Since Substratum is so interested in “setting the record straight,” let's take it one step further and set the record straight regarding SUB's status as a security. Substratum's whitepaper states the following.
The Securities and Exchange Commission recently made a filing that most coins need to be registered as a commodity to run an ICO for US citizens. The exception to that rule is if the token / coin has a purpose as part of a platform or system. If it is used as the FUEL that runs the system. Since Substrate is the fuel that runs the Substratum Network, we are cleared to run for US Citizens.
Declaring a cryptocurrency to be a utility token or “fuel that runs the system” does not exclude it from being a security. We know this because the SEC has made this crystal clear on a number of occasions.
A quick glance at the SEC's website reveals the following.
ICOs, or more specifically tokens, can be called a variety of names, but merely calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security.
Similarly, SEC Commissioner Jay Clayton stated the following in a public statement about initial coin offerings.
Merely calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security. Tokens and offerings that incorporate features and marketing efforts that emphasize the potential for profits based on the entrepreneurial or managerial efforts of others continue to contain the hallmarks of a security under U.S. law.
Now that we've established a utility token can very well be a security, let's take a deeper look at the hallmarks of the SUB token and why Substratum's ICO was likely an unregistered securities offering.
Substratum (SUB) Passes the Howey Test
In 1946, the United States Supreme Court oversaw Securities and Exchange Commission v. W. J. Howey Co., 328 U.S. 293 – a landmark case that resulted in the creation of the “Howey Test,” a simple four-step test to determine if a transaction qualifies as a security offering. Under the Securities Act of 1933 and Securities Act of 1946, transactions that qualify as security offerings are subject to regulation by the SEC – especially when the issuing entity is based in the USA. The four questions that make up the Howey Test are presented below. Let's see how Substratum's SUB token stacks up.
- Was there an investment of money?
- Did investors invest in a common enterprise?
- Is there an expectation of profit?
- Is profit generated from the efforts of a third party?
Was There an Investment of Money?
Yes, investors received SUB tokens in exchange for BTC, ETH, XRP, BCH, and LTC. Substratum also received a $5 million investment from Render Payment.
Did Investors Invest in a Common Enterprise?
Yes, the “common enterprise” is the Substratum development team at Substratum Services, Inc. The SUB token is advertised as a utility token that is used as “payment for serving the network,” Thus, the success of the SUB token is reliant on Substratum developing the Substratum Network, which is not a fully open source project.
Is there an Expectation of Profit?
Yes, an expectation of profit is derived from the network and token’s economic model. Users of the Substratum network are split into two parties — consumers and servers. Consumers must purchase SUB tokens to use the network. Servers earn SUB tokens for forwarding network requests, and the earning rate can be increased by holding or staking SUB tokens in a wallet. Since SUB’s maximum supply is fixed, there is an expectation of profit as consumers must purchase SUB tokens while servers take tokens out of circulation by staking to increase earning rates.
Furthermore, ICO investors contributed money to Substratum for the purpose of raising “working capital for further development” of the Substratum network. Considering Substratum’s website promises users that they will be able to “just run [the] node in the background and make money,” it’s clear that investors put money into a centralized for-profit development team to create a product (SubstratumNode) that enables users to profit from with variable earning rates that can be increased by staking more SUB.
Substratum has also set a clear expectation of profit in promotional videos. In this video, Substratum states, “Hello family! Here at Substratum, we have a long term plan to raise the value of our token as we release products.” This statement is a “marketing effort” that “emphasize the potential for profits” Later in the video, Substratum states, “The piece we’re discussing today is how we are dealing with excess tokens and how we will ensure that for each and every one of you that the Substrate you purchased will quickly but steadily increase in value and maintain that value.” Lastly, Substratum CEO Justin Tabb has publicly given “100x” and “$30” price projections for the SUB token.
Is Profit Generated from the Efforts of a Third Party?
Yes, the “third party” is the Substratum development team at Substratum Services, Inc. The SUB token is advertised as a utility token that is used as “payment for serving the network,” Thus, the success of the SUB token is reliant on Substratum developing the Substratum Network. Since the Substratum Network contains a non-zero amount of private proprietary code and only certain staff members have commit access to the project’s GitHub repository, SUB’s expectation of profit is solely generated by a third party in the sense that investors are incapable of directly contributing to the development of the network without the help of Substratum Services, Inc.
Substratum passes the Howey Test, and thus should be classified as a security. According to the SEC, “ICOs that are securities most likely need to be registered or fall under an exemption to registration.” Since Substratum did not operated on the premise that its token is not a security because of its “utility token” status, it did not go through the necessary registration process with the SEC. Furthermore, Substratum did not file a Form D to register for an exempt securities offering – this can be easily verified by searching for “Substratum” on the SEC's EDGAR database.
In conclusion, Substratum's ICO was likely an unregistered securities offering that also took advantage of investors by falsely advertising companies like Apple, Facebook, and Disney as “current and past clients”.