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News broke this week that the SEC has been issuing a large number of subpoenas to Initial Coin Offering (ICO) issuers, targeting technology companies, and their investors and advisors.
Generally, subpoenas are the guided missiles of SEC enforcement actions. While the SEC has been making noises about the illegality of ICOs for months, issuers and their enablers are now firmly in the crosshairs.
The writing has been on the walls for quite some time that a crackdown would be coming, but many in the cryptocurrency community chose to ignore it. Before subpoenas hit, advisors were giving false assurances to those looking to avoid SEC scrutiny.
On October 2, 2017, the SAFT Project introduced its SAFT Project White Paper to the world. The SAFT White Paper proposed a modification of the existing SAFE framework for ICO token sales, in effect repackaging the SAFE funding mechanism to define tokens as utilities rather than securities. Under a SAFT, or Simple Agreement for Future Tokens, developers raise capital from accredited investors pursuant to a Regulation D offering. The developers use the capital raised to develop the underlying network, and upon completion of the network, the SAFT is converted into a right to purchase tokens at a discount. The SAFT White Paper contends that the tokens purchased by exercising that right are non-security, utility tokens that are magically free-trading. Problem solved.
Except it’s not. In reality, the SAFT, as opposed to an innovative funding mechanism, is simply a window-dressed Regulation D 506c, that attempts to propagate the misguided notion that utility tokens are not securities.
Let’s play this out. Accredited investors invest in a SAFT financial instrument, which is admittedly a security, and at some point later convert their investment into tokens at a discount. The right to purchase the tokens at a discount is clearly attached to the initial security investment. The SAFT White Paper declares, “The SAFT offers investors a discount on the final token sale and is a security itself…” The tokens are rights derived from the security investment and therefore securities subject to the Federal Securities Laws (FSLs).
Ironically, this misguided SAFT Framework introduces regulatory limitations that are contrary to the goals of ICOs: the offering of free-trading instruments open to all investors. In contrast, securities offered in a Regulation D offering are illiquid, restricted, and not freely tradeable until exempt (e.g. Rule 144) or registered in a subsequent registration statement, which requires full public disclosure of all material information. Only accredited investors can participate in a SAFT offering. The rights to purchase tokens derived from any SAFT offering are derivative securities, subject to the same limitations under FSLs that apply to the SAFT itself, thus creating “utility” tokens that are illiquid, cannot be traded in the U.S. securities market place, and are effectively limited to distribution among wealthy participants.
The harsh reality is that virtually all ICO tokens are, and always have been, investment contracts, and thus securities. The proposition that utility tokens are not securities, as posited by the SAFT White Paper, is nonsense. Individuals are investing money in the future user interest in the company (i.e. ICOs) with the hope of making a profit on that investment from the efforts of the developers/individuals/entities in control of the network, thus satisfying the Howey Test and clearly making such investments securities.
The SAFT White Paper continues to promote the utility token paradigm that has been proven to be in violation of the FSLs. ICO issuers are better served from a risk and monetary perspective embracing the FSLs from the start and creating the proper offering and disclosure documents. An ICO issuer will spend approximately $100,000 to create a proper Reg A+ qualified, distributable securities offering, and in such a case, the issuer would be able to sleep soundly at night, without having to worry about any potential FSLs violations looming over their token activities. In contrast, utility token issuers (including users of the SAFT Framework) always have to worry about their tokens being declared a security, resulting in subsequent enforcement actions, even though they paid $100,000+ to have their attorneys craft creative utility token arguments.
Any advocate of the SAFT Framework must recognize the disservice they are doing, and have historically done, to their clients and the industry by promoting the utility token myth that continues to try to circumvent the FSLs.
Recently, SEC Chairman John Clayton explained that the SEC would target attorneys who advised their clients to conduct ICOs without the proper offering documents. One cannot pick and choose if and when regulation applies. Chairman Clayton said it best in February’s Senate hearing: “I believe every ICO I’ve seen is a security.” The blockchain/cryptographic token space needs to realize that the SEC cometh and the industry needs better solutions than the SAFT Framework.
Aaron Kaplan is the COO of Prometheum and a securities attorney at Gusrae Kaplan Nusbaum PLLC, where he has focused on blockchain and securities regulation.
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