A hybrid approach to token sales?

Some thoughts on recent developments

Please note that this blog post is not, and is not intended to be, legal advice and merely reflects my thoughts as a person interested in the legal aspects of token sales. I am not your lawyer, nor am I trying to be. The below is theoretical and represents my views solely in my personal capacity.

While the first half of 2017 was marked by a flurry of token sales, the second half seems to be all about the regulatory aspects of token sales. Leaving aside the direct regulatory responses from international regulators, including most notably the U.S. Securities and Exchange Commission (the SEC), which have been discussed at length by others, I would like to focus here on some of the important developments from practitioners in the token sale space and provide some initial thoughts in respect of them. In particular, I would like to focus on the current debate relating to the Simple Agreement for Future Tokens (the SAFT) whitepaper that has arisen since the release of the Cardozo Blockchain Project’s report entitled “Not So Fast — risks related to the use of a “SAFT” for token sales.” In my view, a partial solution to this disagreement can be found in Section 2(f) of the Commodity Exchange Act (the CEA).

First, let me say that I think the release of the SAFT on October 2, 2017 by Cooley in collaboration with Protocol Labs is a laudable effort that seeks to provide clarity for investors, developers and regulators as to the status of certain token pre-sales (at least within the U.S.). As has been noted by CoinCenter and others, the SAFT is a symptom of regulatory uncertainty, rather than a panacea providing regulatory certainty.

Second, let me recap some of the concerns expressed on November 21, 2017 by the Cardozo Blockchain Project research report. Within that report, a number of concerns were set out that, broadly speaking, centered around the risk posed by blurring the lines between securities/investment contracts and the tokens themselves. In adopting the SAFT, the paper argues, there is a risk that a token is more likely to be considered a security/investment contract because of the explicit investment intent. In addition, the paper argues there is insufficient legal support for the distinctions the SAFT relies upon, and that the pre-sale of a token does not by itself implicate securities laws. Finally, the paper notes that the SAFT does not achieve the distributive goal of tokenization generally, as the pre-sale is limited to certain classes of investors.

In considering these issues, it is worth reiterating some fundamental points. Organizers of a token sale project should always consult competent counsel when structuring any form of token sale contract, including a SAFT. There is no regulator-approved gold standard that is guaranteed to work for all token sales and no one should be under the impression that there is bright line guidance. In addition, the analysis relating to the SAFT is predicated on the idea that the ultimate token is not, in and of itself and by reference to its characteristics, a security or investment contract. The fundamental problem that the SAFT therefore seeks to address is the securities law risk of a pre-sale investment. The fundamental concern of the Cardozo paper is that by using the SAFT to address that problem, another problem is created when the token is delivered to those SAFT investors (i.e. the tokens delivered pursuant to the SAFT may themselves be treated as investment contracts, and therefore may be subject to transfer restrictions, among other issues). The separate concern regarding the limitation of token sales to certain classes of investors is a very valid one, but I think such a concern is fundamentally a policy decision, and therefore is one beyond the scope of this post. I look forward to reading more about ConsenSys’s ‘Brooklyn Project’, but to be clear my thoughts in this post are only intended to address pre-sales in the context of the SAFT framework.

Primarily, I view these two positions as centering on the same legal problem, that of a blurred line between a security and a commodity in the context of a token sale. This legal distinction is significant as it demarcates a quasi-jurisdictional boundary between the SEC and the U.S. Commodity Futures Trading Commission (the CFTC), albeit one that is not entirely conclusive (not least because the CFTC only regulates commodities indirectly, and its jurisdiction is defined negatively by reference to the SEC’s broad jurisdiction). In my view this problem is already addressed in Section 2(f) of the CEA: the SAFT should be viewed as a hybrid instrument that is predominantly a security, with the result that the SAFT itself is a security subject to the jurisdiction of the SEC, but the tokens to be delivered pursuant to a given SAFT are commodities subject to the (potential) jurisdiction of the CFTC.

