Getting to SAFTE: Updating Best Practices for Token Offerings in the Wake of Changing Regulation
First, a warning and disclaimer. This article is in no way intended as legal advice, and reading it does not create any kind of client-attorney relationship with myself or my firm. The content presented here is intended strictly to encourage open discussion on best practices in token markets, and you should not rely on it whatsoever as legal advice. Anyone considering a token offering, or facing any other potential legal issue, should retain experienced counsel.
The Initial Coin Offering (ICO)*, a fundraising mechanism for blockchain projects, is both wildly popular and legally complicated. The cryptographic tokens, or “coins”, offered are frequently linked to a yet-to-be-built network, and are sold on the promise of both 1) future access to that network or related services and 2) the resale profit and secondary market potential for the offered tokens. Following the DAO decision by the SEC in July of last year, much consternation arose in the crypto market about how to conduct a compliant token offering.
The Simple Agreement for Future Tokens (“SAFT”) was an investment instrument designed to square the securities laws with ICOs and present a compliant model for token offerings. The SAFT has become the predominant funding instrument for presale investors in blockchain projects. However, crypto moves fast. The SAFT as it is now, and — more importantly — many of the substantive approaches and assumptions around conducting ICOs and other token offerings, are in need of an update, particularly in light of recent statements and actions by the SEC and other U.S. regulators.
The standard SAFT specifically represents the purchaser’s intent for resale and profit with regards to the tokens themselves. Emphasizing the resale and secondary market potential of the actual tokens has been called out as problematic by Jay Clayton’s December 11th, 2017 statements on ICOs, and by the SEC’s Munchee ICO C&D Order. Marketing and managerial efforts which emphasize the future profit opportunities or secondary trading opportunities of the tokens cut against the characterization of the token as a commodity rather than a security. Moreover, this suggests that a token presale instrument, even if it’s a security, should carefully distinguish between the purchaser’s intent with regards to the presale instrument, and any subsequent relationship with the token itself.
At the same time, although explicitly termed an investment contract, SAFT-based token presales often provide no meaningful disclosure of risks regarding the team, regulatory status of the ICO, or the particularities of the network protocol or project itself. Indeed, many projects provide no disclosures whatsoever beyond their the white paper. The white paper itself is typically a combination pitch piece and technical paper, as averse to the kind of disclosures calculated to apprise investors of the qualities and risks associated with their investment.
The general ICO model, for which the SAFT is intended, tends to take as a given fact that the tokens will ultimately be distributed in one large liquidity event. Early-stage purchasers are typically guaranteed a discount on the final offering price. This is concerning to the SEC, which has noted that these kind of insider purchases followed by an unrestricted secondary market opening present a heightened risk of market manipulation or insider trading.
The ICO model consciously apes the concept of the IPO — a heavily regulated activity which is so regulated because we know from experience that IPOs present rampant opportunity for abuse. This due to the basic misalignment of such a mass distribution event and its relationship to insiders, as much or more than the actual rights or characteristics of the security instrument being offered. Directed marketing efforts touting the ICO as an investment opportunity, sometimes involving seemingly unrelated promoters such as celebrities, heighten the concerns regarding retail investor.
The cryptocurrency community has focused on the idea of inherent utility as a key factor distinguishing commodity from security tokens. The SAFT framework was inspired by, and was widely adopted as a consequence of, the idea of utility as the distinguishing factor between securities and commodities — hence the widespread ‘utility token’ concept. The basic idea was that a token tied to a fully functional network drew its value primarily from the general use and acceptance of the network itself, and thereby from the highly distributed users of the network, rather than the efforts of the managers or promoters. This might take the token outside of the “from the efforts of others” prong of the Howey test, and thus outside of treatment as a security.
While the ‘utility’ concept is a theoretically compelling distinction, and benefits from providing a clear line between security and commodity token, the SEC has recently explicitly disavowed the ‘utility token’ as a meaningful legal distinction in this context. Instead, it seems to be both the underlying facts of the offering process, alongside the actual characteristics of the instrument being offered, which determine the distinction between a commodity and a security token. The nature of the rights, the intent of the purchasers, the focus of the marketing, and the means by which the tokens are acquired or distributed, may all bear on the characterization of a token, particularly the “efforts of others” and “expectation of profits” prongs of the Howey test.
Finally, particularly given the recent heightened scrutiny of bitcoin derivatives markets by the CFTC, there is a concern that the SAFT may be a non-exempt forward commodity delivery contract falling outside the 28-day physical delivery forward contract exemption. The Commodities Exchange Act and subsequent amendments and laws place commodity derivatives of all types under the jurisdiction of the CFTC. Following the passage of Dodd-Frank, most commodity derivative contracts — including futures contracts — must be traded on a regulated exchange or otherwise through an CFTC-regulated party. (For an easy litmus test on derivatives — ask whether the value of the contract derives from some unrelated commodity or event. Here, the value of the SAFT contract arguably derives exclusively from the future value of some unrelated commodity — in this case, the commodity token, whether or not it exists yet).
