We do the research, you get the alpha!
Is it still possible for a crypto startup to raise money selling tokens without bending to the will of the SEC—or, worse, later incurring its wrath? There’s at least one major company in cryptoland still willing to die on that hill.
While the ICO craze might be over, and STOs have been the talk of the town over the last year, ConsenSys (Decrypt’s source of funding) plans to forge ahead with no fewer than four Consumer Token Offerings (CTOs) in 2019, according to comments made by ConsenSys founder Joseph Lubin during SXSW.
A CTO involves the sale of a token that is designed, marketed, and sold using the “consumer token framework” developed by the ConsenSys-backed, crypto legal consortium The Brooklyn Project. “The bottom line is that these are digital assets that are inherently consumptive in nature—meaning, they’re designed fundamentally to be used or consumed,” says Brooklyn Project co-chair and ConsenSys Deputy General Counsel Patrick Berarducci.
Consumer tokens are close cousins of the “utility tokens” of yesteryear. Intrinsically, they are the same—tokens meant to be used, not traded and resold as speculative, financial tools. They differ, however, in their extrinsic properties. Consumer tokens aren’t just a clever rebranding of the utility coins in-name-only sold by ICOs looking to pull a fast one on federal regulators (although that doesn’t hurt); these are tokens specifically designed to not skyrocket in value, and are highly restrictive in the way they are distributed and later resold.
As such, the sale of these tokens is completely open to the public. There’s no need to register these sales with the U.S. Securities and Exchange Commission, file a registration exemption, or restrict them to “accredited investors,” according to ConsenSys General Counsel Matt Corva. In fact, he says it wouldn’t make any sense to do so, since we’re talking about the sale of consumer goods “that look nothing like an investment contract, or a security, or any other financial instrument.”
“Of course you should be able to sell tokens that are pieces of software without implicating financial securities laws. I think even the SEC would have a hard time arguing [against] that,” he says.
The SEC declined Decrypt’s request for comment.
“It’s misguided to say that everything should be SEC-compliant,” says Corva. “Of course, everything you do should be regulatory compliant, but the starting position should not be that just because something is a token, it is regulated as a security.”
So far, two crypto startups have sold their tokenized wares using the CTO framework—blockchain-based journalism network Civil, and proof-of-location, GPS alternative FOAM. But with more seemingly on the way, questions linger as to how the SEC will ultimately view these ICO-like offerings. And not everyone is convinced that the Commission will decide to live and let live.
We can count Drew Hinkes, an adjunct professor at NYU Law and Athena Blockchain general counsel, among those who urge caution.
"Although the [Brooklyn Project] framework is interesting,” he says, “until the SEC approves it, provides express no-action relief for companies seeking to issue tokens under that framework, or articulates new standards for token issuance, the safest course of action is to proceed in compliance with securities laws or exemptions therefrom.”
Hinkes’ position mirrors that of the SEC’s senior advisor for digital assets, Valerie Szczepanik, who said recently during a public forum at SXSW that the Commission strongly prefers crypto companies ask for its permission, rather than forgiveness.
But Corva disagrees. He says waiting on the SEC’s approval to launch the sale of what amount to software products is an “untenable position for innovators in the U.S.,” and the reason many of them are moving their companies overseas. Corva adds that it’s also a misconception that crypto companies haven’t actively been seeking the SEC’s guidance.
“People are trying to be SEC compliant,” he says. “But, for one, nobody knows what SEC compliant means, and two, regulators have not held up—from my perspective—their end of the bargain.” Corva says the SEC has so far failed to deliver on its promises of clear, “plain English” guidance for the crypto industry, and suspects it will likely never come.
“The SEC, over a year and a half ago, said ‘come to us seeking no-action relief. Come to us for approved offerings.’ We haven’t seen a single no-action letter published,” he says. What’s more, for the “hundreds” of startups that have pursued token sales under a Regulation A+ exemption—the same kind that Twitter alternative Gab applied for and would have allowed it to raise funds from non-accredited investors in an SEC-compliant way—not a single one has received the Commission’s blessing.
