When confronted with the imminent invasion of the Persian king Xerses in 480 b.c., the Athenians consulted the Oracle of Delphi. The Oracle was well known for ambiguous advice which would look correct regardless of the outcome and advised that: ‘a wall of wood alone shall be uncaptured.’ Did this mean Athens should fortify the city with wooden ramparts or instead build ships to confront the invaders at sea?
Divining the path to a SEC compliant coin offering seems as challenging as understanding the Oracle of Delphi, and when SEC Director Jay Claton says that Ether is not a security, but that it would have been classified as a security when originally offered, similar confusion grips entrepreneurs and investors. This confusion is compounded by the asymmetry between the well publicized SEC enforcement actions and the absence of information about the about projects the SEC has quietly permitted. But through my experience initiating Hedera’s regulatory engagement with the SEC, I see a path. Commissioner Pierce’s Rule 195 safe harbor proposal sheds further light into the SEC’s priorities while also showing how Telegram is a case study in how not to architect a compliant project.
Security into a Utility
A SAFT (simple agreement for future tokens) offering is governed by the securities laws, and US based issuers are now careful to abide by the private placement exemption. SAFTs are only sold to accredited investors and marketing (advertisements) isn’t permitted. The critical question is how can securities sold in a SAFT evolve into a non-security.
This evolution is important because if coins are deemed securities, a whole host of regulatory compliance is required which impairs their use for powering networks. If Ether was a security, for example, every application on Ethereum would need to abide by securities laws which would effectively prevent Ethereum from functioning. SEC Director Claton recognizes the importance of this transition from security to utility and stated that ‘the designation may change over time’.
So how does this evolution take place? What is the path from raising capital via the issuance of a security to a digital asset no longer retaining that classification?
Decentralization Requirement
One of the key areas of SEC focus is that of decentralization. Typically, a company offers the security and then uses the funds to build the network technology. After the network launches, the SEC focuses on the decentralization of network control and development.
This requirement for decentralization is foundational to the SEC’s approach but can be difficult for entrepreneurs to understand and presents compliance challenges. How do you hire developers and build a network technology and then decentralize it? Who are you turning it over to? And when? The Ethereum Foundation, for example, has been deemed sufficiently decentralized because it incorporates the input of the community to develop and prioritize technical updates, and because the updates must be accepted by a majority of the independent (decentralized) miners who have proven to be no pushovers.
Hedera’s approach, which seems to have been sufficient, was to turn over governance to a council of 39 companies prior to the availability of the coin. This council has the responsibility for overseeing management including budgets and the technical development of the network. Council members are term-limited and, at scale, at least one third will turn over every year. Also at scale the network of decentralized nodes will need to accept any code changes as well. What doesn’t work, however, is Telegram’s approach of a foundation that is controlled by the same individuals that raised the funds and are building the technology. Just creating a foundation doesn’t result in decentralization.
Efforts of Others and Functionality
Related to decentralization is the critical importance that ‘efforts of others’ (i.e. not the company) drives value increase after network launch. This ‘efforts of others’ focus is necessary to avoid the “common enterprise” designation; an enterprise in which the ‘fortunes of the investor are interwoven with and dependent upon the efforts and success of those offering or selling the investment.’
Of nearly equal importance, when the coin is released to investors, the network should have functionality and the coin should immediately have the use for which it is intended. Projects can develop on test nets or with test coins in advance of the actual coins being released, but need to have day one functionality. Hedera officially launched its network on August 24th, 2018 but didn’t release coins until over a year later on September 16th 2019 and on that day, dozens of applications were live, developed by independent companies, creating a vibrant ecosystem with real use for the coins to power applications. Just a few weeks later, the Hedera network was processing about 450,000 transactions a day, about 70% of Etherum transaction volume which had been operational for four years.
Capital Raise, Trading and Market Making
Also of importance to the SEC is that the last capital raised is completed prior to the network launch which allows the SAFT security to ‘season’. During that seasoning period, the company cannot facilitate or permit the transfer of coins in the secondary market. Given small volumes and the lack of a globally cohesive regulatory approach, the SEC is focused on potential market manipulation and is adamant that companies cannot repurchase coins. It was this repurchase prohibition that torpedoed the Basis stable coin project which returned their $133 million raise.
