Last week’s hearing by the Senate Banking, Housing and Urban Affairs Committee frenzied the always-excitable ICO crowd. The legal world also joined. Legal Eagles watched closely as SEC Chair “Shallow-End Jay” Clayton and CFTC Chair Chris Giancarlo testified.
SEC and ICO don’t mix
One takeaway was the SEC’s views Initial Coin Offerings (ICOs) as securities. As “Shallow-End Jay” explained, “From what I’ve seen ICOs are securities offerings they are interests in companies much like stocks and bonds under a new label.”
This isn’t new. Clayton has stated so in op-eds, speeches, and bulletins.
And “Shallow-End” Jay rebuked “market professionals” advising contrary.
From the hearing:
- Many issuers are conducting ICOs illegally, their promoters and other participants are not following our securities laws. Some say this is because the law is not clear I do not buy that for a moment.
- A note for professionals in these markets, those who engage in semantic gymnastics or elaborate structuring exercises in an effort to avoid having a coin be a security are squarely within the crosshairs of our enforcement division.
- I don’t think the gatekeepers that we rely on to assist us in making sure our securities laws are followed have done their job.
“Shallow-End Jay”: Everything that moves is a security
Clayton sounded the same theme in a recent speech:
- First, and most disturbing to me, there are ICOs where the lawyers involved appear to be, on the one hand, assisting promoters in structuring offerings of products that have many of the key features of a securities offering, but call it an “ICO,” which sounds pretty close to an “IPO.” On the other hand, those lawyers claim the products are not securities, and the promoters proceed without compliance with the securities laws . . .
- Second are ICOs where the lawyers appear to have taken a step back from the key issues – including whether the “coin” is a security and whether the offering qualifies for an exemption from registration – even in circumstances where registration would likely be warranted.
- I have instructed the SEC staff to be on high alert for approaches to ICOs that may be contrary to the spirit of our securities laws and the professional obligations of the U.S. securities bar.
His remarks led some to speculate the SEC has unpleasantness awaiting lawyers who gave faulty advice.
Fancy lawyers give bad ICO advice
Lawyers advising ICOs have had two views about SEC warnings: “Meh” and “Don’t Tase Me Bro.”
The SEC’s first declared ICOs securities last July via the defunct ‘DAO’ project. DAO had been a hotly debated (and eventually hacked) ICO.
Later that year the SEC stopped the Munchee ICO; the company returned all funds. Both projects relied on a “utility token” defense. Essentially the tokens bought protocol access and thus escaped the SEC. In the Munchee order, the SEC addressed this argument: “even if MUN tokens had a practical use at the time of the offering, it would not preclude the token from being a security.”
Despite the warnings, some ICOs continue to use the utility defense.
Singular DTV is an entertainment platform that raised $7.5 million in 17 minutes in 2016. When the SEC’s DAO report emerged, it took a devil-may-care stance, welcoming the ruling but insisting it didn’t affect them.
SNGLS tokens weren’t securities because they had utility. And anyway the company proudly boasted it had spent “large sums of money” on various law firms and lobbyists in Washington to “advise and educate” policy makers. SEC definitions, it proclaimed, were “antiquated.” “Today is a new world. We in the center of the cryptosphere know it and of course the SEC knows it. We’re looking forward to a more progressive policy being instituted in the coming years by US regulators.”
Those well-paid lawyers may care more after last week.
Legal advice may boomerang
Lawyers for BlockMason are even more combative. They insist BlockMason sold utility tokens and distinguish them from Munchee through marketing strategy and network age.
Still, Mason’s legal team acknowledges it may be in trouble. And thus it warned the SEC any attack would contravene Supreme Court precedent. “Ambiguities in the SEC Munchee order and the SEC Chairman’s statement leave open the theoretical possibility that they could find any and every ICO token to be a security based on the mere fact that some purchasers bought tokens expecting to profit from a rise in the token value over time. If the SEC were to take such an extreme position, it would create severe tension with Supreme Court precedent and invite a test case.”
A test case may provide clarity from the courts but it’s high risk, high reward.
Marco Santori and his Disappearing Acts
Finally, there is the “Great Santori Disappearing Act” (Act). Marco Santori was a New York City lawyer with Cooley LLP. His firm profile page states: “I help innovators navigate financial regulations. Sometimes, we rewrite those regulations together and make them better.” (Mr. Santori has apparently recently accepted a new position.)
Mr. Santori invented a security vehicle that disappears when used. Some issuers accepted his handiwork. “A few of our clients are already testing it in the wild.”
The Act holds utility tokens are securities in presale before a useable network protocol. These SAFT security tokens disappear and reappear as utility tokens once the protocol is live. “So, the SAFT framework calls for securities laws when the buyer takes on enterprise risk, and calls for the consumer protection laws when the buyer takes on product risk. That struck us, the authors of the white paper, as the right state of affairs, and we think the SAFT gets us there.”
Critics widely panned “The Great Santori Disappearing Act” and given Clayton’s remarks, it won’t work. The Cardozo Blockchain Project at Cardozo Law School critiqued the Act and concluded: “Artificially dividing the overall investment scheme into multiple events does not change the fact that accredited investors purchase tokens (albeit through SAFTs) for investment purposes, and likely will not prevent a court from considering these realities when assessing whether these tokens are securities.”
It’s unclear whether Santori’s clients in the wild will stick with the Act particularly since the magician left.
Smart lawyers don’t like getting tased
- Don’t Tase Me Bro
Some cautious lawyers have advised ICOs to follow some combination of equity-crowdfunding titles from the JOBS Act: Reg CF, Reg D, and/or Reg A+.
Lawyers explained this posture at an LA conference late last fall where they discussed SEC-less ICOs. According to an article, “Concerned audience members eagerly asked the expert panelists whether there was ability for a company that did unregulated ICOs to come into the fold and now adhere to regulations.” Experts gave grim answers.
One reminded the crowd that firms that gave legal opinions handed their clients “lottery tickets.” “If you get sued or regulated by the SEC, CTFC, or someone else, you can then go sue your law firm for giving you bad advice. It doesn’t actually save you.” Another described an SEC investigation as “living in hell without dying.”
How hard the SEC pursues lawyers who badly advised ICO clients is unknown. It’s also possible utility tokens do exist somewhere beyond the SEC’s reach.
But after last year’s wild ride, most lawyers will avoid the taser this year.