Hard truths from the landmark Malaysian Blockchain Regulatory Report 2018.

by Edmund Yong

Just when everyone seems to think that the Howey Test from the U.S. Supreme Court is all that matters, think again. They overlook the bigger existential risk that belies the nature of ICOs, and one that is much closer to home.

If you are an ICO issuer, you’d have met Howey in the fog of news literature and urged by well-meaning advisors to apply Howey indiscriminately, even though it is a 1946 ruling some 10,000 miles across a very, very big pond. For those who don’t know Howey – he was a guy who planted those juicy Florida oranges and raised funds by selling service contracts (for farming oranges) to buyers from out of town. The courts decided that what Howey did is an investment contract, which must be registered as a security with the authorities.

Fast forward to the new age of crypto, an undead Howey now rears his head to figure out whether one’s token is a security or not. In the mostly lawless state of ICOs, Howey has become like a sorting hat.

What ICO issuers do is to zoom their focus onto the token, and sanitize it of any security features. Post-Munchee, they will painstakingly remove any expectation or promissory statement of return or dividend on the token, which many often did with ridiculously high and gamey numbers. Post-The DAO, the decision makers or so-called curators that review how proceeds of token sales are used will be held responsible, which in a way led many to put up fictitious identities on whitepapers instead e.g. the Centra case. Then post-Centra, even ICO advisors, promoters and celebrities that shill these tokens are in the hot seat.

Good thing is, all that media buzz on Howey helped step up self-vigilance. A whole discipline of tokenomics have sprung up in the ICO industry, to make sure the duck doesn’t walk like a duck or quack like a duck. But while this is prudent, it could be misdirected.

Howey is not law of the land in our neck of the woods. Local laws, as findings from a new report show, actually look at the entire structure of the scheme, not just the token instrument itself. Regulators will look at how the forest grows, not just the trees in it. So don’t bet on them to miss the forest for the trees!

Before that, let me give a shout out to the academic team from the University of Malaysia (Faculty of Law and Center of Regulatory Studies), which published the seminal Malaysian Blockchain Regulatory Report last week. Finally, here is a go-to-source (with the makings of a legal textbook) that can be confidently referenced by the powers that be. Disclaimer: I was privileged to be one of the report reviewers and was involved early on in their research focus groups.

If you have read this far, you’d be waiting for the rub:

Most ICOs will fit the definition of a collective investment scheme (CIS), which as the name self-explains, is simply a setup that many people put money in to get a return. This sounds awfully like your friendly neighborhood ICO, doesn’t it?

Four elements need to be present (below) to fit into the statutory definition of CIS under Section 2 of the Capital Markets and Services Act (Malaysia) 2007, and therefore a security product:

  1. Expectation – There is an arrangement to expect or receive profits arising from the asset or business that is funded by the tokens.
  2. Pooling – The contributions from token holders are “pooled” which can mean that they are sent to a common account (wallet address).
  3. Reliance – The expectation of profits is based on the reliance of a third party, which in this case is the ICO issuer.
  4. Control – Finally, there is no day-to-day control over the management and operations of the ICO by token holders.

If these sound like your ICO, then gotcha!

To be sure, these elements are also specified in the Interest Schemes Act (Malaysia) 2016. And in case you are wondering, CIS is not a local oddity. Since Oct 2013, the Securities Commission of Malaysia, Monetary Authority of Singapore, and Securities & Exchange Commission of Thailand have signed a MOU to establish an ASEAN CIS Framework for cross-border offerings of CIS in Southeast Asia. You can download the ASEAN CIS Handbook here.

Singapore has codified this in Jan 2018, and prohibits any cross-border offer of CIS unless authorized under Sections 286 and 287 of the Securities & Futures Act (Singapore) 2006. Its ICO guidelines released by MAS in Nov 2017 flag out CIS explicitly as securities. In Australia, the CIS is called MIS or “managed investment scheme” with similar principles to Malaysia. In Hong Kong, where targeted crackdowns are rare, the Black Cell ICO was caught specifically under CIS provisions.

So the next time you think about Howey, remember not to look just at the token oranges but the whole setup that gets you those oranges. How you get those oranges is more important than how many you get or how they look. Even when the orange tells you it’s not an orange.