Designing crypto tokens in light of the SEC announcement

Earlier this week the Securities and Exchange Commission handed down its ruling on crypto tokens as potential securities.

The investigation was prompted after the DAO “hack” that saw $55 million redirected by a rogue party in the DAO network.

In the specific instance of the DAO, the SEC found that the tokens were offered as securities, and therefore fell under regular securities laws. Applied to other tokens or ICOs, this would mean that coin offerings would be subject to SEC regulation. Depending on your philosophy this could be good or bad for cryptocurrencies.

ICOs have certainly benefited from no regulatory oversight and there would be many in the crypto space would argue that is a feature, not a bug.

Much of the coverage on the SEC ruling has suggested this would be the end of the ICO-mania. Certain kinds perhaps.

In actuality, the SEC ruling was specific to the DAO instance, however they did offer guidance for other tokens, and suggest that it is more on how the tokens are designed and offered that will determine whether they are a security or not.

This Report reiterates these fundamental principles of the U.S. federal securities laws and describes their applicability to a new paradigm—virtual organizations or capital raising entities that use distributed ledger or blockchain technology to facilitate capital raising and/or investment and the related offer and sale of securities. The automation of certain functions through this technology, “smart contracts,” or computer code, does not remove conduct from the purview of the U.S. federal securities laws.

When does a token pass the Howey Test?

The Howey Test was created by the Supreme Court to determine whether certain transactions qualify as investment contracts, or security offerings. If under the Howey Test a transaction is determined to be a security, then the investment is subject to certain disclosure and registration requirements.

The Howey Test came about from a ruling on a property lease initiative, where a Florida citrus farm decided to lease half of its property to finance an additional development. The way the Howery Co. structured the lease agreements, who were enticed by expectation of substantial profits, so that the Howey Co. would provide the work (farming) while the investors would provide the capital. Therefore the investors became the nominal landowners, in doing so becoming speculators where the land was the vehicle for investment.

In their ruling, the Supreme Court concluded:

“The transactions in this case clearly involve investment contracts, as so defined. The respondent companies are offering something more than fee simple interests in land, something different from a farm or orchard coupled with management services. They are offering an opportunity to contribute money and to share in the profits of a large citrus fruit enterprise managed and partly owned by respondents…Thus, all the elements of a profit-seeking business venture are present here.”

And:

“It is immaterial whether the enterprise is speculative or nonspeculative, or whether there is a sale of property with or without intrinsic value. What matters is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.”

Dapps have the potential to act like investment contracts—and there’s certainly no shortage of speculators who go into ICOs with profits as the sole motivation.

Coinbase published a whitepaper posing how tokens can—and must—be designed with the Howey Test in mind and they offer an open-source framework for this.

If designed correctly, tokens should be deemed as a simple contract, equivalent to a franchise agreement. Therefore “token holders are granted rights to contribute to a larger system, rather than through a passive investment interest.”

The SEC ruling may slow down growth, but perhaps this is a needed correction. Anybody familiar with ICO markets have seen plenty of Ponzi-scheme tokens offered on the market. It’s a timely reminder that like it or not, federal regulation are monitoring this space, so act accordingly.