Two separate settlements last week between issuers of tokens and the Securities and Exchange Commission (SEC) demonstrated how two-token models could potentially establish decentralized networks with tokens that are not “securities,” and so are not subject to securities regulation under U.S. law.
On September 30, the SEC announced a $24 million civil penalty against Block.one, the firm behind the EOS network, in connection with the firm’s 2017 and 2018 initial coin offering (ICO) of an ERC-20 token that raised approximately $4.1 billion. The proceeds from the ICO were used to develop the EOS network, after which holders of these Ethereum-based tokens (which are no longer in circulation) were permitted to swap them for EOS tokens. While the enforcement action against Block.one related to the firm’s failure to register or offer its ICO tokens under an exemption from SEC registration regarding its ICO, the SEC remained silent with respect to the current EOS token or network, and did not require Block.one to take any further actions on ongoing regulatory requirements.
Separately, on October 1, Nebulous, the company behind the Sia network, announced a $225,000 settlement with the SEC for disgorgement of profits and civil penalties in the company’s sale of a token in 2014 to raise approximately $120,000 and subsequent 2015 conversion of those tokens into tokens called “Siafunds.” Nebulous also raised an additional $3.5 million in 2018 through the sale of additional Siafunds pursuant to Regulation D that was led by Bain Capital Ventures, the sale of which was not subject to the SEC’s enforcement action. Notably, despite Nebulous’ efforts to comply with SEC guidance contained in the 2017 DAO report in this 2018 sale, the SEC still penalized the company for its failure to register or offer the 2014 tokens under an exemption from registration. Currently, the Sia network operates two tokens—Siafunds, which receive dividends from revenue obtained through the operation of the Sia network, and Siacoins, which allow holders to buy and sell cloud storage space on the Sia network. In a statement following the SEC’s enforcement action, Nebulous confirmed that while Siafunds were deemed to be securities, “the SEC did not take any enforcement action with respect to the Siacoin token or any current activity on the Sia network, and the order does not require Nebulous to register the Siacoin token as a security with the SEC.”
While these two enforcement actions suggest the SEC concluded that EOS and Siacoin were not securities, its failure to address these issues head on requires us to rely on prior SEC guidance in making the determination if any particular coin will be deemed a security. And other facts present in the EOS case, namely, that the original ICO token was issued more than a year ago, make it possible that the SEC instead just concluded that EOS tokens received pursuant to the swap for the original ICO tokens were issued pursuant to an issuer exchange exemption from registration, and are now freely tradable securities under the SEC’s public resale rules.
But while the SEC’s actions only demonstrate its ongoing concern about unregistered and nonexempt securities offerings and failed to provide any specific guidance, the silence regarding the operational networks of EOS and Siacoin demonstrate two potential paths for how tokens might be issued without being deemed to be securities. The two-token model would first involve a company issuing a token that is a security (or another more traditional security such as equity, SAFEs, or convertible notes) in a registered or exempt offering to raise funds. The company would then use those funds to develop a functional network that either provides for true decentralization or utility value, and then sell a second token (or permit for the conversion of the earlier security into that token) for users to access that network, in which case the token would not be a security.
While important questions remain as to whether EOS and Siacoins are investment contracts, and so, securities, under U.S. law, the fact that the SEC focused only on the initial token issuances is consistent with the statement in 2018 by William Hinman, the Director of the SEC’s Division of Corporation Finance, that if a “network on which [a] token or coin is to function is sufficiently decentralized—where purchasers would no longer reasonably expect [an identifiable] person or group to carry out essential managerial or entrepreneurial efforts—the assets may not represent an investment contract.” Thus, in the wake of ongoing SEC enforcement actions regarding past unregistered and nonexempt ICOs, it seems possible that this two-token model will become a more prominent method of developing tokens outside of the SEC’s regulatory reach going forward.