When developing a cryptoventure, one thing is crucial. Understand the law and the law is complex. So this module, I will talk about some of the challenges that a venture faces in terms of the regulatory environment. The landscape is vast. So who are the regulators? Well, there's the SEC in terms of federal regulations, Securities Exchange Commission. The CFTC which deals with Commodity Futures Trading. The Treasury Department, their branch is called FinCEN, the Financial Crimes Enforcement Network. On tax, we have the IRS and of course there's also the Federal Trade Commission. So these are five players at the federal level. But it's not just federal regulation, it's also state regulation. So states have their own securities laws, they have their own commodities laws, they've got their own consumer protection and anti-fraud laws and crucially for this particular space, each state has got its own money transmitter regulations. So if you're going to be in the business of transmitting money, you need to go to all 50 states and be registered, and that process is costly to do. So while most people focus on the SEC, and today we'll be focusing on the SEC mainly, much the action actually comes from the state regulators. For example, they're often the first in. North Carolina and Texas were the first in for the Bitconnect, BTC a Ponzi Scheme. This is another example where New Jersey effectively shut down an offering that they deem was potentially fraudulent. So we'll mainly focus on the federal regulations because to go to the state regulations would take a full course. So let's first talk about the SEC, its probably the most important regulator. So the SEC was established in the wake of the Crash of 1929 and the Great Depression. At that time, many investors lost their savings and their fortunes and often due to investments that were fraudulent. So the idea, the goal of the SEC is to protect uninformed investors from fraud in US markets. They also provide guidance in terms of how to comply with the laws, they've got enforcement power. So it's not just making regulations. They can actually enforce through civil penalties and if it's the case that there are criminal penalties that are possible, that goes through a different branch, the Department of Justice. So jurisdiction is a sale of securities to US persons. So let's talk about the SEC's application to digital assets. So the key is that any offer or sale of a security has to be registered under the Securities Act. Unless and we'll talk about this later, an exemption is granted. So when is a digital asset a security? So category one, it's obvious. So it's a token that represents a traditional security like a stock or a bond and might even represent a fraction of a share of stock. That doesn't matter. That's just a repackaging of a security that effectively is well known and recognized under the Securities Act. The second category is much more subtle, and we need to talk about that in more detail and is called an investment contract. So when is a digital asset an investment contract? So to go there, we need to understand a famous decision of the Supreme Court in 1946, and it's called the Howey Decision. So this is a time before digital assets but hopefully you can see that there's similarities in terms of this case and what we're talking about in terms of digital assets. So WJ Howey and Company, they owned a vast amount of orange groves in Florida. To finance their business, what they did was to offer some of the land for sale to investors. So the interesting aspect was the investor could buy the land and then lease the land back to Howey, who would take care of it. So they'd harvest the oranges, market the produce. So the Supreme Court deemed that this was a type of lease back and was an investment contract that needed to be registered under the Securities Act. So the decision is something that is referenced today routinely and the decision, I've highlighted the key aspects in blue in our four key aspects. So number one, it is an entity that is investing money and that investment is in a common enterprise and that investment, you expect to actually earn a profit on it. This profit is generated solely from the efforts of the promoter or entrepreneur or third-party. So these are the four components of what we now call the Howey Test. It's interesting to see how it applies to some of the cryptocurrencies that we know already, for example, Bitcoin. So Bitcoin is used for transactions. When you invest in a bitcoin, you expect to use it for transactions. You're not expecting necessarily a profit. There are no dividends, there are no coupons on bitcoin and there's no company or entrepreneur that's behind it that is making decisions in terms of promotion. So it's not obvious that Bitcoin is a security. So this is the Howey Test, very important. So in summary here, the SEC and the US Security Laws, they want to protect the so-called retail investor. The Howey Test only applies in a situation where the token is not obviously a security. When the SEC actually looks at a token under the purview of the Howey Test, they will look at many things. They'll look at the manner of sale, they'll look at the promotional material behind the sale, and they'll also look at the nature of the token. So is it something purely for speculation or does it have a basis and utility? So what about the example that we talked about earlier in the course, the DAO. The Decentralized Autonomous Organization. Let me review the DAO. This famous smart contract attracted a significant investment where investors deposited Ether into the smart contract in return for the DAO tokens. The Ether in this contract was going to be deployed to invest in other ventures. So think of it as a giant venture capital fund. Interestingly, the DAO token holders got the right to vote for the various investments. So now let's go back to the Howey test. So you're putting money in, this seems to be an enterprise that has a clear expectation of making profits from the investment. Why would you put your money in if you didn't expect to make a profit in terms of the investment and the DAO? So it turns out the SEC ruled that the DAO tokens were Securities and subject to the Federal Securities Laws and essentially they said, "Before you actually issue the tokens, you must register with the SEC." It turns out that the DAO, as we understand, was effectively re-funded to all investors and it does not exist today. But this is one of the first rulings that the SEC had to make in terms of tokens in securities. So what are the options here? You've got a token that you're thinking of offering. Where do we go? So the number one option, if you think it's a security, if you've got an opinion that it's a security, you could register with the SEC. This is expensive to actually pull off. So it's expensive and there's also annual update fees that are necessary to support the documentation to the SEC. So most startups cannot afford to actually do that. The other possible route is exemption, and there's two types of exemptions. One is so-called Regulation S and that means, well, just don't deal in the US. So go outside the US and offer your token to non-US persons, then the SEC won't necessarily bother you. The more popular route because often many of the investors are in the US is to go to Regulation D. This is the so-called private placement. So you only offer the tokens to investors that are deemed to be accredited. So these are sophisticated investors. They'd been through this before, they've got the capitals so that in this investment, they can afford to lose it. So that is the more popular route to go to these highly qualified investors and get them to actually buy in. So overall, the message here with the SEC, the cost to actually engage a lawyer to determine whether your token is a security, that cost is actually low. To actually go through the application is expensive but determining whether you have a token that's a security, that is a relatively straightforward exercise. Indeed, just what I've said helps a lot in making that determination. The other thing that's super important is that if you just go this on your own, don't engage a lawyer, you issue your token and later it's deemed to be a security, the cost is very high. So my advice here is to get the legal advice.