“None of them have been approved,” says Stephen McKeon, assistant professor of finance at the University of Oregon and Chief Strategy Advisor of the Security Token Academy. “And that’s why most entities are using [Regulation] D, because Reg D doesn’t go through an SEC approval process—it’s just a filing—whereas Reg A does go through a review process.”
The result is that any offering seeking the SEC’s stamp of approval must, in practice, be limited to accredited investors—individuals with a yearly salary of at least $200,000, or a net worth of $1 million.
And for the projects, protocols, and networks that depend on their tokens being used by the people who purchase them, gating off their platforms as strictly for the wealthy doesn’t make much sense. Take a “decentralized Uber,” for example, says Berarducci. “Maybe you need the token to be a rider or a driver or both. If that token was a security, then you're left with an Uber network where, effectively, the only people who could be drivers are accredited investors.”
McKeon largely agrees. Conceptually, he says, consumer tokens and CTOs make all the sense in the world. “I think of it in terms of markets. What Lubin is describing are tokens that are designed for product markets—like, you purchase a good or service with them—as opposed to security tokens, which we typically think of as [pertaining to] capital markets.”
Things get murky, however, when the token tries to exist in both product and capital markets, he says. “When it’s both trying to provide access to a good or service, and it’s being used to raise capital to fund a project, I think that’s where it gets tricky from the SEC’s standpoint.”
“If it’s trying to be both, they’re going to call it a security,” McKeon says.
But Corva takes issue with that analysis. He says raising capital is not and should not be the line in the sand that decides whether the sale of an asset or product falls under the SEC’s jurisdiction.
“How do you think Elon Musk pays for production for all of his cars? He pre-sells them years in advance and uses that capital to build up his product,” says Corva. “One, he’s able to determine what his demand is, and two, he has the capital to build up his production line and actually build the cars. A Tesla is never a security at any point in the process.”
In this sense, Corva believes that the Howey Test—the much ballyhooed measuring stick by which federal regulators in the U.S. determine whether an asset qualifies as an investment contract, and the bane of ICO-funded startups faced with enforcement action—actually works in the consumer token’s favor.
It all comes down to whether the token is sold with the “expectation to profit from the efforts of others,” as Howey enumerates, or “inducement to purchase based on financial motives,” as Corva likes to frame it. That alone means that consumer tokens fall “squarely in non-securities land,” he says.
Both Corva and Berarducci say they worry about the effect that overzealous regulators in the United States are having on the crypto industry. While the SEC has successfully “chilled the market” in a way that prevents bad actors from running amok, well-meaning innovation is being stifled, they say.
Entrepreneurs can spend hundreds of thousands of dollars, and anywhere between six months to a year, seeking no-action relief and other forms of guidance from the SEC for their token-powered projects and, in the end, still have nothing to show for it, says Corva. “And the flip side to that is, what’s going on in those 12 months is there’s a company in the UK that’s already launched your service with your proposed mechanisms. It severely disadvantages innovation in the United States,” he says.
"When we're talking about innovative technology, and every day counts,” adds Berarducci. “Companies and payrolls have a hard time being met if we can't keep the innovation cycle going.”
Mckeon wonders, however, whether a market even exists for consumer tokens. After all, the appetite for tokens sold during ICOs is all in the financial return for investors.
While FOAM raised $15 million in its CTO, it did so during the tailend of the token-fundraising boom. Civil, on the other hand, failed to reach its soft cap of $8 million last October, and since relaunching its sale in early March, has so far only raised just over $300,000.
“I think the challenge is whether the demand for these products and services is actually going to be there. And that’s what remains to be seen,” says McKeon.
Either way, consumers will soon get their chance to decide.
Consumer tokens “may work nowhere; they may work everywhere,” says Corva. “But we need to try it more, and that’s going to take a lot of research and thinking. And I think ConsenSys will always try to be at the forefront and try to do things responsibly.”