holders were in fact substantially dependent on “the entrepreneurial or managerial efforts of others.”
DAO Token holders indeed had voting rights, which might have shown that managerial control of The DAO was directly held. The SEC concluded that those voting rights were of limited power and utility, and that DAO Token holders were not able to exert direct managerial control. In fact, many of DAO Token holders were semi-anonymous, with no standard ability to contact each other or to form groups able to exercise voting rights or managerial control.
Because the curators vetted proposals prior to a vote, DAO Token holders had little to no meaningful ability to take actions undesired by the curators or The DAO founders. The founders could create proposals that were purposely vague and were subsequently approved by the DAO Token holders. The actual voting process was designed in such a way that a proposal submitted to a vote was likely to be approved.
The SEC concluded that DAO Token holders did not have effective managerial control over The DAO, which further facilitated a conclusion that the efforts of the founders and the curators were the “undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.”
Because The DAO pooled investor money and then made investments in other initiatives on a commingled basis, the Investment Company Act of 1940 was also implicated by the arrangement.
When closely examining the arrangement, it really was no different than a standard private investment fund that happens to poll its investors about their opinions before committing capital. That is clearly an investment company, for which either an applicable exemption must be found – or for which a separate registration under the Investment Company Act of 1940 must be filed.
There are also significant tax implications of The DAO structure. Even though it is unincorporated, it still nevertheless is an association of some sort, and that will attract an entity-level tax. Subchapter M (which is the conduit tax rule that mutual funds rely on) is only available if the entity has registered under the Investment Company Act of 1940.
Broker-Dealer and Securities Exchange Considerations
The person promoting the sale of a coin or token may need to be registered as broker-dealer with the SEC and with the Financial Industry Regulatory Authority (FINRA). It is often mistaken that, if the promoter is not taking a “commission,” then the promoter is not acting as broker or underwriter.
The presence of a commission or transaction-based compensation is usually indicative of broker-dealer status; however, a person may still be acting in the capacity of a broker and be subject to licensure and regulation notwithstanding the absence of transaction-based compensation.
Once the coins or tokens are issued, then the question becomes what happens if they are traded in the secondary market. If the coins or tokens are not “securities,” then the securities laws will not restrict secondary trading. If the coins or tokens are “securities,” then, for secondary trading to take place, either the initial issuance of the security needs to be registered under the 1933 Act or an exemption from registration must be applicable and any restrictions on transfers must have lapsed.
If the exchange is listing a coin or token for purchase and that coin or token for purchase is determined to be a security, then the exchange is also most likely required to be licensed as a broker-dealer and as a national securities exchange or as an alternative trading system, depending on the functionality of the exchange.
This calls into question the long-term sustainability of many centralized blockchain token trading exchanges around the world.
Commodities Regulation in the United States
The U.S. Commodity Futures Trading Commission (CFTC) is an independent agency of the US government created in 1974, that regulates futures and option markets.
The stated mission of the CFTC is to foster open, transparent, competitive, and financially sound markets, to avoid systemic risk, and to protect the market users and their funds, consumers, and the public from fraud, manipulation, and abusive practices related to derivatives and other products that are subject to the Commodity Exchange Act.
CFTC Regulation of Cryptocurrency
The Dodd-Frank Act of 2010 broadened the authority of the CFTC to regulate most derivatives, swaps and commodities. So, establishing that a particular coin or token is not a security does not mean it is not regulated as a commodity future, swap or commodity. It is still necessary to determine whether the CFTC will exercise jurisdiction with its parallel regulatory regimen.
It will also be necessary to determine if various money transmitter laws applicable to the movement of currency need to be addressed, and also whether the Commodity Futures Trading Commission (CFTC) will exercise jurisdiction over the coin or token or its offering in an ICO and subsequent trading under the theory that it is the offering of a commodity futures contract, commodity interest or commodity subject to the jurisdiction of the CFTC.
In March of 2014, the CFTC acknowledged it was considering the regulation of Bitcoin. The CFTC could treat Bitcoin transactions as swaps, futures, or spot transactions, otherwise Bitcoin would likely be a commodity under the CEA.
In the U.S., Bitcoin is given the same financial safeguards as traditional assets. The U.S. Commodity Futures Trading Commission has granted LedgerX, a cryptocurrency trading platform operator, approval to become the first federally regulated digital currency options exchange and clearinghouse in the U.S.
In December of 2017, the CFTC approved the trading of Bitcoin futures on the CBOE and CME.
Regulatory Impact on Tokens & ICOs
All this regulation, including the potential application of U.S. commodities and securities laws, means that ICOs specifically offering security tokens will need to be either offered and sold in the United States to accredited investors, sold as a crowdfunding project, only or offered and sold only outside the United States to non-U.S. persons to be exempt from the reach of U.S. securities laws.
The fundamental question is, therefore, “is the instrument a security?”
If the “coin” or “token” being issued meets the Howey Test, then it is considered a security from inception. If, on the other hand, it does not meet all elements of the Howey Test, then it may not be a security.
Does the coin or token provide the buyer with the mere opportunity to access and use a technology protocol – like purchasing an access key to unlock software installed on a device?
Those types of utility tokens allowing “participation” (including potentially future releases and access to changes of the software) and do not otherwise include any investment interests may very well not be securities. There are certainly other types of tokens that do not invoke the Howey Test, and would therefore not be securities.
The SEC report creates a potential roadmap for determining whether an ICO has a “reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.” If the tokens can be traded and this trading involves an asset that meets the Howey Test, then it is likely that the SEC’s jurisdiction will be invoked. As the SEC report clearly illustrates, the conclusion is very fact specific and highly dependent on the features of technology protocol and the associated coin or token.
The SEC has made it clear that it is the responsibility of the offeror in the ICO, the exchange on which the coins are traded, and the purchaser of the coins to evaluate if the “coin” being purchased in the ICO is an “investment contract” or “security” subject to regulation under the U.S. securities laws.
As we can see, the regulatory environment is shifting, and we expect that the continued evolution of blockchain technology will invariably face more and more regulatory oversight.