A ‘Howey test’ for Blockchain? Why the SEC’s ICO Guidance Isn’t Enough

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Just how much clarity is enough clarity?

Amidst the 18 pages of the recent 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.

In short, there was a lot to sort through. And there were obvious takeaways.

First and foremost among the lessons gleaned 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 have been conducted on national exchanges, such as Nasdaq or the New York Stock Exchange.

But, beyond that, there’s much that was left unsaid, and if you want to know more, you’ll have to contact them directly. In the end, the SEC’s stance can sufficiently be summarized as this: every token is a snowflake and will be dealt with on a case-by-case basis.

Wish as we might for a cookie-cutter application, maybe even one based on the 71-year-old Howey test for determining securities, no such technology or list exists.

Instead, it seems that what we’re left with is the irony that blockchain builders capable of creating incredibly disruptive technologies from their basements are being told to seek expensive legal council.

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 week, and finished wondering if what they’ve 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 such a principles-based solution 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 are fierce competitors have been 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.

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.

These builders frequently do not have lawyers, they almost never have investors and their advisors might just as well be their high school teachers.

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 disruptive technologies.

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 request even asked 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 week 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 penalties typically changed 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.

For example, it had to have been an unsettling prospect that the regulator, in saying anything at all, might have risked setting a standard that it would only find later it couldn’t actually enforce. But it is because of the possibility of enforcement 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 citizen 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.

To this day however, hacks in which investors are not made whole continue to mount, with dozens having already occurred. These are not the typical subjects 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 a lack of transparency in the markets overseen by the SEC.

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 infrastructure.

Snowflake image via Shutterstock

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