Five Reasons Why We Need Securities Tokens Now
Securities tokens are becoming the next big thing in the crypto sphere. With federal and state regulators imposing stricter requirements on ICOs and with the success rate of ICOs falling, there is a push to find a solution for secure and compliant crowdfunding.
This article will look at five reasons why we need securities tokens now.
A Securities Token Can be Self-Regulating
A key feature of a security token is that, like a utility token, it is a smart contract. A smart contract is an autonomous program that facilitates the functions of a contract, such as execution of a transaction, enforcement of its terms, and satisfying financial requirements. For a securities token, this smart contract can also insure that only eligible investors can buy it and meet any necessary reporting requirements. In a sense, a well-programmed securities token can be assigned and maintained without the need of an exchange.
This “dodging” of potential liability is important. According to Section 5 of the 1933 Securities Act, the selling of unregistered securities to non-accredited investors can incur monetary penalties and up to five years imprisonment. Selling these tokens on a secondary market could incur penalties for failure to register as a broker-dealer, alternative trading system, or securities exchange. Finally, individual token buyers that improperly buy tokens that can be interpreted as a security may be subject to monetary damages or the cancellation of the sale under Section 12(a)(1) of the Securities Act. This does not include any liability that may be subjected under the “Blue Skies” state securities laws.
In February, U.S. Securities and Exchange Commission Chairman Jay Clayton said before the Senate Banking Committee, “A number of concerns have been raised regarding the cryptocurrency and ICO markets, including that, as they are currently operating, there is substantially less investor protection than in our traditional securities markets, with correspondingly greater opportunities for fraud and manipulation. The ability of bad actors to commit age-old frauds with new technologies coupled with the significant amount of capital – particularly from retail investors – that has poured into cryptocurrencies and ICOs in recent months and the offshore footprint of many of these activities have only heightened these concerns.”
“You can call it a coin, but if it functions as a security, it is a security,” continued Clayton. “To the extent that digital assets are securities – and I believe every ICO I’ve seen is a security – we have jurisdiction and our federal securities laws apply.”
If the general vibe of the regulators is that every token offering is a security, wouldn’t it be better to have a token that recognizes that?
A Securities Token Can Offer a Route to Regulations-Compliant Crowdfunding
A securities token is a token that infers ownership of a security, such as shares of a company or a debt. If one is buying tokens as an investment, then it would make sense that what an investor would want to buy is a security and not simply a usage token for a platform.
Think about it: does it make more sense to invest in a bus line’s stocks or in its bus tokens? Even if the bus line owner was to convince you that purchasing the tokens are a loan and will obligate him to share the company’s profit with you, from the point of legal prominence, the bus tokens only entitle you to a free bus ride.
As such, offering a stake in the company being funded would simplify the crowdfunding process. It is cheaper, considerably, to offer a securities token under a regulatory framework, such as Regulation D, Regulation S, Regulation A+, or Regulation Crowdfunding than to do so as an IPO, and with less risk.
Regulation D is the standard regulation for domestic securities, where the accredited investor rule is vested. Regulation S covers offshore offers and sales to United States nationals. Regulation A+ offerings are made available to non-accredited investors (for tier one) that are limited to $20 millions in offering for a 12-months period or $50 million for a 12-months period for accredited investors only (tier 2). Regulation Crowdfunding is an exception for offerings of $1,070,000 for a 12-months period. Investors are subject to investment limits under this class.
Organizations are in their best interest to protect against potential work stoppages by offering securities that are following national and state regulations from the beginning. Assuming the uncertainty of the regulation landscape, it is best to assume that crowdfunding offerings are securities and prepare accordingly.
In countries that have United States-style securities laws, the regulations were designed to protect uninformed investors from unnecessary risk. The accredited investor rule, for example, was made to shield mom & pop investors from the perils of unregistered investments. While it may seem unfair that the casual investor cannot invest in every ICO being offered today, there is valid rationale behind the decision.
The accredited investor rules hail from the 1920s and the 1929 Wall Street Crash. The opening salvo of the Great Depression, the crash was fueled by runaway speculation. In the post-World War I economy, there wee massive expansion in the industrial and agricultural sectors, with produce overproduction causing prices to drop and for financial pressures to mount on the nation’s farmers. At the same time, Federal Reserves policies created stress on the nation’s weak banking structure. Despite the fact that manufacturing has slowed and easy credit was drawing much of the nation into debt, speculation continued at a fever pace until the London Stock exchange crashed on allegation of fraud and forgery from several of its top investors. This cause a domino effect that lead to the collapse of the American stock exchanges.
