A 'Howey Test' for Blockchain? Why the SEC's ICO Guidance Isn't Enough

The SEC may have finally published guidance on ICOs, but the vague concepts may not be enough for a new breed of financial professional.

AccessTimeIconAug 6, 2017 at 3:10 p.m. UTC
Updated Sep 13, 2021 at 6:48 a.m. UTC

After years of waiting for the SEC to give formal guidance on cryptocurrencies and their close blockchain relative, cryptosecurities, the regulatory agency in charge of protecting investors and ensuring the integrity of markets last month unleashed a trove of documents.

Amidst the 18 pages of the U.S. Securities and Exchange Commission (SEC) report detailing what makes a token a security was a statement from its division of corporate finance, an investor bulletin, and most notably, a decision that tokens issued by ethereum project The DAO qualified as securities.

First and foremost among the lessons gleaned from these documents was that not all ICOs constitute the issuance of securities. Second, and of perhaps more widespread significance, is that the SEC found that ICO trading should only be conducted on national exchanges, such as Nasdaq or the New York Stock Exchange.

Anyone hoping for more clear guidance is being advised to have their lawyer contact the agency directly. The regulator even provided a specific email address.

The irony here is that for the first time ever individual entrepreneurs working in garages and community work spaces around the world are being empowered through blockchain to build technologies with the power to disrupt a variety of global financial infrastructures. But the lawyers they need to build these tools compliantly remain the exclusive partners of the establishment and venture-funded startups.

Perhaps of even greater significance though, not only have these individuals been empowered to create financial platforms capable of doing what only banks could have done before, but for the first time, ever large numbers of blue collar workers were given the ability to commit white collar crime — on purpose, or not.

By failing to understand that the people most likely to violate the SEC regulations do not have legal representation, and by failing to communicate clear tests, the regulator is setting the stage for an explosion of prosecutions against young people who have the power to create these disruptive technologies.

Principles-based framework

Historically, the SEC has conveyed its regulatory policies, and even its interpretation of those policies through orders, rules, opinions, administrative proceedings, amicus briefs and the complaints it files in federal district courts.

Questions about nuance, interpretation or misunderstandings are, in turn, deferred to the lawyers who may or may not take the matter to the SEC in a formal capacity.

For those who read the report published last month, and finished wondering if what they created might put them afoul of the guidance, the SEC explicitly encouraged them "to consult with securities counsel to aid in their analysis of these issues."

But the problem with what the SEC calls a "principles-based framework" is that principles change, and some technologies change them. In the instance of blockchain, it appears to be an example of exactly such a technology.

Since the first blockchain, bitcoin, was unveiled in 2009, banks that had been fierce competitors are forming friendly-seeming consortia designed to better capitalize on the potential benefits of a shared ledger. Likewise, governments that have traditionally relied on the issuance of currencies to fund their agendas and control inflation are even learning to play nicely with cryptocurrencies.

In other words, principles are being changed by the idea that a technology can serve the role of a trusted third party, and they are being changed by young people writing in new computer languages and using new open-source technologies available for free to the public.

These builders frequently do not have lawyers, they almost never have investors and their advisors might just as well be high school teachers. Wish as we might for an easy-to-use, affordable application that translates blockchain features into the language of the 71-year-old Howey test for determining securities, no such technology yet exists.

New principles

To the SEC's credit, the regulatory body exhibited restraint in the way it reveled its first formal guidance to the industry. But being slow to implement potentially aging principals-based regulation isn't the same as adapting to changing principles.

While other regulators such as the New York State Department of Financial Services and its 2015 "BitLicense" appear to have rushed in their attempt to establish early industry precedence, and implemented a more prescriptive regulatory solution, the SEC took its time in spite of formal requests for clarity.

One such request even went so far as to ask that the SEC create of a "regulatory sandbox" for innovators to safely experiment without fear of being prosecuted.

In the interim, the SEC assembled a distributed ledger working group consisting of at least 75 people and hosted public meetings with blockchain leaders to learn more about industry demands and trajectory.

These and other methods of gathering information and customizing guidance have worked well for the regulator since the Securities Act was first established in 1933 in the aftermath of the Great Depression.

Nevertheless, the mandate to create financial transparency, and ensure the reliability of corporate information that resulted from that earlier collapse failed to prevent the rampant fraud that helped contribute to the loss of 8.5 million jobs in the U.S. alone in what is now called the Great Recession.

Within a year of that collapse, blockchain had emerged, thick with allusions to the resulting broken trust in the financial status quo.

Empowered by the bitcoin blockchain that now supports $44.5 billion worth of cryptocurrency, the world was invited to copy its open-source code and improve it, with other platforms for wildly different distributed ledgers to follow.

But the trouble these blockchain builders will get into if they fail to comply with the SEC guidance published last month won't just cost them money, it will cost the SEC money. The final cost of pursuing penalties against violators who can ill-afford the exorbitant fines typically charged by the SEC will be passed onto taxpayers, regardless of whose fault the violation actually is.

Clarity is even more important now that anyone can build potentially non-compliant technology.

The student becomes the master

Undoubtedly, the SEC's decision to rely on lawyers to sort through the guidance is intended to ensure it doesn't accidentally give its blessing to an application that complies with the word of the regulation, but violates its principles.

It must have been an unsettling prospect to the regulators that in saying anything at all, they might accidentally set a standard that they would only later find out could not be enforced. But it is exactly for this potential difficulty of enforcing violations that more clarity is needed, not less.

After all, blockchain innovators were first attracted to the technology because after the Great Recession, they stopped trusting third parties to look after their best interests, even while others sought to subvert the system to malicious ends.

But in either case, these builders are not the typical citizens the SEC is used to dealing with.

For example, in the case of The DAO, the founders of the company who wrote the code on which it was based (but who have denied on the record that they actually launched the code) will not be prosecuted, according to the report.

It is widely presumed that the small group of coders who initially set out to raise funds for the project were not prosecuted because the investors in The DAO were "made whole" in the aftermath of a controversial ethereum hard fork that will be difficult, or impossible to duplicate.

Nevertheless, to this day, hacks in which investors are not made whole continue to mount, with dozens having already occurred. These are not the typical recipients of SEC fines who regularly pay tens of millions of dollars in penalties for irresponsible behavior, but who do not serve prison time.

These are a new class of innovators capable of creating incredibly powerful financial instruments far from well-capitalized Wall Street. These are the people who began building financial platforms as a result — directly or otherwise — of what they perceived to be a failure of the SEC's framework built on its own aging principles of transparency.

In this light, the inadequate communication of simple straightforward principles can be seen as a failure to understand that the new principles being created are already trickling upward, changing the way even the highest levels of the global financial infrastructures are being run.

Snowflake image via Shutterstock


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