That Section 2(f) exists at all suggests this difficulty in distinguishing which agency should regulate certain products is not a new problem. The SEC and the CFTC have a long history of interaction and have considered questions relating to hybrid instruments since the 1980s (of particular note is the report of the President’s Working Group on Financial Markets in 1999). Since that time, the hybrid instrument exclusion (formerly the hybrid instrument exemption) has been an appropriate method of determining how a legally awkward instrument should be regulated. Given the unique and novel nature of token pre-sale investments, I think conceiving the SAFT as a hybrid instrument is a pragmatic and common-sense approach to a scenario that exhibits the characteristics of both a security and a commodity. Fundamentally, I do not think that treating the SAFT as both an investment contract (i.e. a security) and a contract for forward delivery of a commodity is a sensible approach, and it is one that runs counter to the legislative history and general position of both the SEC and CFTC that products should generally be regulated by a single agency.

It has been suggested that simply assuming tokens are commodities is too simplistic a view. The definition of commodity is of course broad, and one which I think would be satisfied for most tokens, particularly given their fungible and tradeable characteristics. By commodity, I am referring to the token itself, as a commodity is defined broadly (“all services, rights, and interests […] in which contracts for future delivery are presently or in the future dealt in”), and includes virtual currencies. While virtual currencies are not synonymous with tokens, they do share some of the same novel characteristics, such as the possibility of ongoing development efforts, possible protocol forks and therefore remain, in my view, the best available analogy. In many cases, although perhaps not in all, protocol tokens are therefore likely to fall within this classification.

However in the context of a tokenized platform that has not yet launched, the ‘commodity’ does not yet exist. Although one can attempt to describe the SAFT as a contract for future delivery of a commodity, really it is a contract for future delivery of a future commodity. It is within this odd legal context that the SAFT operates — it attempts to separate from the (future) token the (speculative) contractual right to receive the token when, or if, it launches. While this is of course an unusual and legally uncertain state of affairs, by placing the SAFT within the framework of a hybrid instrument, I think the distinction between the contractual right to receive the token and the delivery of the token (as a commodity) is given some legislative grounding, and perhaps the risk that the SEC would view the SAFT pre-sale and delivery of tokens as a contiguous investment contract may be lessened.

Below, I first consider the SAFT in light of the CEA’s definition of a ‘hybrid instrument’ and conclude that strong arguments exist to assert that the SAFT should qualify as a ‘hybrid instrument’. Next, I consider token pre-sales pursuant to a SAFT in light of the CEA’s exclusion of such instruments which are predominantly securities and likewise I conclude that strong arguments exist to assert that the exclusion should apply.

A ‘Hybrid Instrument’

Section 1(a)(29) of the Commodity Exchange Act defines a ‘hybrid instrument’ as “a security having one or more payments indexed to the value, level, or rate of, or providing for the delivery of, one or more commodities.”

The SAFT is intentionally a security (in the form of an investment contract). The specific language of the remainder of the definition carries slight ambiguity in this context. The most natural understanding of the definition, that a hybrid instrument is “a security […] providing for the delivery of, one or more commodities” is satisfied, provided that the token satisfies the definition of a commodity. Alternatively, the SAFT is also “a security having one or more payments […] providing for the delivery of, one or more commodities”.

Although perhaps a tautology in the context of the disagreement outlined above, I think concluding that a token (once the platform launches and it exists within a fungible class) is a commodity is a generally sensible position given the broad definition of a commodity (basically, anything that is a noun), and the CFTC’s position that virtual currencies are commodities. I do not think the means of delivery of such a token should necessarily alter that determination (the characteristics of a commodity should not be affected by its means of delivery), although the SEC could of course disagree. Were the SEC to take the view that the tokens delivered pursuant to a SAFT remained an investment contract or security, a strange state of affairs would exist where functionally identical tokens would be legally distinguished despite having no physical distinction. From a policy perspective, I think this is undesirable for both the SEC and the CFTC and a prime example of where the hybrid instrument definition could be used. On balance, treating the underlying token as a commodity is an outcome that I think is consistent with the fundamental legislative intent of the hybrid instrument exclusion. It is also consistent with recent statements of CFTC Commissioner Brian Quintenz that [digital currencies] “may actually transform at some point from something that starts off as a security and transforms into a commodity” and that “they may start their life as a security from a capital-raising perspective but then at some point — maybe possibly quickly or even immediately — turn into a commodity”. Given the relationship and history of cooperation between the two agencies, it would be somewhat problematic for the SEC to take a completely contrary approach. Coordinated guidance from both agencies would of course be welcome.

