Regulation has become a hotly debated topic among blockchain circles. Most governments have shown a fairly tolerant attitude towards the new technology under concern of not stifling innovation in their own turf. However, this doesn’t mean that no lines are being drawn in terms of how blockchain investments should be handled.
Many projects are now sorting out what compliance means in their particular territories. In the US, relevant institutions have been forthcoming about allowing the space to grow while being clear that incumbent regulations for commodities, securities, and taxes will be enforced. This sets the tone in terms of what blockchain startups should look out for if they wish to operate in the country.
The basic question is to determine what is the purchase of a virtual asset and what actually constitutes the acquisition of a security. Tokens should be considered utilities, not shares. They must pass the Howey test, the family resemblance test, as well as the risk capital test in order to ensure Initial Coin Offering participants that they are in full compliance with regulations.
Understanding these tests should be seen as a risk reduction strategy. Although this job corresponds to a startup’s legal team, participants should be informed about the criteria before making any decision, so as to ensure the legality of their transactions.
The Howey Test
The first step in determining whether or not a token is a security is the Howey test. The name comes from the landmark 1946 Supreme Court decision on SEC v. W.J. Howey Co., in favor of the Securities Exchange Commission. The ruling basically established that transactions are classified as securities whenever profits are entirely dependent on the work of a third party. In these cases, it is required that they be registered with the federal agency.
A simple way to evaluate this is whether the arrangement can be defined by all three of following elements:
- An investment of money.
- In a common enterprise.
- With an expectation of profits predominantly from the efforts of others.
Family Resemblance Test
This method is used to determine whether there is a horizontal commonality in a transaction. The 2002 McNabb vs. SEC decision defines horizontal commonality as a “means pooling of interests, not only between the seller and each individual buyer, but also among all those who buy an investment contract in the same venture.” This may lead to classification as a security as well.
Experts outline four factors to be considered in this case:
- The motivation that prompts a reasonable buyer and seller to enter into the transaction in question;
- The plan of distribution of the instrument;
- The reasonable expectations of the investing public; and
- The existence of an alternate regulatory scheme reducing the risk of the instrument.
Risk Capital Test
In many ways it is an extension of the Howey test with the main difference being that it eliminates the profit requirement. Although it is not used at a federal level, approximately 16 states apply this test to determine whether a transaction is a security.
In the 1959 Silver Hills Country Club v. Sobieski case, the California Supreme Court considered:
- Whether funds are being raised for a business venture or enterprise;
- Whether the transaction is offered indiscriminately to the public at large;
- Whether the investors are substantially powerless to effect the success of the enterprise; and
- Whether the investor’s money is substantially at risk because it is inadequately secured.
In summary, the way these three tests relate to blockchain startups is that ICO participants should not be subject to shared profits nor shared risks. A startup’s tokens should not be used for the distribution of profits. As recently made clear by investment expert Nick Evdokimov, a startup’s token economy should be “built in such a way that the token is the means to pay for the product offered by a startup.” In this case, it is clearly a utility.
Likewise, a startup should not produce shared risks either. This is why escrow services should be used during an ICO. Participant’s funds should be held until utility tokens are released and ready to be used, removing them from any potential risk during the fundraising period. When a token creates neither shared profits nor shared risks then it is guaranteed to be a utility and not a security.
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