Far from insulating token issuers against regulatory actions, the proposed SAFT framework may actually increase the risk certain sales run afoul of securities laws, according to a new report out today.
The 13-page report lays out a detailed, though civil, critique of the SAFT white paper issued last month by the Cooley law firm and Protocol Labs. That paper was billed from the get-go as a conversation-starter, and Marco Santori, the Cooley lawyer who spearheaded the project, invited feedback from the legal community.
But the feedback in the Cardozo paper suggests that making initial coin offerings (ICOs) compliant with securities laws, while still delivering on the technology's disruptive promise, may be a harder needle to thread than the SAFT solution anticipates.
The paper cautions:
Stepping back, the SAFT framework called for splitting the ICO process into two parts in order to avoid the risk certain types of blockchain tokens might be classified as securities.
First, the developers of a token-based blockchain network would raise money from accredited investors to build it. In return, the investors would get the right to tokens once the platform is completed, possibly at a discount. This agreement, known as a SAFT, would be registered as a security with the Securities and Exchange Commission (SEC).
In the second part, once the network is up and running, the tokens are sent to the investors, who can then sell them on the open market. The tokens themselves wouldn't be securities, allowing the general public to buy them for use on the platform.
In this way, only wealthy individuals and institutional buyers, not the proverbial mom-and-pop investors, would bear the risk of the project failing, while consumer protection regulations would still apply if the final product – the network – turns out to be defective. And importantly, the publicly available tokens would not meet the so-called Howey test of whether something is a security, the SAFT white paper argued, since only the early investors would be expecting a profit from "the efforts of others."
But according to the Cardozo paper, bifurcating the process like this may actually compound the risks to token issuers and consumers alike.
Not so simple
For starters, the paper says, there is no easy test for whether an instrument is a security.
"[C]ourts and the SEC have repeatedly, and unambiguously, explained that the test for whether a particular instrument will be deemed a security depends not on bright-line rules but rather on the relevant facts, circumstances and economic realities," the Cardozo paper says.
Further, in order to attract the early investors in a SAFT security, the sellers would naturally be expected to "emphasize the speculative, profit-making potential of the underlying utility token," the authors write.
Yet, marketing the agreement this way "may well impact a federal securities law analysis of a token developed pursuant to a SAFT," they warn, adding:
Hence, "[t]okens underlying a SAFT may be more likely to be deemed securities, thus potentially subjecting token sellers to significant legal or economic risks," the paper says – the opposite result of what the proposal set out to do.
Meet the new boss...
The other main danger is that the SAFT approach "creates a class of early investors that are incentivized to flip their holdings instead of supporting enterprise growth, which could fuel speculation and hurt consumers," the Cardozo critique says.
The concern is that well-connected insiders "will receive exclusive access to purchase utility tokens — a fundamentally consumptive technology — at an early stage in the platform's development and at substantial discounts, even though they have no intent to use these tokens or enjoy the underlying technology."
Rather, these gatekeepers would drive up the price of the tokens through speculation, "potentially making it more expensive for consumers to purchase tokens and participate on these networks," the report says.
It concludes ominously:
In other words, rather than democratizing access to technology, as blockchain networks are often purported to do, the SAFT might just create another old boys' club.
For his part, Santori said he and his SAFT white paper co-authors welcomed the Cardozo response.
"We're over the moon to see the SAFT project work like this," he said by email today, adding: "Generating this kind of commentary and discourse is precisely the aim of the Project and precisely what the industry needs to develop a compliant token sale framework."
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