The ICO landscape was shaped throughout 2019 by a number of different factors–an increased influx of institutional cash, the increased prevalence of alternative token sale models (including IEOs and STOs), and the growing popularity of professional ICO management platform.
The year has also seen some important developments in the ways that ICOs are regulated, particularly within the United States. The United States Securities and Exchange Commission took action against several high-profile firms that have held some of the largest ICOs in history, including encrypted messaging services Telegram and Kik.
Although many analysts and experts agree that token sale regulations are still unclear in the United States, the ways that the cases have continued to unfold in court have the potential to set important precedents for the future of token sale regulation.
But will the potential for truly effective regulatory clarity–by some standards, the holy grail of the cryptocurrency industry–be reached anytime soon?
The SEC’s cases against Kik and Telegram have “[done] little to clarify the current murky regulatory environment”
Many analysts and experts agree that as far as protections for US-based investors are concerned, the SEC seems to have made progress, particularly over the last two years. J. Gray Sasser, co-chair of the Blockchain and Digital Currency team at Kentucky-based law firm Frost Brown Todd, LLC, told Finance Magnates that “to its credit, the SEC has chased many of the fraudsters out of the space.”
Despite this, however, Sasser does not see much progress in terms of regulatory clarity on compliance measures for crypto-related firms who wish to hold token sales accessible by US-based investors.
“As both Kik and Telegram highlight in their court filings, the SEC’s complaints against the two companies do little to clarify the current murky regulatory environment,” Sasser explained.
“Counsel and their clients are forced to parse through a variety of speeches, statements, guidance and reports – none of which constitutes binding legal precedent,”
Indeed, Kik has tried to argue (unsuccessfully) that the SEC’s lawsuit against it should be considered “void for vagueness”; Telegram argued that the SEC has “engaged in improper ‘regulation by enforcement’ in this nascent area of the law, failed to provide clear guidance and fair notice of its views as to what conduct constitutes a violation of the federal securities laws, and has now adopted an ad hoc legal position that is contrary to judicial precedent and the publicly expressed views of its own high-ranking officials.”
Our full response to the SEC complaint: https://t.co/l0wlfFcwef
— Kik (@Kik) June 4, 2019
Sasser explained that “the dearth of federal legislation and the SEC’s failure to use its formal rulemaking authority means that U.S. issuers of digital assets must engage in modern-day Kremlinology to divine what passes regulatory muster,” he said.
In other words, Sasser believes firms that wish to hold ICOs for US investors must become experts in the art of deducing what is really happening within a rather opaque organization.
“Counsel and their clients are forced to parse through a variety of speeches, statements, guidance and reports – none of which constitutes binding legal precedent,” he explained.
“Rather than updating statutes and regulations to account for this new technology, Congress and the SEC seem content to let the federal courts establish the rules of the road when it comes to digital asset offerings.”
To a large extent, the Commission’s actions this year may simply be reiterations of the past
While it could be argued that although regulating by enforcement is unfair and perhaps even illegal, it could be said that (albeit rather ham-fisted), regulation by enforcement is still a possible means to an effective end.
However, Rebecca Rettig, partner at FisherBroyles, LLC, in the firm’s Litigation Department and FinTech & Blockchain practice group, said that so far, the actions that the Commission has taken this year haven’t presented anything new in terms of how the crypto industry should be regulated.
Indeed, “[the] SEC’s lawsuits against Telegram and Kik are only a continuation of the position the SEC enunciated in The DAO Report in 2017,” she said to Finance Magnates. The DAO report was an investigative report on the DAO token sale that took place several years ago. The SEC described the report as “cautioning market participants that offers and sales of digital assets by ‘virtual’ organizations are subject to the requirements of the federal securities laws.”
And what were the positions that were enunciated in the DAO report? Ms. Rettig explained that the report was the SEC’s “line in the sand” where it believed it was putting the industry on notice that participants needed to comply with the U.S. securities laws, regardless of whether firms conducting ICOs were based in the United States or abroad.
After all, Ms. Rettig explained, the SEC’s mission is to protect US investors and therefore, any token sale that has touched US investors is within the SEC’s jurisdiction; for example, Kik is based in Canada, while Telegram is incorporated in Germany.
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“In some cases, issuers [have abandoned] the United States altogether in search of jurisdictions with codified rules.”
In any case, the absence of a clear set of regulations has resulted in ongoing confusion. “The lack of clarity has left many blockchain developers scratching their heads and engaging in metaphysical discussions about how much ‘functionality’ a token must have not to be considered a ‘security’ in regulator’s eyes,” Sasser said.
He argued that ultimately, this kind of “cloudy regulatory environment” has stunted the growth of the cryptocurrency industry within the United States. “In some cases, issuers [have abandoned] the United States altogether in search of jurisdictions with codified rules,” Sasser said. “Other issuers have postponed any token offering, electing to raise capital through private placements of traditional securities to accredited investors via the safe harbor afforded by Regulation D.”
