by Peter B. Nichol

Are you participating in the ICO excitement of cryptocurrency funded development?

May 19, 2017
InnovationIT LeadershipIT Strategy

Innovative CIOs are considering an emerging channel for raising capital—funding via ICO.

blockchain bitcoin
Credit: Thinkstock

The excitement is real, but so is the risk. Decentralized business model discussions are the talk in board rooms and C-suites around the world. A new market to raise development capital is emerging called initial public coin offerings (IPCO or ICO).

Token sales and crowdsales embrace empowering a network of users to participate in a project. Participants are incentivized to get involved—early participation has greater rewards—in anticipation of the project increasing in value.

Access to ICOs has significant potential for up-side benefits with an equally startling downside risk. The main concern of ICO risk is unduly escalated asset values or irrational exuberance. Fed Chairman Alan Greenspan, in The Challenge of Central Banking in a Democratic Society (1996), first introduced the concept of irrational exuberance, defining it as unsustainable investor enthusiasm that drives asset prices to levels of frothiness not supported by fundamentals.

A sudden interest in investor protection

How did we arrive at this highly regulated state? It didn’t happen overnight but was instead a century in the making.

Investing was initially reserved only for the wealthy. Greed and deceit scared off all but the toughest investors until the early 1900s. As disposable income increased, casual investors needed a place to put their money. The Blue Sky Laws were first introduced in 1911 and were meant to protect investors from the pump-and-dump schemes of worthless securities. This was the first time that sellers of new issues (a security sold to the public) had to register and release the financial details to the public. The 1920s were booming, and just saying the word “stock” was thought to make money.

This excitement ended abruptly with the Black Tuesday crash of October 29, 1929. The Dow Jones Industrial Average (DJIA) plummeted 12 percent in the largest one-day drops in stock market history with more than 16 million shares traded in a panicked sell-off, triggering the Great Depression.

Protecting banks from themselves (Part I: 1933)

It wasn’t only individual investors who incurred heavy losses; the banks were prohibited from playing the market with clients’ deposits. The Federal Reserve didn’t lower interest rates, forcing the government to generate alternatives to get the economy back to recovery.

Congress passed two substantial regulations that FDR signed in 1933: the Glass-Steagall Act and the Securities and Exchange (SEC) Act. Glass-Steagall separated commercial from investment banking, which did two things. First, it prevented securities firms and investment banks from taking deposits. Second, Glass-Steagall kept commercial Federal Reserve member banks from four kinds of transactions: dealing in non-governmental securities for customers; investing in non-investment grade securities for themselves; underwriting or distributing non-governmental securities; and affiliating with companies involved in such activities. The Securities and Exchange Act of 1934 governed the secondary trading of securities (stocks, bonds and debentures). These acts gave the SEC considerable power over Wall Street and required additional financial disclosures and stricter reporting schedules. Additionally, individuals and companies found guilty of fraud now faced civil criminal charges.

Protecting banks from themselves (Part II: 1975)

The Securities Acts Amendments of 1975 is an often-overlooked but impactful regulatory amendment that imposed an obligation on the SEC to consider the impacts that any new regulation would have on competition, thereby further empowering it. The Act enabled the Regulation National Market System (Regulation NMS) and created the Municipal Securities Rulemaking Board (MSRB).

Creative and deceptive accounting by Enron, WorldCom and Tyco International resulted in additional regulations, including the Sarbanes-Oxley Act of 2002. Sarbanes-Oxley added teeth in two areas: Section 302 (senior management were required to certify financial statement accuracy under threat of civil and criminal penalty) and Section 404 (guidelines for storage and retention periods and the proper destruction of financial documents).

Do blockchain tokens fall under federal security laws?

Are these regulations too far reaching? Maybe. But keep in mind, the catalyst behind these regulations represent historical events we’d prefer not to relive—such as the crash of 2007 to 08, from which the economy still hasn’t fully recovered and which is beyond the scope of the current discussion.

Before you fund your company’s development with an ICO, it’s wise to stay clear of ICOs that are more likely to incur heightened scrutiny and regulatory control. Several forward-looking marketplaces—such as ICONOMI and Tokenmarket—are offering ICOs with AML and KYC compliance.

Two regulations govern whether a cryptographic blockchain token is considered a security: the Securities Act and the Exchange Act.

  • Securities Act of 1933: Section 2(a)(1)
  • Securities Exchange Act of 1934: Section 3(a)(10)

In SEC v. W.J. Howey Co., the Supreme Court concluded that an investment contract fell within the scope of the Securities Act. Howey owned a large citrus grove and sold smaller strips of land to buyers with ten-year service contracts for cultivating, harvesting and marketing the land, which the buyer (investor) was not involved with in any way. The company allocated net profits to the buyer based on the produce yielded from each strip of land.

The pivotal question was, “Is the term security referencing any document(s) that provide evidence of a monetary investment in a common enterprise whose profits come only through the labors of others?”

The SEC stated this action was a violation of the sale of unregistered securities. The Supreme Court determined that because Howey provided an investment opportunity and the potential to share in the profits of the citrus fruit operation, the document traded was considered a security and therefore fell under SEC scrutiny.

Howey also defined an “investment contract” as:

“a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.”

Therefore, the “Howey test” can be used to determine if an investment instrument is considered an investment contract using a four-prong test:

  1. An investment of money,
  2. In a common enterprise,
  3. With an expectation of profits,
  4. Solely from the efforts of others.

This test is useful when considering whether to participate in an ICO in order to fully grasp your potential legal obligations.

The missing link in the Howey test

The four-prong test, however, isn’t that straightforward. Unfortunately, Howey didn’t define the term “common enterprise.” Three basic definitions exist:

  1. Horizontal commonality: an enterprise in which the investors’ contributions are pooled, and the future of each investor depends on the success of the overall venture.
  2. Broad vertical commonality: an enterprise in which the investor is dependent on the promoter’s efforts or expertise for the investor’s returns; requires investor’s fortunes be tied to the efficacy of the manager’s efforts.
  3. Narrow vertical commonality: an enterprise in which the investor is dependent on the promoter’s efforts or expertise for the investor’s returns; requires that the investor’s profits are tied to the manager’s profits.

At present, we’re left with more questions than answers, such as these four: are blockchain tokens being sold as crypto-equity? How involved are investors in the project, other than profit sharing? Are the investors passive investors? Does this meet the requirement of a financial security? We don’t have all the answers, but we do know that companies pursuing KYC- and AML-compliant ICOs will be less disrupted as regulatory bodies continue to define the financial security boundaries of tokens, app coins and protocol tokens—now and into the future. So stay tuned!