While knowledgeable investors – such as Percy Rockefeller and Joseph Kennedy – could read the market turbulence and was able to withdraw their portfolios to no harm, ordinary investors were caught up in the speculation and ended up getting hurt. The resulting Securities Act of 1933 was designed to provide “full and fair disclosure of the character of securities … to prevent frauds in [their] sale.” Congress, however, allowed exemptions and exceptions to registration in areas where “there [was] no practical need for its application or where the public benefit are too remote.” In these cases, investment is allowed, but only by those that have a direct stake in the venture, by those that are proven knowledgeable to mitigating the risks of an unregulated investment, or to those that have the capital to absorb the loss of investment should the venture collapse.
The dangers of a utility token are that it is unclear if a casual investor can invest in it and if that investor has been warned of the potential risk. A securities token clears this up by declaring itself a security. This helps investors know if the token is lawful to be purchased casually. Additionally, securities token are smart contracts that restrict their ability to be purchase to only those that can lawfully do so. This elimination of ambiguity protects the issuing company and the investor.
Long-Term Value versus Utility Tokens
Utility tokens are gambles on multiple levels. First, unless a token has no true value inherent to it, it could be construed as a security – despite its current structure.
The Howey Test, devised as an analogy to explain the role of equity in determining if an investment is a security in the U.S. Supreme Court ruling SEC v. Howey Co., argues that an investment where profit is earned by the labor of others and not yourself constitutes a security. In the case of Howey Co., a Florida citrus farm, the company sought to sell off unused parcels of its farmland an investment opportunity. The buyer could then sign on Howey Co. as the land manager, who would then plant, tend, and harvest the citrus crop on the parcel, market and sell the produce, and send the owner a percentage of the proceeds – all without the owner needing to step foot on the land. The terms of the agreement were made – in fact – to say that the owner had no right to step upon his/her land, as that would constitute trespassing.
Even though Howey Co. opted not to register as a securities company, the notion that the company was offering an enterprise to those “attracted by the expectation of substantial profits,” while those buying knowingly was “lacking the knowledge, skill, and equipment necessary for the care and cultivation of citrus trees” made Howey Co. guilty of paper shuffling. Howey Co. retained the effective ownership of the land and instead sold the buyers on a profit-sharing scheme.
“For purposes of the Securities Act, an investment contract (undefined by the Act) means a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise,” the Supreme Court ruling reads.
“The fact that some purchasers, by declining to enter into the service contract, chose not to accept the offer of the investment contract in its entirety does not require a different result, since the Securities Act prohibits the offer, as well as the sale, of unregistered nonexempt securities.”
As such, a utility token that can be argued gained value by actions outside of the investor’s own efforts can be ruled as a security, per the Howey test.
Second, if a utility token has no inherent value, how can it be argued that it would hold its investment value after the novelty of its launch has passed? Bitcoin.com found that – in 2017 – 56 percent of all ICOs launched that year failed or collapsed. That’s 531 projects where their utility tokens lost all value.
From a pure investment point-of-view, investing in a securities token over a utility token makes sense as you are investing in something tangible instead of an idea. Even if the project collapse, the security will retain some value. A utility token loses all value when the platform it was designed to work on ceases to exist.
If the idea is to HODL your tokens, wouldn’t it make sense to ensure that your tokens will have guaranteed value in the future?
Securities Tokens May be the Next Big Tradable Asset
Overstock.com was already a major player in the crypto world as it was the first major retailer to accept cryptocurrency as payment. This played a large part in the “normalizing” of cryptocurrencies for daily use. Despite being under SEC investigation, Overstock.com is moving to make it easier for companies to crowdfund without running afoul of securities regulations.
“The ICO craze of last year created a toxic waste dump of financial assets. To me, that world of ICOs is a Superfund site,” Overstock.com Patrick Byrne said. “What we’re developing is a mechanism so that there will be a legal way to go forward and not create any new toxic waste.”
“I think the SEC should essentially shut down the utility token world,” Byrne continued, alleging that all ICOs are “flagrantly illegal.” “Eventually the security offerings will just be done in lieu of the IPO in lieu of shares.”
Overstock.com’s unit, tZERO.com, has announced that it is partnering with BOX Digital Markets to create the first regulated security tokens exchange. The exchange will list and publicly trade securities tokens, including tokens converted from existing company stock. The exchange will need U.S. Securities and Exchange Commission’s approval before the exchange can open to the public, buy Byrne is looking to start trading by the third quarter.
“The introduction of this technology (blockchain) is likely going to be controversial because it’s so much better than the current technology that the capital market is built on,” said Byrne. “Going hand in hand with a blue-chip partner like BOX would be a great advantage for us.”
With ICOs involving utility tokens being a fundamental exercise in trust, and with ICOs being subjected to regulatory review, it would make sense that a better option to ICOs to emerge. It is an open question if the industry will embrace securities token offerings (STOs) over ICOs, but it would seem that ICO’s days may be numbered.