In the last few days, a lot of reports are coming out about charges against ICO’s. Today, this news came out:

U.S. securities law can be used to prosecute fraud cases over cryptocurrency offerings, a New York federal judge ruled on Tuesday in what appeared to be the first court decision to address the issue. The ruling from U.S. District Judge Raymond Dearie in Brooklyn allows federal prosecutors to pursue their case against Maksim Zaslavskiy. The Brooklyn resident was arrested in November on charges that he defrauded investors in two cryptocurrencies, violating the federal Securities Exchange Act.

Prosecutors have said that Zaslavskiy last year raised at least $300,000 from investors in a cryptocurrency called REcoin, which he claimed was backed by real estate, and another cryptocurrency called Diamond, which he said was backed by diamonds.

In fact, prosecutors said, no real estate or diamonds backed the virtual currencies. In our opinion, investors should have a very cautious approach when it comes to investing in ICO’s. Every investor should do their own due dililgence. Many ICO companies are not transparent at all, and claims they make or made are often nothing more than beautiful promises.

In March, Zaslavskiy’s lawyers asked Dearie to dismiss the charges, arguing that REcoin and Diamond were currencies, not securities, and therefore not covered by the Securities Exchange Act.

Dearie rejected that argument, writing on Tuesday that the federal securities law must be interpreted “flexibly.” The judge noted that the U.S. Securities and Exchange Commission, which brings civil securities fraud actions, has said that it considers some cryptocurrencies to be securities. We agree with this view. When determining whether crypto’s are securities or not, one should look to the decentralized nature of it. If it’s still managed by a central (group) of people of a company, than it is probably centralized and thus nothing else than a security. Therefore, there is the ‘Howey Test’.

Howey Test:

In order to find out if an investment – specifically an ICO in this case – is or is not an investment contract, we can use the example of a U.S. Supreme Court case, SEC vs. Howey. This is known among legal crypto folks as the “Howey Test!” This case established the standard test for whether an arrangement qualifies as an investment contract, which is a type of security, and therefore needs to be regulated by the SEC.

The U.S. vs. Howey case established that the following three elements must be met in order for an investment to qualify as a regulated security:

1. An investment of money

2. An investment of funds in a common enterprise

3. An investment with an expectation of profits predominantly from the efforts of others

The textbook definition of a “security” is:

A security is a fungible, negotiable financial instrument that holds some type of monetary value. It represents an ownership position in a publicly-traded corporation (via stock), a creditor relationship with a governmental body or a corporation (represented by owning that entity’s bond), or rights to ownership as represented by an option. – Investopedia.com

However, in this case, the “Howey Test” specifically focuses on the term “investment contract” within the definition of security. The “Howey Test” basically considers several variations of a contract, transaction, or scheme whereby an investor gives out money with the intent to secure income or profit from the use of that cash (or cryptocurrency).

Thus, marketing a token as a speculative investment, or drawing comparisons to existing investment processes, may mislead or confuse potential buyers. It may also increase the likelihood that the token is considered a security in the eyes of the US Supreme Court, FINRA and or SEC.

Furthermore, we also believe that a Blockchain Token with one or more of the following 7 investment characteristics likely will be considered as a Security Blockchain Token (ICO):

1.     Ownership interest in a legal entity, (LLC, Corp., General Partnership you name it…)

2.     Equity interest

3.     Share of profits, losses, assets and/or liabilities

4.     Status as a creditor or lender

5.     Claim in bankruptcy as equity interest holder or creditor

6.     Holder of a repayment obligation from the system or the legal entity issuer of the Blockchain Token

7.     A feature allowing the holder to convert a Utility Blockchain Token into an instrument with investment interests

It should be noted here that an ownership interest in a fund or other legal entity vehicle that buys utility tokens would still constitute ownership of a security, even if the fund would not be deemed to own any securities.

Reves Test:

An alternative test, known as the “Reves Test,” (Reves vs. Ernst & Young) may also be used to test is an ICO is truly a security. This test considers whether an investment may be viewed as passive and relying on the efforts of others to establish whether or not ICOs qualify as securities. Specifically, this test looks at four factors:

1.     Whether funds are being raised for a business venture or enterprise

2.     Whether the transaction is offered indiscriminately to the public at large

3.     Whether the investors are substantially powerless to affect the success of the enterprise

4.     Whether the investor’s money is substantially at risk because it is inadequately secured

It is crucial to consider the manner in which the sale of a Blockchain Token occurs, particularly the promotion and marketing! For example, if the language used to promote the Blockchain Token includes words like “investment,” “returns” or “profits,” the purchasers of the Blockchain Token may be more likely to expect profits from the efforts of others than if the Blockchain Token is promoted on the basis of the usefulness of the rights attached to the token. Disney Stock (DIS – NYSE) vs. Disney Dollars!

Therefore, the essence of a non-security or utility Blockchain Token is that they are for commercial use rather than investment, and a security Blockchain Token is for any kind of investment contract and transaction.

Now if you consider that utility Blockchain Tokens will allow for the exploitation of the system by the holder, much like a licensee has rights to commercially exploit the license. One may see the non-security or utility Blockchain Token holders as active participants, like franchisees of McDonalds.

On the other hand, having or not voting rights confuses many people. So, similar to the argument above, the existence of voting rights itself should not define a Blockchain Token as a security or a utility token. The focus here should be whether the holder and or purchaser of the token would or would not be viewed as one that is passively relying on the efforts of others. Given that holder of a non-security or utility Blockchain Tokens play a more active role by using, contributing to or licensing the platform, it is less likely that having the right to vote on the future of the project will constitute the token as a security. Likely, as a metaphor, Disney could start asking people to vote on how many new roller coasters the new parks and resorts should build or have.

Our Opinion

Coins or tokens that have any aspect of an investment contract should be SEC compliant under SEC regulations such as, REGULATION D506C or REG A+  in order to be operating within the United States law and be able to sell to U.S. citizens. Remember, it only takes 1 (only one) U.S. investor in your ICO to force you to comply with U.S. securities laws.

The SEC will most likely see any ICOs as securities tokens unless the issuer can prove otherwise. It makes sense that the regulatory government agencies will try to protect investors from fraudulent investments by making the ICO issuer responsible for doing everything that is necessary to release a utility tokens and not security if they choose to do so.

Given the SEC’s recent actions concerning ICOs, we would strongly suggest that companies considering ICOs and promoting them to investors should be very careful and compliant with securities laws, requirements and regulations.

If not, your ICO will end up like this.

Thanks for reading!

 

 

2 comments

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