Back to Basics
Let’s ask the burning question: what’s the difference between Bitcoin (clearly a commodity) and so many of the tokens offered via ICOs (often securities)? Why are they so hard to distinguish? The crypto sector has been wandering around securities looking for the answer to a compliant token distribution, but the way forward may lie closer to the laws and transactions traditionally used in commodities businesses. Specifically, a useful conceptual model for approaching a compliant presale and public distribution framework hearkens back to the very ‘mining’ terminology of the Bitcoin network. Token presales, distributions, and retail transactions closely resemble the suite of financing and retail transactions surrounding actual mineral mining activities.
If you buy a royalty right in the future production of a mineral property to finance its expansion, you’re clearly buying a security … but that security instrument results in the acquisition of a portion of the gold stream from the mine! That fact in and of itself doesn’t change the nature of gold from a commodity to a security. A person who purchases gold from an already-operational mine isn’t buying a security; they’re buying a commodity, even if someone else received a portion of that gold allotment for their royalty payout pursuant to a security instrument.
To apply the analogy to Bitcoin: if Satoshi had sold a right to bitcoin tokens in order to pay for his/her development of the network protocol, it would have been a sale of a security, much like a mineral royalty right sold to finance future expansion. If instead Satoshi simply mined a bunch of tokens at the start of the network, and then sold them (making physical delivery within 28 days of the sale) later to further develop the network, it’s a probably a retail commodity transaction — much like a bootstrapping gold miner who pan-handles his way to purchasing proper mining equipment. Finally, let’s say the network is live, and a bitcoin miner earns herself some bitcoins. Satoshi hasn’t issued the miner a security; indeed, she hasn’t purchased anything. Instead, she put in work (in the form of computation rather than digging, in this case)and has been paid by the network for her contribution — computing power — to the network’s functionality and security. Her mined bitcoin clearly isn’t the product of the efforts of others; it was compensation for her native interaction with the network. It’s ultimately coincidental that she, like the presale security purchaser, just happens to have been paid in the Bitcoin network’s native token — just as a royalty interest of a mine and a gold miner might both be paid directly in gold.
As we considered how to approach token offerings and the SAFT, our initial starting point was that the revised presale document should more closely resemble a preferred share or convertible note. However, this made it a bit of a struggle to conceptually frame and analogize to established deal structures. Our revelation came when we realized that it’s best conceptualized not as a preferred share or convertible note, although it contains some of those aspects, but as a set of commodity transactions surrounding a mineral-bearing property. With that in mind, we have developed a Simple Agreement for Future Tokens or Equity (“SAFTE”). This instrument draws heavily from the work done on the original SAFT, and is clearly a security instrument. However, in function it resembles a gross mining production royalty right, dis-chargeable in actual commodities (here, tokens rather than minerals), secured with a conversion right into an equity stake in the mine property (i.e., the intellectual property underlying the token network) or its operator (the token developer or issuer) in the event the promoters fail to bring the mine (network) into operation. Conversely, individuals who natively “mine” tokens themselves through direct effort or interaction, or purchase tokens directly from the “miners” for bona fide commercial use, are more likely to be treated as engaged in retail commodity transactions much as though they were purchasing minerals for commercial use or a store of value.
The key is that the security instrument and underlying commodity it relates to can each coexist without affecting the characterization of the other. Indeed, similar to a gross production royalty grant, the pre-sale right grants a percentage of the ‘mined’ tokens that would otherwise be sold to retail purchasers or held by the miners themselves. The existence of a security instrument *resulting* in the commodity doesn’t change the nature of the commodity itself. The distinction lies partially in the investment intent of the original instrument or transaction, and the means by which tokens are ultimately issued.**
A royalty instrument sold as a financing mechanism to bring the mine online is a security; the primary intent wasn’t to secure a regular stream of the particular commodity, but to profit from the development of the mine. It’s irrelevant that the profit manifests in the form of a commodity.
Conversely, a gross mineral production royalty instrument, sold as a source of regular supply of the commodity at a fixed cost to a bona fide commercial user of the commodity, probably isn’t a security. In that case, the royalty instrument more closely resembles a commodity future or forward delivery contract. The goal isn’t necessarily profit from the commodity’s change in value, but its use in the course of business.
