Securities Law and Blockchain Adoption
The term “regulation” can elicit a lot of negative feelings, especially in the blockchain space in which conforming to the traditional regulatory frameworks can be antithetical to core elements of the innovation. While the role of regulation is hotly debated, one fact remains: formal regulation on one level or other is prerequisite to the adoption of the technology.
Before diving into what regulation applies to the blockchain space, let’s take a look at a typical example of why regulations exist. You may not know this but there is a litany of regulations one must comply with in order to open and operate a restaurant. From the shape of door handles and thickness of drywall to the type of dishwasher and grease trap used in the kitchen, no detail is too small for the inspector. Why such scrutiny? To ensure a safe and accessible environment for the production of food. Safety and accessibility are two outcomes that benefit both the business and its patrons.
Blockchain technology offers innovation which affects many sectors of the economy. This innovation poses threats to the established way of doing things which have existed with their own entrenched regulations. In this article, I’d like to explore securities law and its role in the adoption of new blockchain technology because the financial sector is poised to experience the most disruption in the near term, and because most applications, no matter the sector they are operating in, will bump up against securities regulation.
A security is a financial instrument that represents monetary value. The monetary value comes from either ownership in – or a creditor-relationship with – a common enterprise. Financial securities are no more valuable than the paper they are printed on; however, the claims they entitle to their owners carry value. That value depends on the security issuer’s financial condition. Securities laws, therefore, aim to ensure that investors receive accurate and necessary information to make a fair judgement regarding the type and value of the interest under consideration for purchase.
Following the Great Depression, Congress enacted the first of various federal securities laws, the Federal Securities Act of 1933, to regulate the public offering and sale of securities in interstate commerce. This Act also prohibits the offer or sale of a security not registered with the Securities Exchange Commission (SEC) and requires the disclosure of certain information to the prospective securities’ purchaser.
The clearest example of the intersection of securities law and blockchain exists in the ICO market. ICOs, initial coin offerings, have been an early innovation of blockchain technology which have allowed companies and projects to raise capital to support their development and growth. An ICO is similar to an IPO, an initial public offering, in that it gives the public market a chance to invest. However, unlike an IPO, the investor is not purchasing shares in an underlying company but rather a token native to the company’s network. The token may have different purposes, such as governance or network utility, but it does not represent ownership and thus falls into a legal gray zone.
The SEC uses a framework for determining if an offering should be deemed a security and thus subject to existing securities regulation. Because of the rapid rise to prominence of ICOs — they raised over $7 billion in 2018 alone — the SEC released an evaluation tool for ICO classification. In summary, the framework questions whether or not ICO investors are participating in a speculative enterprise, and, if they are, whether the profits those investors are hoping for are entirely dependent upon the work of a third party. If both conditions are true the offering is deemed to be a security.
“In pursuit of our goal to see the adoption of blockchain technology grow and flourish, we recognize that regulatory hurdles must be navigated in a compliant fashion.”
Once a particular ICO is classified as a security, the SEC can then determine the legal requirements for selling the token to U.S. investors. The classification also compels U.S. investors to register their token holdings with the SEC. This has an important impact on the development and adoption of the technology. The SAFT Project, a group with the goal of creating a compliant legal framework for blockchain projects, notes that ICOs play a critical role in creating decentralized communities, jumpstarting network effects in addition to providing liquidity to investors and capital to creators. For example, projects like Ethereum have come about by selling tokens and using the proceeds to fund the development of their virtual supercomputer, which in turn hosts thousands of decentralized projects (all of which may be independently subject to the same SEC regulations).
Regulations aimed at ICOs effectively add time and expense to project development, and narrow the pool of willing capital to support its vision. They therefore threaten to starve projects of the capital and network support critical for success.
Compliant Options for Adoption
In pursuit of our goal to see the adoption of blockchain technology grow and flourish, we recognize that regulatory hurdles must be navigated in a compliant fashion. So how does a blockchain company work with the SEC to remain compliant, assuming it offers utility tokens? For context, a utility token is used to gain access to the good and services provided by the blockchain innovation. This should not be confused with security tokens which are simply tokenized claims on a traditional financial instrument.
The SAFT project advocates a specific roadmap for token sales that starts with a security offering that uses Rule 506(c) of Regulation D of the Federal Securities Act. This allows the company to sell a security that is effectively a discount on the final token sale to verified accredited investors. The company can use the proceeds to develop the network into a product that provides genuine utility to the users, at which point a broader public sale would no longer satisfy the conditions that deem it to be a security offering.
“We believe smart regulations encourage and support innovation.”
The SAFT approach works because it sells the right to buy tokens – as opposed to directly selling tokens that do not yet have functional value. The downside of the SAFT approach is that it limits the number of people that can participate to accredited investors, which are those individuals with more than a $1 million net worth and/or earning more than $200,000 per year.
There is another compliant alternative to a token sale being pioneered at the moment by Blockstack, which is a Regulation A+ crowdsale. This type of fundraise is similar to an IPO, but it has restrictions on the total amount you can raise. A primary benefit of Regulation A+ approach is anyone can purchase tokens, not just accredited investors, thus creating a larger base for network participation.
We believe smart regulations encourage and support innovation. Our hope is for the evolving framework of blockchain regulation to balance its role of protection with the possibility for support and flourishing.