Connect with us

Token issue considerations: Why Howey Test is ineffective for Blockchain and Crypto space?

Howey Test has no place in Blockchain and Cryptocurrency space and why SEC has to change the rules before other countries take over the Blockchain space. Switzerland is already pushing the envelope to become global Blockchain Hub.
Highlight and Share any text
Initial Coin Offerings (ICOs) were the craze in the world of cryptocurrencies during 2017. While it may seem like they have died down, the fact is they are still out there.

If you are a company that is looking to raise the money using ICO route, you may have wondered as to the accounting and tax implications. At least, the real businesses will have to ask the questions about legality, accounting, and tax issues before they go onto raise the money. Only companies that are trying to scam people will ignore these aspects.

In this article, we will try to talk about the accounting and tax considerations from a business perspective (not individual tax, for individual tax considerations, check out our FBAR and FATCA article and Individual FBAR and FATCA Guide here).

Because this topic is quite broad, we will break it down to the following content to understand it piece by piece.

Content:

Is it a coin or a token?

coin or tokenA coin denotes an ‘exchange value’, much like a US dollar.  You can use the coin for products and services.  For instance, if you hold a dollar bill in your pocket, it doesn’t do anything unless you use it to buy a product or service or invest.  Similarly, a coin does not offer anything on its own blockchain unless the holder exchanges it for something.

Bitcoin is an example of a coin. Litecoin and Ethereum also are native coins of their respective blockchains. Ethereum assumes additional features than a coin because of its ability to execute smart contracts and facilitating Initial Coin Offerings (ICO) and may qualify as a coin and a token (depending on who you are talking to).

Token, on the other hand, is designed to be more than mere ‘exchange of value’. For instance, a token can grant you:

  • Access to services on its blockchain platform
  • Rights to profits from the business
  • Speculative trading opportunities
  • Discounts to certain features on the platform
  • May grant voting rights
  • Master nodes, a new way of locking of the certain number of tokens to generate dividends in the form of native tokens or paid out in coins

It is important to note that although a token may have one or more of the above-listed functionalities, it is not required that a token offers all of the above functionalities to qualify as a token, it does, however, has to offer more than mere ‘exchange of value’.

In summary, a coin can be regarded as ‘cash i.e., exchange of value’ while a token can be regarded as ‘cash i.e., exchange of value + functionality’. 

In summary, a coin can be regarded as ‘cash i.e., exchange of value’ while a token can be regarded as ‘cash i.e., exchange of value + functionality’.

Why is it important to distinguish a token from a coin?

Sec RegulationsAuthorities are trying to apply regulations that are as old as landline phones to a technology landscape that deals with voice activated-face recognizing-thumb printing smartphone era. Just as many of the old era thriller plots would not work in the age of smart-phones, trying to apply regulations that are not designed for the technological revolution such as blockchain will not work.

However, within the current framework of regulations, it is important for the startups and established organizations to be vigilant and avoid triggering a regulatory nightmare.

One way to minimize tripping security regulations is to determine whether what you are offering through your ICO qualifies as a coin or utility token or security token.

One way to minimize tripping security regulations is to determine whether what you are offering through your ICO qualifies as a coin or utility token or security token.

How to structure the token sale and best strategies?

The whole ICO area is at its infancy.  Even those who claim to be ‘experts’ are in a learning phase.  This does not spare you from the need to seek professional legal counsel help before launching an ICO.

The legal counsel will look at various aspects that are specific to your offering to determine whether or not your ICO will result in issuing security tokens or utility tokens.

While the literature is exhaustive, we have put together a summary that compares a utility token with the security token and contrasts with fiat and coin.

utility token over security token

Legal counsel can help with determination of whether a token issued in the ICO leans toward a utility token or a security token based on the characteristics, some of which are referenced in the above table.

While the above Howey test has been used extensively thus far, SEC has recently been cracking down on ICOs that issued tokens recharacterizing them as ‘security offering’. This trend will continue until a complete shakedown of ICOs. The good news, if there is any, is that SEC has not been pursuing criminal charges, rather they have been settling with penalties (although severe).

For the most part, Howey test could be easily challenged by SEC and it is an onerous process to counter SEC’s allegations and companies have to be absolutely sure that what they are offering are indeed utility tokens and not security tokens.

