Wolters Kluwer's White Paper About SEC Guidance & Crypto Trading Platform Risks

Initial Coin Offerings (ICOs) have spiked in popularity in the past year. Thousands of hopeful startups have successfully raised cryptocurrency through the crowdfunding strategy. Primarily run through the Ethereum blockchain protocol, an Initial Coin Offering features coins created by a company that represent stock or shares in a company.

More often than not, the financial utility of these coins is that they can be sold when, after the business takes off and gains momentum, the value of the currency increases.

What to Know About Wolters Kluwer's White Paper About SEC Guidance & Crypto Trading Platform Risks

Since their conception, cryptocurrencies have been the subject of extensive legal debates. In particular, the debate rages on regarding the extent to which cryptocurrencies can be considered securities. With the introduction of ICOs, though, the implications of a theoretical debate became actualized concerns.

When a company uses cryptocurrency crowdfunding strategies as a legitimate way to raise money for their project, both the currency and the company are factors in the status of the economic transaction.

The Securities and Exchange Commission released an official statement responding to the ICO problem on March 7, 2018. The comprehensive document is laden with tough legal terminology and complicated references to existing precedents and concepts.

Consequently, interpretations on what the document might mean for cryptocurrencies and Initial Coin Offerings.

In an effort to alleviate some of the confusion surrounding the mysterious and impactful document, respected financial services company Wolters Kluwer released a much-anticipated white paper explaining their interpretation of the SEC’s statement.

Wolters Kluwer concludes that the SEC statement, in simplest terms, concludes that some ICO coins fall under the category of a security and is thus subject to SEC regulations and standards.

Additionally, Kluwer echoes the cautious sentiments of the SEC, recommending that investors “proceed cautiously” while things develop in the rapidly-changing cryptocurrency market.

This guide will provide an in-depth analysis of the interpretation of the SEC document by the financial firm, surveying the key problems in the status quo that prompted SEC response, the concerns and solutions found in regulation, and what investors and founders should expect to see moving forward in this volatile industry.

Unregulated ICOs: Persistent Problems

The lack of regulatory authorities in charge of ICOs has caused a few notable issues. For the most part, regulatory efforts seek to target “pump and dump” schemes, scams in which owners of a fraudulent organization create a currency, artificially inflate its value through the promotion of an ICO using the currency, and then selling—dumping—their shares for profit.

While the initial investors in these schemes often maintain profit if they sell their coins quickly enough, most contributor just end up losing their money when the price of the currency crashes following the dump. This is not a new concept; the traditional economic models have always struggled with pump and dump schemes within the stock market.

The key difference between ICO scams and Wall Street scams has little to do with the types of companies being founded, but everything to do with the regulation involved in the process.

While Wall Street investors are often protected from scams by the vigilant eye of the Securities and Exchange Commission (SEC), cryptocurrencies have not been given such a protection. In fact, the SEC had not made an actual, direct statement regarding the regulatory status of Initial Coin Offerings and cryptocurrencies until early March of 2018.

And these scams constitute the most straightforward legal qualm some have with the crowdfunding practice on the blockchain. A recent class action lawsuit has been opened against the giant cryptocurrency company Ripple Labs.

The plaintiffs claim that the tokens purchased after the conclusion of the company’s ICO are definitively securities, and that the company muddied the distinction between the company and the tokens, causing a loss of profit.

This isn’t the only conflict regarding the securities classification in the world of ICOs. Pundits all over the world have debated for years about what constitutes a security, as well as the extent to which the coins sold in ICOs belong in the regulated category.

Adding to the confusion is the fact that many ICOs are run in foreign countries. For the SEC, this makes the apprehension of criminals and the recovery of lost/stolen funds a moot point. These borders provide a significant barrier, especially considering the SEC’s classification as a United States regulatory entity.

The SEC statement on the Initial Coin Offering added weight to a couple arguments which had already been heavily-emphasized by advocates of regulation for ICOs. The commission warned investors to exercise extreme caution when financing crowdfunded blockchain-based companies. In addition to concerns about the lack of accountability that a decentralized system provides to founders and leaders, they warn that no protections exist for buyers of the ICOs, at least until successful regulation methods are established.

As it stands, ICO scams are incredibly prevalent. From the perspective of the market, the negative effect that scammers exert on investor faith is extremely troublesome. Clearly, something must be done to prevent abuses from scaring more potential investors out of becoming contributors to the economic system.

The statement released by the SEC made waves in the cryptocurrency world. If ICOs were to be regulated as Wall Street IPOs are, it could usher in an entirely new dawn for the blockchain community and economic ecosystem.

The impacts of the eventual fate of Initial Coin Offerings will be felt by the entire blockchain industry. Wolters elaborates to say that total funds raised through token funding increased by nearly 1000% from 2016 to 2017, and that numbers continue to swell as increased legal scrutiny is applied to the industry and its commodities.

Types of ICO Coins

The Wolters Kluwer white paper begins by outlining the different kinds of tokens provided to investors in an Initial Coin Offering. This distinction is very important to understand, especially, when they later begin to analyze SEC interpretations of what constitutes a security.

The first kind of token is a utility token, which denotes “access to the new technology” created by the company. Equity tokens, on the other hand, represent not access, but value, in the technology being developed. These types of coins much more closely resemble stocks that would denote value in a traditional corporation.

For the SEC, coins that denote value in an organization come dangerously close to representing stock in a company—a security to be sure.

Investor Warning

Naturally, the SEC’s primary focus with the release of their official statement was to protect investors from participating in a dangerously underregulated market. Wolters Kluwer highlights two problems and a potential solution to the unregulated ICO dilemma.