”Both the SEC and CFTC are looking to become the regulator charged with fighting wrongdoing.”
However, while regulations are still rather murky within the United States, the SEC’s cases against Kik, Telegram, and a number of other ICO issuers seem to point toward an increasingly ambitious attitude in taking law enforcement action against firms that hold ICOs.
Indeed, “the high-profile filings by the SEC show that they are increasing their scrutiny on the space,” said Braden Perry, Government Investigations and Corporate Governance Counselor at Kennyhertz Perry, LLC, to Finance Magnates. “It also shows that both the SEC and CFTC are looking to become the regulator charged with fighting wrongdoing.”
Perry also pointed out that the SEC has begun to widen the scope for cases that it considers to be in violation of the law. He said that the high-profile filings that the Commission has made throughout the year “[show] that even companies that attempt an ICO compliantly can get cross-ways with the regulators.”
“Take Kik for example,” he continued. “This was the SEC’s first Section 5 case, not alleging any fraud or abuse, but simply for failure to register what it deems as a security.”
The Howey Test is a living, breathing legal doctrine that has been purposefully designed to grow and change over time
And indeed, what does and does not count as a security in the SEC’s eyes seems to be an ongoing source of confoundment for the cryptocurrency industry–both Kik and Telegram, for example, have been accused of selling unregistered securities, although both companies have argued that their coins are utility tokens.
SEC’s response to Skadden’s/Telegram’s opposition to the SEC’s preliminary injunction application against Telegram:https://t.co/ZPZvFcHOHE
— ☠l̶̫͚̍̃͊́͐e̷̛̊́x̸-̴́̿n̷̛̜̣̥͛̋͛̓ǒ̶̾̿̒͂̈́̍d̸͛̔̀̽ë̵́☠ (@lex_node) October 20, 2019
“The Howey test is notoriously vague and many times based on a case-by-case basis,” Perry continued. “And for now, it looks like KIK will have to convince the court that Kin was not a security while rewriting what they believe the facts to be and facing a large legal expense.”
However, Rebecca Rettig pointed out that the Howey test’s notorious vagueness is at least partially by design. Ms. Rettig said that although the Howey test has been in existence for over 70 years, it is a living, breathing legal doctrine that has been purposefully designed to grow and change over time as novel instruments come into existence. In making that statement, Ms. Rettig cited SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344, 351 (1943), which states:
“[T]he reach of the [Securities] Act does not stop with the obvious and commonplace. Novel, uncommon, or irregular devices, whatever they appear to be, are also reached if it be proved as matter of fact that they were widely offered or dealt in under terms or courses of dealing which established their character in commerce as ‘investment contracts,’ or as ‘any interest or instrument commonly known as a ‘security’.”
In other words, the test was designed to be flexible in order to adapt to the evolving financial world. However, at what point does this intentional flexibility become negligence? Many within the cryptosphere argue that the line was crossed a long time ago.
The SEC believes its “enforcement in this space has been thoughtful and consistent.”
What does the SEC have to say for itself in terms of its pattern of enforcement and regulation? In the Commission’s 2018 annual report from the Division of Enforcement, the SEC said that “led by the Cyber Unit, the Division emerged as a global leader in addressing misconduct relating to digital assets and initial coin offerings (ICOs).”
“We believe our approach to enforcement in this space has been thoughtful and consistent. Importantly, it has provided a template for authorities in other countries, where fraud and misconduct targeting U.S. investors often have been based,” the report continued.
“Given the explosion of ICOs over the last year, we have tried to pursue cases that deliver broad messages and have market impact beyond their own four corners. To that end, we have used various tools—some traditional, such as the Commission’s trading suspension authority, and some more novel, such as the issuance of public statements—to educate investors and market participants, including lawyers, accountants, and other gatekeepers. We believe these investor-protection efforts have been successful.”
“Knowing their business model will be scrutinized may push the good actors out of the space but may not deter the bad actors.”
However, even though the SEC’s actions have perhaps not yet resulted in increased regulatory clarity, the cases that are currently underway could eventually result in more tangible regulations.
-For example, Braden Perry said that although Kik may not win the case, the court battle does present an opportunity to clarify regulation. “it is a time for righting facts and getting the litigation on an even line,” he told Finance Magnates. “It’s going to be a long battle, with extensive discovery, but the main issue is pretty simple: was this a security or not. And that will be a legal issue and likely ripe for a substantive judicial interpretation.”
And even then, the outcome of the case could have unintended consequences: “this likely will be a chilling effect for ICOs looking at attracting investors,” he explained. “Knowing their business model will be scrutinized may push the good actors out of the space but may not deter the bad actors.”