What structure fits your criteria will depend on what you are trying to accomplish. For instance:

  • If you are working on a project that relies heavily on the mass adoption of the technology itself, you might be better off issuing a utility token
  • If you are looking to raise capital in the traditional sense but want to avoid the complications of a traditional IPO, you might be looking to issue security tokens

It is important to note that your intentions have very little to do with how the tokens will ultimately be treated unless you structure your ICO to match your intended purpose with the required professional help.

  1. Howey test and its application to blockchain space

When it comes to following SEC guidelines, most ICOs provide a document that shows where they fall within the Howey Test in determining whether their token should be treated as a security by the SEC.

Howey Test looks at three main considerations:

  1. Investment of money;
  2. The existence of a common enterprise, and
  3. Expectations of profits.

We believe this model of determining the nature of tokens is really an outdated one.  Below you will find our opinion on whether or not Howey test applies to tokens and why it is an ineffective method of determination for the blockchain space.

Rule 1: Investment of money

Money Investment Security Tokens

Tokens:  Satisfies; Although digital currencies are regarded as ‘commodities’, the argument has been placed that those that intend to purchase tokens in a crowdsale have to first exchange fiat in order to procure digital currencies and later exchange such digital currency for tokens and accordingly this first rule will be met.

Why Howey test may limit blockchain space?

Both the Commodities Commission and IRS have regarded Bitcoin as ‘commodity’; Ethereum also resembles features of a commodity although it is a utility token in our opinion, both of which do not satisfy the definition of ‘money’.  However, for the purpose of applying the Howey test, most companies consider Fiat and Digital currency as satisfying the definition of ‘money’. While this is a conservative approach, we think there is a need for clarification;

                  Rule 2: Investment in a common enterprise

Tokens: Yes, this rule is met because, generally speaking, individuals are investing into one ‘identified’ entity; See comments below.

Why Howey test may limit blockchain space?

While in the traditional stock market, investors play a passive role and still earn a share in profits and ownership, it is not entirely so in the blockchain/crypto space.

Investors can increase the demand for tokens of a given enterprise by:

– HODLing (holding to create scarcity in the market and thus increasing the demand)

– Creating hype in the market, this market is in its infancy is very susceptible to the hype (in the form of exaggeration and/or misinformation)

– Writing articles about the project

– Creating support groups and awareness campaigns, both online and offline

As you can see, although the common enterprise controls the profitability of the project by their performance, it is not a sole determinant of the success of the platform (and thus the change in the value of the investment);

We live in a world of shared economy and this also means that millennials not only take part in investing a novel idea, they also take part in its success. Accordingly, applying draconian rules of ‘passive’ investment into an identifiable enterprise to determine whether a token is a security or utility token does more harm than good.

Rule 3: Expectation of profits from the investment

Tokens: Depends; If the expectation of profit is based only on the success of the platform and eventual utility of token in exchange of SERVICES or features on the platform, then the expectation of profits criteria falls into a gray area and such token structure may be regarded as ‘utility token’.

If the expectation of profit is based on a promise of a share in ownership and/or profits and/or equity

and/or voting rights, then token qualifies as security.

Why Howey test may limit blockchain space?

Strictly speaking, this criterion applies to all classes of assets on the blockchain: Coins, utility tokens and security tokens alike.  Those who are investing into these classes are investing in the hope of an increase in value or utility or demand, all of which represent ‘expectation of profits’, in our view.

However, when this line of thought is applied, the whole blockchain (and ICO) space can be stifled.

An immediate overhaul of the regulations is required to enable the growth of blockchain technology space while providing a legal framework to curb bad players.

SEC is your friend, not a foe, a secrete route to avoid needing registering with SEC

US Securities Exchange Commission (SEC) understands that imposing unrealistic rules will not stop the innovation.  What it facilitates is the ‘migration of intellectual capital’ to more friendlier jurisdictions.  This is one of the main reasons why SEC has taken a ‘do no harm’ position.  While ‘do no harm’ is the right direction, it is not a deterministic one.