Kluwer first emphasizes that though ICOs may appear to be regulated, approved distributors of securities, they are not. This is empirically backed; the SEC has never approved a cryptocurrency to be sold as a security. This fact speaks both to the lack of clarity in the classification of the coins and the lack of faith the SEC seems to have in the validity of the crowdfunding platforms.

The risks for consumers who mistakenly believe an ICO to be SEC-approved are dire. SEC oversight and protections are provided to investors who spend their money on approved and regulated exchanges. These protections can give investors access to important information and protection in the case of fraud. Because ICOs are unregistered with the SEC and often outside of the United States, investors who are scammed should not expect the SEC to successfully recover their lost funds.

Perhaps even more troubling for the ICO industry is the second SEC argument emphasized in the Kluwer white paper. The advising company laments that in the absence of a regulatory authority like the SEC, there is no way to ensure the fair business practices, trading mechanisms, or internal structures that typically mark a legitimate, SEC-approved platform for trade.

The key takeaway of the SEC’s warning to investors, according to Wolters Kluwer, is that investors who choose to become financially engaged with an ICO is not offered the kinds of protections that normally underscore investment and security trades in the traditional economic sector.

Trading Platform Forewarning

Another consequence of the Securities and Exchange Commission statement on cryptocurrency exchanges (ICOs) is that online trading platforms are now clearly ordered to either comply with existing security exchange regulations or apply for an exemption. The one caveat to this requirement comes from the tricky wording used by the SEC. They elaborate that if the platform trades “securities” and “operates as an exchange,” they must then either comply or apply for exemption.

For savvy companies, the likely move is going to be to either avoid their tokens qualifying as a “security” or downplay their status as an “exchange”.

But the SEC seems to have predicted this legal grey-area. Kluwer expands on an additional remark by the commission. They note that even if companies do not technically qualify as an exchange of securities, there are additional laws regulating different kinds of platforms, and that ICOs must still comply with applicable laws.

For companies that are deemed to be selling securities, the ramifications are even more significant. The SEC requires the filing of meticulous documents, the compliance of company members with federal securities laws, and the discipline of violators. For the vast majority of ICOs currently on the market, this would be a major setback—if not the end—to their development.

For existing exchange platforms, it seems clear that there exist two options.

First, a platform could argue that they do not fall under the category of an exchange, and/or that they are not offering the sale of securities. While this argument may be effective, it still leaves companies susceptible to additional regulatory laws—conformity seems inevitable.

Alternatively, a platform might decide to adopt status as a security-marketing exchange and subsequently comply with SEC regulations. The problem with this model becomes apparent when readers recall once more that, though platforms have certainly applied, the SEC has neglected to name even a single ICO as an approved exchange for securities.

The SEC statement has clearly created a legal maze that ICOs will have to navigate if they want to avoid potential disciplinary efforts from the SEC.

The conclusion of their statement, however, provides some fair advice for investors and founders alike. They elaborate that participants should “consult legal counsel” in order to understand applicable securities regulations and evaluate potential options.

The SEC on Cryptocurrencies as Securities

The history of the security debate in the cryptocurrency world is long and complicated. Wolters Kluwer concludes that the SEC’s investigation of the hacking of the DAO provides the most direct empirical precedent for the commission’s view on crypto-securities.

According to the SEC, three conditions facilitated DAO Tokens’ classification as a security. The DAO organization’s classification as a for-profit entity, the anticipation of earnings on the part of purchasers of the DAO Tokens, and the ability of shareholders to exchange the tokens on digital exchanges were all factors that contributed to the SEC’s concluding recommendation int their report that ICOs should “ensure compliance” with U.S. securities laws.

This latest statement largely reiterates the previous SEC position that tokens that meet certain conditions fall under the category of securities and are consequently subject to SEC regulations regarding the exchange of securities.

Cryptocurrencies as Regulatable Commodities

The SEC is not the only regulatory agency turning its sights on the blockchain technologies of the modern era. The Commodities Futures Trading Commission (CFTC) has already classified Bitcoin and Litecoin as commodities. Perhaps even more troubling for those that wish to avoid additional regulation, Commissioner Brian Quintenz hinted that many ICO coins eventually become commodities when their price stabilizes, and they cease to represent value in the company which initially sold them.

The Wolters Kluwer white paper isolates major impacts in a legal outcome where cryptocurrencies are viewed as commodities. One interesting interpretation offered is that, because a currency can be both a commodity and a security, complying with relevant laws can become “even more difficult.”

SEC Compliance Enforcement Efforts

Though there has not yet been a major incident of arrests or fines levied on the grounds of improper sale of securities through an ICO, statements from Stephanie Avakain of the Enforcement Division note that “dozens” of investigations are open.

Additionally, reports cited by Kluwer indicate that some exchange platforms have been issued subpoenas for information.

It could very well be the case that the SEC will soon begin enforcing previously-neglected violations of securities laws committed by startups crowdfunding through Initial Coin Offerings.

Conclusion: Lasting Potential Impacts in the Cryptocurrency Ecosystem

It is not just the owners of massive ICO-funded companies that need to consider the prospect of regulation by the SEC. The trade of securities comes with its own set of tax laws, reporting standards, and laws that must be followed by investors as well. In a post-regulation ecosystem, investors could be elevated to the same legal obligation status as investors in the traditional U.S. stock market.

It is clear that massive problems result from under-regulation of Initial Coin Offerings. As the SEC points out, investors are not given important protections in this unregulated market, and violations are very much possible.

Because of the lack of regulation, and also because of the intense legal battle being waged over ICOs and cryptocurrencies, both the SEC and Wolters Kluwer’s white paper recommend that investors and participants should “proceed cautiously” into financial engagement with Initial Coin Offerings.

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