Presuming that a SAFT can be considered a hybrid instrument, the next question is whether it applies for the exclusion under Section 2(f) of the Commodity Exchange Act.

The Hybrid Instrument Exclusion

Section 2(f) Exclusion for qualifying hybrid instruments of the Commodity Exchange Act provides:

(1) In general

Nothing in this chapter (other than section 16(e)(2)(B) of this title) governs or is applicable to a hybrid instrument that is predominantly a security.

(2) Predominance

A hybrid instrument shall be considered to be predominantly a security if —

(A) the issuer of the hybrid instrument receives payment in full of the purchase price of the hybrid instrument, substantially contemporaneously with delivery of the hybrid instrument;

(B) the purchaser or holder of the hybrid instrument is not required to make any payment to the issuer in addition to the purchase price paid under subparagraph (A), whether as margin, settlement payment, or otherwise, during the life of the hybrid instrument or at maturity;

(c) the issuer of the hybrid instrument is not subject by the terms of the instrument to mark-to-market margining requirements; and

(D) the hybrid instrument is not marketed as a contract of sale of a commodity for future delivery (or option on such a contract) subject to this chapter.

(3) Mark-to-market margining requirements

For the purposes of paragraph (2)(c), mark-to-market margining requirements do not include the obligation of an issuer of a secured debt instrument to increase the amount of collateral held in pledge for the benefit of the purchaser of the secured debt instrument to secure the repayment obligations of the issuer under the secured debt instrument.

Taking these criteria in turn, I think there are strong arguments that they are satisfied and that a typical SAFT should be considered predominantly a security and therefore not subject to CFTC oversight:

(i) the developer ordinarily receives payment in full of the purchase price of the hybrid instrument (i.e. the price specified in the SAFT) and the SAFT is entered into immediately. The substantially contemporaneous ‘delivery of the hybrid instrument’ requirement is therefore satisfied upon signing.

(ii) the investor is ordinarily not required to make any payment to the issuer in addition to the purchase price.

(iii) the developer is ordinarily not subject to mark-to-market margining requirements.

(iv) the SAFT is intentionally a security and should be marketed as such to the extent there is any marketing. The SAFT should not be described as a contract of sale of a commodity for future delivery (or option on such a contract) subject to CFTC oversight. This limb is presumably designed to address regulatory confusion in the marketing of the product. Given that the SAFT is an investment contract entered into directly by developers and investors who intend to treat the SAFT as a security, I think adding an additional legend to the SAFT making clear that the SAFT is not approved by the CFTC under the Commodity Exchange Act would be prudent.

What this might mean for the SAFT

By placing the SAFT within the qualifying hybrid instrument framework, the distinction between the investment contract (the security) and the delivery of the token (the commodity) becomes somewhat clearer. By establishing the SAFT as predominantly a security under the hybrid instrument exclusion (which, as a matter of definition, relies on the future delivery of the tokens in their capacity as commodities), the distinction between the security-like aspects of the token pre-sale and the token itself is given grounding in legislation that was designed to address products with such hybrid characteristics. Although traditionally the hybrid instrument exclusion is used in the context of a note or security linked to underlying commodity-based returns, I see no reason why the SAFT should be precluded if the SAFT in question satisfies the requirements.

The SEC (or indeed the CFTC) may of course disagree with this theory. I am not a securities law expert, and the SEC may find that a token purchased pursuant to an investment contract continues to be a security. Nor am I suggesting that treating the SAFT as a qualifying hybrid instrument solves for some of the broader policy concerns regarding the SAFT framework. Nevertheless I hope the above is a useful addition to the ongoing discussion, from a commodities perspective at least.

A special thank you to Charles Heenan for feedback, and to David Lucking generally for discussing token sales and the hybrid instrument exclusion concept with me. Also, a note of thanks to Josh, Patrick, Marco and the other SAFT authors as well as Matt, Aaron and the other authors of the Cardozo paper, for progressing such an interesting debate. I welcome any feedback and am working towards putting something more formal together with colleagues on the hybrid instrument exclusion as it applies to token sales soon.