SEC has launched a helpdesk to help companies figure out whether their offering will be regarded as security or not. Advice will be provided by the help desk on ‘facts and circumstances’ basis’. Address for the help desk is: FinTech@sec.gov

SEC has a dedicated page for emerging FinTech.

SEC also has an exemption to raise capital without needing registration. Under Rule 506(c), a company can broadly solicit and generally advertise the offering and still be deemed to be in compliance with the exemption’s requirements if:

  • The investors in the offering are all accredited investors; and
  • The company takes reasonable steps to verify that the investors are accredited investors, which could include reviewing documentation, such as W-2s, tax returns, bank and brokerage statements, credit reports and the like.

Purchasers of securities offered pursuant to Rule 506 receive “restricted” securities, meaning that the securities cannot be sold for at least six months or a year without registering them.

Being security is not all that bad

While a major part of this article dealt with an ICO tripping security laws and overburdening regulations, there are many companies that are working on solutions when a company deliberately wants to go into an ICO to issue security tokens.  In other words, instead of avoiding being security, some companies may choose to issue a security token.

One such company that is working on solutions in the security tokens space is Polymath.  Their very slogan to market is “securities token platform”.  They want to help the companies with the issuance of security tokens that comply with SEC regulations without the underlying costs. They offer security token launch service to companies that have no legal knowledge as Polymath team will handle the legal side of issuing security tokens.  We anticipate many more service offerings in this space in the coming months and years.

A recent one that we reviewed is called WeOwn (CHX). Own’s Company representative explains their platform as, “We see ourselves as a service and not just an issuance platform. Whilst we do offer and manage primary issuance of financial asset backed tokens, we provide much more services after the issuance event: we manage investor and shareholder data (on our DSR), we manage the dividend disbursements, we create and generate tax and financial reports for both issuers and investors, and we support and manage corporate actions and other events.”

If Own’s vision comes to fruition – the whole complicated and unnecessarily cumbersome capital raising business could become as simple as tapping your smartphone (a bit of exaggeration but you get the point).

We at Cryptotapas believe that Security Token Offerings will storm the capital market in the coming years.  We will inevitably get guidance from the authorities and we will enter into an era of tokenization.  We will ultimately move from raising billions without guidance to raising Trillions of dollars using recognized, institutional platforms.  This will be part of Blockchain promise that will come to pass within the next 3-5 years, in our opinion.

Recently, SEC has proposed that they revisit the existing rules and regulations to facilitate the FinTech space. Switzerland has already started making progress in building a framework that facilitates FinTech space. Many other countries will follow the suite and Howey Test (and similar stock market rules) may be a thing of the past for the Blockchain space soon.

Thank you for reading this article.

Subscribe to be notified for new updates in Crypto and Free eBooks!
Subscribers get our upcoming copy of ‘STAYING RELEVANT’, an essential primer from Cryptotapas for FREE!
Staying Relevant by Cryptotapas
Buy us a Coffee: Keep information FREE. We do not sell what we research. A small tip from you can help us bring you more content like this for FREE.

BTC: 37kJr9PodRHzsG5u1ZfKkfYpHFSZrS8s9n 

If you are thinking to open KuCoinKucoin Referralaccount, please consider using our referral link.

IMPORTANT DISCLAIMER

Everything in this article is an opinion, not an advice of any kind. This material has been prepared for general informational purposes only and it is not intended to be relied upon as accounting, tax, investment, legal or other professional advice. Please consult with a professional for specific advice.

CryptoTapas does not endorse or guarantee the accuracy of the information and claims made in respective publications referenced in this database.

About the author

RK Reddy holds two Masters degrees, one in Accounting and another in Business Administration with over 15 years of experience in the financial services industry.

RK Reddy is an ardent fan of Blockchain and Cryptocurrencies. You can see the excitement about this new technology in every article on Cryptotapas.com. Sometimes this excitement leads to an overly optimistic view. Guilty as charged. RK Reddy says what may seem like an ‘overly optimistic expectation’ today may become an everyday norm in 5-10 years; look at the history of cars or airplanes, Blockchain and Cryptocurrencies belong to a similar frame of reference.”  Of course, that is just his opinion.

Share:

Share on facebook
Facebook
Share on twitter
Twitter
Share on linkedin
LinkedIn

TRENDING