Applying this to a cryptocurrency token and associated distributed network protocol, the token is the ‘mineral’ or commodity being mined; the network protocol is the actual ‘mine property’; and the SAFTE is the ‘convertible royalty’ financing instrument which can be satisfied in equity of the promoter, or commodities generated by the network. The distinction between the investment intent of the presale purchasers as to the network platform generally, and the retail users and purchasers downstream, is emphasized by a right to convert to an equity interest in the mining operation or mine property itself; the purchaser in that case cares less about the actual commodity and more about returns. Investors may well prefer not to convert to equity, and instead participate in that growth through their royalty stream; even if so, their returns depend upon long-term growth in the network, rather than short-term token prices.
Recommended Practices for Token Sales and DLT Network Development Funding and Approach
1) Moving to SAFTE
We started from the idea that a token is ideally a simple commodity, but that a contract for presale of a token at a fixed price is necessarily a commodity future contract or an investment contract. With that in mind, we have modified the SAFT investment instrument as outlined above in an attempt to address some of the recent changes and clarifications which have issued from regulators over the last six months. However, the rules and guidance surrounding conducting a token sale, whether or not utilizing the ‘SAFTE’ or a similar model, are complex and in continuous flux. Promoters of a new token or related business are well-advised to retain experienced counsel in connection with their offering.
2) Mechanics of Token Distribution
Form should follow function, and mere words will not make a token offering compliant. Our SAFTEs reflect what we believe to be an improved set of practices for token offerings which more closely align to current trends in regulation.
The key distinction between the Bitcoin network and many other, newer offerings seems to be a mix of the timing, mechanics, and demonstrated intent of distribution. Developers should consider building their apps and network protocols to reflect ‘native generation’ of tokens, analogous to mining, which directly reward users for their efforts or interaction with the platform. Consider distributing the bulk of the tokens through “mining” or other native use of the network.
Developers should consider indexing vesting, release, and distribution of presale purchaser tokens in accordance with distribution of tokens due to “mining,” or equivalent network usage. This both encourages alignment of incentive and network effects between presale holders and subsequent network users, and resembles existing gross production royalty right terms with regards to other commodities.
The SAFTE or other presale instrument should provide some form of equity, equity conversion right, or other backstop to the presale investors. This serves to help defend against characterization of the presale instrument as a non-exempt commodity derivative. It also emphasizes the distinct rights and intents of the token holders v. SAFTE holders. SAFTE holders want to invest in the team and technology for profit; delivery of a commodity is merely one option for discharge of the obligation, and resembles in some ways a repurchase option on investor equity. Equity conversion rights allows pre-sale investors (as averse to consumer purchasers of the tokens) to further protect themselves against malfeasance and demand disclosure from the development team, preserves the option to pivot away from tokens without screwing investors, and generally acts as a fallback in the event tokens become overly regulated or simply banned. Retail users and consumers, conversely, should primarily acquire tokens through native interaction (in other words, their own efforts).
Prior to full network launch, developers should conduct early alpha and beta tests, using both private and limited public test phases, whereby the actual consumptive use of the commodity token is proven. Aside from the technical importance of smart contract auditing and software testing generally, this may have some regulatory benefits. The early deployments are not intended to demonstrate utility per se, but rather to distinguish between the intent of SAFTE investors and retail purchasers or users of the tokens, and reinforce the division between the SAFTE or other pre-sale instrument and the commodity token with which the obligations to SAFTE holders may be discharged.
Finally, developers should work with their counsel to provide succinct, appropriately tailored disclosures in the SAFTE, written in plain English and describing the particular risks factors inherent in the specific project. Comply with the simpler aspect of the securities laws, and offer the SAFTE or other pre-sale instrument under applicable Blue Sky, Reg D/Reg S, or other exemptions from registration of the offering.
In this rapidly evolving landscape, these proposed guidelines for token distribution mechanics and an associated SAFTE instrument are a work in progress, and intended to further the public conversation around the best way to properly structure tokenized capital formation. We invite, encourage, and look forward to others’ iterations, criticisms, and comments regarding or proposed framework, and hope that it will serve as another brick in the road towards established, compliant, and rational token offerings.
* For the purposes of this article, an ICO is particularly a public sale of a token with some (sometimes future or hypothetical) functional utility, usually involving a mass liquidity event and unrestricted secondary market trading, wherein the proceeds are at least partially intended as a form of project or development financing.
** Just recently, Wyoming passed an ‘ICO Exemption’ from state securities and money transmission laws. We applaud the efforts of the states to innovate in this regulatory sector, and look forward to writing more extensively on this new development. For the purposes of this article, however, the notable feature of the bill is one of the key requirements for the exemption: the ICO cannot be marketed as an investment opportunity.