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03.04.18
3.04.18

Pigs vs Hogs

The decision NOT to ICO.

Early on in the company formation of 9th Gear Technologies, Inc., it was unanimously decided by our Board of Directors, of which I hold one of the seats, NOT to raise money via the ICO route. I have personally watched many companies raise enormous amounts of money via this manner; some raising what we in Silicon Valley think are Series D amounts without having written any code. Most of the token economics are not firmly in place (my estimates are less than 10% have their token structure correctly executed). Many of the so-called experts kept telling me just do an ICO, but we have steadfastly held to our core beliefs that the ICO route is NOT in our future. Let’s examine some of the regulations that surround this industry that led us to this conclusion.

What makes something a security? It is based on the Howey Decision (also known as the Howey Test) of 1946. The question is really: is the value of the thing dependent on the efforts of someone else? An equity or stock is dependent on the efforts of management and the employees in the corporation; therefore, it is an equity. A hundred dollar bill is not dependent on the value of anyone else for its value so it is NOT an equity; it has its intrinsic value just like copper, a bushel of corn or a pound of coffee.

With any new asset class in the United States, there is an oversight scramble between the Commodity Futures Trading Corporation (“CFTC”) and the Securities Exchange Commission (“SEC”). It all has to do with a 1946 case called the Howey Decision. Securities and Exchange Commission v. W. J. Howey Co., 328 U.S. 293 was a case in which the Supreme Court of the United States held that the offer of a land sales and service contract was an "investment contract" within the meaning of the Securities Act of 1933, 15 U.S.C. If something is a security as defined by the 1933 Securities Act, then the SEC regulates it. You cannot sell a security, publicly or privately, without registering it with the SEC and asking for its approval or by coming in through one of the two chief exemptions from registration: Regulation A that allows a firm to exempt a limited dollar amount of public offers over a 12-month period, or Registration D that allows for private placement exemptions.

What is a digital asset or token? What is an ICO?

The purpose of the ICO is to raise money to fund the development of a protocol. So it is dependent on the efforts of others (e.g., the company’s management, the software engineers that are writing the protocol, and the sales and marketing who are responsible for token adoption and its use as a unit of value for a specific application). So tokens start out as a security.

On July 25, 2017 in Release No. 81207, the SEC issued a ruling with regard to the decentralized autonomous organization (“DAO”) in which it said that if anyone does what the DAO has done, we are going to prosecute, but we are going to let the DAO go this time. A DAO, decentralized autonomous organization, is an organization represented by rules encoded as a computer program that is transparent, controlled by shareholders and not influenced by a central government.

The SEC does not draft laws in advance of activity; rather, it watches, forms opinions, and then issues rulings. The reason the SEC did not prosecute the DAO is that it allowed them to announce their policy on these instruments. If they had simply prosecuted the DAO, then the DAO would have the ability to respond and the matter would be tied up in litigation for the next two to three (2-3) years. So the commission staff decided that they needed to issue policy and the way they issue policy in these types of instances is that they announce what they are going to grandfather in as exemptions and going forward what they are going to prosecute. ICOs are a security. If they are not registered, they have to come in under one of the exemptions.

The DAO ruling has profound implications. For anyone that has done an ICO that has partaken of sales and marketing efforts in the United States or has sold an ICO to someone in the United States, they are guilty of a felony for selling an unregistered security that is not exempt. Secondly, for anyone that has purchased an ICO that then sold that token in the secondary market, they are deemed an underwriter under the 1933 Act which means that they had the legal responsibility to register it with the SEC; and if they did not, they risk prosecution. It’s a BIG deal.

If you read a lot of ICO whitepapers, at some point the goal of these models is to have these tokens (aka coins) as a unit of value with the protocol already built at some point and people using them like they use dollar bills or airline reward points to transact in value. Now they are no longer dependent on the value of others to have value, they have intrinsic value. So there is a point at which these tokens become currencies or something other than securities.

THERE’S A SAYING IN THE SOUTH: WHEN DOES A PIG BECOME A HOG?

There is a saying in the SOUTH: When does a pig become a hog? When it goes to slaughter. There’s a point in every pig’s life when the farmer says, it’s time to make bacon. So the legal analysis is going to hinge on at what point do these coins stop being securities and evolve into such a unit of established currency that they have intrinsic value.

Clearly an ICO becomes a currency after the protocol is built and after the initial stage of adoption. That is of such profound importance that all of the market data around that will be extraordinarily valuable.

It is not enough for the protocol to be built. The ICO needs to have an intrinsic value which means someone else has to attribute value to it; to do that, you really need to be transacting. So there will be a grey period--WHICH IS WHERE WE ARE RIGHT NOW!!!

The moment an ICO becomes a currency, you can sell it without having to file a disclosure statement (even on eBay or craigslist). The whole harvesting of profits on an ICO depends on the ICO going from a security to a commodity/currency; everyone will know when it happens.

When you start a new market, there is never a clear line. People think it is spontaneous, but that never happens. With an IPO, no company has ever simply listed a stock up on the board and waited for what happens. They do a road show a month before and they do pre-orders. It is all pre-wired. It is not a naked market.

With most of these currencies, there will not be a specific point in time. Big banks will just fix the price (e.g., at 1 Euro). But with most of these tokens, they will be dependent on having the marketplace determine the value. Marketplaces do not automatically spring into existence; it will take days, weeks, months or even sometimes years. There will be a gradual migration and there will be a lot of grey area. All that information on where we are along the continuum will be super valuable.

In February, 2018 the SEC and CFTC started sending out subpoenas to companies, individuals that work at those companies, the attorneys that represent them and even investors that partook in the ICOs. Today as I finish writing this blog, it’s a heavy regulatory action day as a judge rules that ICOs are covered by securities laws and the SEC takes action against a crypto fund and ICO Superstore for acting as an unregistered broker dealer.

For us, we made the right decision NOT to ICO.

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