THE SEC MAKES A CLEAR STANCE ON CRYPTOCURRENCIES

This past week, one of the biggest regulatory agencies in the world weighed in on the future of cryptocurrency classification in the world’s biggest financial market. While the decision made by the Securities and Exchange Commission’s (SEC) Jay Clayton wasn’t ground-breaking, it was something that was certainly important. In fact, the SEC standing its ground on how it defines securities creates a clear picture for blockchain and cryptocurrency companies looking to become listed on U.S. exchanges. The SEC’s ruling not only affects U.S. markets and companies, but it sets a precedent for other international regulators.

We are not going to do any violence to the traditional definition of a security that has worked for a long time… We’ve been doing this a long time, there’s no need to change the definition,” said Jay Clayton, U.S. Securities and Exchange Commission Chairman, last Wednesday. Clayton also stated, “If you have an ICO or a stock, and you want to sell it in a private placement, follow the private placement rules. If you want to do any IPO with a token, come see us.” So, while the SEC will not be bending the rules when it comes to the definition of a security, it is demonstrating willingness to helping such companies launch an ICO.

 

THE HOWEY TEST

So how does the SEC define a security? It uses precedent from 1946 set by the Supreme Court of the U.S. in the case SEC vs. W.J. Howey Co. The most valuable takeaway from this case was the inception of an evaluation tool for transactions that would help decide if they were investment contracts or not, known as the Howey Test. In the Supreme Court case, Howey Co. sold citrus farm land to investors in a lease-back agreement that was also tied to profits from the farm. The investors in the land were deemed to have no knowledge, skill, and equipment critical to the care of the citrus crop. Because of this, it was assessed by the Supreme Court that the investors saw value in the transaction due to potential profit from the work of others. This key decision, along with supporting evidence, thrust the Howey Co. deal into the realm of an investment contract.

The sale of the land was flagged by the SEC who later issued an injunction on it. After Howey Co. appealed the injunction, the case made its way to the Supreme Court and consequently yielded the Howey Test as a benchmark for future scenarios involving investment contracts and securities. The Howey Test has four parts that help to determine whether an asset is an investment contract or not:

  1. It is an investment of money
  2. There is an expectation of profits from the investment
  3. The investment of money is in a common enterprise
  4. Any profit comes from the efforts of a promoter or third party

The Howey Test was formulated to look at the substance of an investment rather than its title or form. By evaluating a security on the four parts to the Howey Test, one can begin to see if said security is an investment contract or not. When it comes to blockchain and cryptocurrency, it is easy to apply the Howey Test in these three rules:

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

 

HOW IT AFFECTS ICOS

With dozens of initial coin offerings (ICOs) happening each month, you may be wondering how the SEC’s recent ruling will affect these companies hoping to raise funds. The answer to this is quite simple: the SEC will apply the Howey Test and long-standing definition of a security towards each fundraising project to evaluate whether there is validation of the security being an investment contract or not. While the SEC has not made official statements on pursuing non-compliant ICOs, they have stated that there are several investigations underway. One can assume with a safe level of certainty that the SEC will enforce its power as a regulatory agency to protect investors from fraudulent or potentially fraudulent ICOs, just as it would do for an initial public offering of stock. A classic of example of this is the SEC’s pursuit of The DAO token ICO and the subsequent report that followed after a hacking scandal left many investors empty handed. As mentioned earlier, the SEC’s stance as observed by Jay Clayton’s statements have set a global precedent. In early June, Thailand’s equivalent of the SEC issued regulations governing cryptocurrency exchanges and ICO – one of many national regulatory agencies to do so.

While more and more regulations are placed on the highly unregulated cryptocurrency arena, said regulations should not halt blockchain technology and the innovative platform it provides. It is up to blockchain companies to abide by local regulations, and also the responsibility of consumers and investors to conduct their due diligence. Potential investors must use their best judgement, and when in doubt, apply the Howey Test when evaluating a coin’s substance.

Image source: Shutterstock

 

David Eisenhauer
David Eisenhauer

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