The SEC’s most schizophrenic position is their suspicion of a project’s involvement in the listing of their coins on exchanges. A global, liquid market clearly is an advantage for users of the coin, but to get a liquid market, projects must be listed on multiple exchanges. And to be listed, projects need to explain the project in detail to exchanges and work with their technical teams to integrate their technology. Of course speculators can also purchase coins on exchanges, but just because speculators can purchase vast amount of Euros or Yen in the forex market doesn’t invalidate their use as currencies. The SEC’s fantasy that projects can have almost no involvement with listing is counterproductive to its real goal of increased liquidity, use and price discovery.
More rationally, the SEC is opposed to crypto currency market making. Market making is common for listed equities where market makers deploy their own capital to close spreads between buyers and sellers. In crypto, however, the accepted practice has been for market markets to use the project’s treasury coins which has the effect of using company funds to support trading. No matter how well intentioned, the opportunity for manipulation is clear especially when market makers can earn a percentage of profits.
Coin Release and Investor Base
The SEC also cares that the volume of coins released bears some relationship to near term expectations of use. In the Telegram complaint, the SEC was concerned about the ‘dumping’ of coins on the market; referencing the 26% of supply that would be released on day 1. Hedera released just 1% on day one, an additional 1% over the following week, and the remainder will gradually be released over the next 15 years.
Finally, SEC Commissioner Hester Pierce said recently that the number of US investors in a project is relevant, and the SEC cited the $400mm of US sourced investment in Telegram as an issue. The largely successful steps EOS took to restrict its offering to non US investors likely influenced the small fine they paid.
Telegram
What do these considerations imply for high profile projects who have raised significant capital but have yet to launch their networks or coins? Telegram seems to have checked every single box on what not to do: raising from US investors, centralized governance by a foundation controlled by the two Telegram founders, promising to drive value and development post launch (not the efforts of others), releasing a large amount of coins on day one far in excess of any potential use…on a network that was going to have few live third party applications while allegedly working closely with exchanges to be listed. They missed every single signal. Recent steps such as the ecosystem development will be helpful, but unclear if sufficient.
With regard to other projects, Polkadot’s non-US raise should be helpful and their community is enthusiastically building out functionality. Dfinity and Filecoin, however, both have large US investor bases. What will the stage of each of their networks be upon coin release and how many applications will be live? And how much of the coin will be released for trading? How decentralized will the network governance be? The highest chance for success is a small release of coins on a functioning, decentralized network with real use day one.
Difficulty is the Point
If meeting all of these conditions seem difficult, that is partly the point. The SEC’s job is to protect investors, and it looks suspiciously upon any attempts to avoid the codified practice of investor protections. To someone with a hammer, everything looks like a nail, and the SEC sees securities wherever it turns; only in very specific circumstances will it make exceptions. But it actually has to figure out a way for securities to evolve into utilities because if it doesn’t, then they have granted Ethereum a monopoly. And that is not the outcome they want.
Unlike the Oracle of Delphi, the SEC actually has laid out a path, but until very recently, real sleuthing was required. But Commissioner Pierce’s February 6th safe harbor proposal made their priorities clearer and follows the example that Hedera divined. Her proposed Securities Act Rule 195 includes a three year securities registration exemption during which time projects that offer adequate disclosure and appropriate use of funds can build out sufficient functionality and decentralization to demonstrate utility status. Even though her proposal is unlikely to be adopted in the near future, and her term is up in June, it remains instructive. Meeting the hurdles outlined above, and adhering to proposed Rule 195 should significantly increase the chance for a project’s success and eventually catalyze a thriving, SEC compliant coin ecosystem.
Ultimately the Athenians decided that ‘walls of wood;’ referred to ships, and their fleet triumphed over the Persians at sea. But if Telegram has misread the Oracle of Washington, they will be in for defeat.
