The SEC and ICO Regulation [Video + Transcript]

The growing number of mainstream media covering cryptocurrencies and other cryptoassets such as ICOs has lead a lot of people to wonder: how does it all get regulated? I have previously covered ICOs and tokens, so if you need a refresher, make sure to go check that out.

This is a two-part series covering the regulatory aspects of cryptoassets. To give some background, two of the major federal regulatory agencies in this space are the SEC and CFTC. Broadly speaking, the SEC regulates ICOs, and the CFTC regulates virtual currencies. We recently saw the Chairman for each of the two agencies testify before the Senate—which means that lawmakers are getting serious about regulating this space.

In today’s episode, I want to focus on the SEC- what they do, what they have power over, and how that relates to ICOs.  My next episode will cover the CFTC.

Before I launch into this discussion, I want to make a disclaimer here, since I had previously worked at the SEC: none of what I am about to say reflects the official views of the SEC and are my personal opinions only.

So what is the SEC? The SEC stands for the Securities and Exchange Commission. They are headquartered in Washington DC, but have 11 regional offices across the U.S. that all work with each other.

Largely speaking, the SEC is a U.S. federal agency with jurisdiction over securities and the participants in the marketplace. Examples of securities include things such as stocks or bonds. And the market participants refer to the securities exchanges, brokers and dealers, investment advisors, investment companies, issuers, and investors.

The SEC has a three-part mission, which is: 1) to protect investors; 2) to maintain fair, orderly, and efficient (financial) markets; and 3) facilitate capital formation (which is to make capital markets more accessible—making it easier for people to raise money for good business ideas and projects).

The SEC is divided into five divisions and 23 offices. For example, there is the Office of Compliance Inspections and Examinations, which is probably what you see on TV sometimes, where the SEC will send a bunch of people to go into a bank or a company and examine their financials and other relevant documents and practices to make sure that everything looks ok. There is also the Division of Enforcement. They are made up of the lawyers who prosecute the violators of securities law. Within the enforcement division, it is further divided into units that take on a certain sector or area of the law. For example, the market abuse unit covers insider trading, illegal market price manipulation, fraudulent schemes, or any other conduct that abuse the fairness of the markets. The recently established Cyber unit within the enforcement division specifically targets cyber-related misconduct, including violations involving distributed ledger technology and ICOs.

So—why have we seen so much debate in the crypto space with regards to the SEC? First things first— cyrptocurrencies are not defined as securities as under the law, and thus are not under the SEC’s jurisdiction, meaning that the SEC has no power over cryptoassets such as Bitcoin. Rather, SEC has power over securities—which can extend to the ICO and token space.

How does the SEC actually define “securities”? Well, if you have been following the news in this space, you may have heard of the Howey Test. The Howey Test came out of the 1946 Supreme Court case SEC v. W.J. Howey Co., which laid out a four-prong test for judging whether or not something can be classified as a security: “an investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person [1] invests his money in [2] a common enterprise and [3] is led to expect profits [4] solely from the efforts of the promoter or a third party.” Basically, the Howey Test is a test you actually want to fail if you don’t want to be considered to be a security. A lot of the debate has been over the third factor, which is around an investor’s expectations to make profits. On one side of the argument: because people buy into ICOs and tokens with the expectation that these tokens will rise in value later on  (meaning they can just sell their tokens for a higher price than what they bought it at), this would make the token a security. The other side of the argument is the obvious opposite: people aren’t buying these tokens just to make money. Rather, the tokens are for actual use cases only, with no expectation of profits. As you can see, this is actually kind of a gray area, which is why there is so much room for argument.

If all tokens are considered to be securities under this Howey Test—and there are very strong indications from the SEC saying that they are– that actually is very bad news for a lot of the ICOs out there, because, to this day, not a single ICO has registered with the SEC. All securities must register with the SEC, which basically means that you have to file and disclose all that the SEC requires you to. Examples include filing a description of your business and assets, of the security being offered, the further details of the offering, description and names of the company’s management, and the company’s financial statements that have been certified by an independent accountant.

Of course, the law allows for certain exemptions if you can qualify for it. This means that instead of having to register all of your ICO’s financial information with the SEC, you just need to make one public filing that says you meet that exemption. Examples of those exemptions are Regulation D, which limits the kind of people you can take money from, or Regulation CF, which limits the amount of money you can raise. This is also something only a handful of ICOs has done.

On one hand, we see why ICOs don’t want to register with the SEC. It’s more paperwork and cost for them, and it makes it a lot harder to raise money by slowing down that process. On the other hand, being able to raise tons of money with absolutely no obligation to provide any information to people buying your tokens mean that there is a lot of room for really bad projects. That creates a lot of room for frauds and scams, which ultimately will end up hurting the investors the most. Without the necessary financial information, how do you even know what you’re investing in? Remember that the SEC’s whole mission is to protect investors and ensure that the financial markets are fair. There are people who are in debt who are taking out additional loans to buy into projects that are at best terribly designed and at worst scams to rob you of your money.

I want to emphasize that there is a lot of really positive things about the ICO fundraising model. And there are a couple of really interesting ICO projects led by really smart people who aren’t out there to take your money and run. But my personal opinion is that regulation is really important, because it will force everyone to behave in a more responsible manner. Yet sometimes, too much regulation can also stifle innovation. It’s definitely a difficult balance to find. Regulators, law makers, and the crypto community need to work together to figure out the best way to allow for ICOs as a fundraising mechanism to survive, but also better protect people who want to invest in the projects.

I hope that this brief overview was helpful in understanding what the SEC is and what they do. I also hope that you now have a better understanding of the latest debate in the regulatory space with regards to ICOs.

All opinions published on this blog are my own and do not reflect the opinions of any institutions that I am affiliated with in any capacity. None of this should be taken as legal or financial advice. If you are interested in investing in cryptocurrency, please do your research thoroughly. 

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