Not All That Sits On Blockchain Is Gold (Read: the Basics of Regulatory)
Just about every securities lawyer in the info tech space, including myself, has watched with no small amount of sweat for the SEC’s response to the explosion of the ICOs as a quasi-investment vehicle. I use “quasi” because the difference between a utility token and security makes all the difference between a company engaging in an innocent, and unregulated, form of crowdfunding versus an illegal offering of unregistered securities.[i]
In late July 2017, the SEC fired its first shot at the proliferation of potentially illegal securities offerings. Focusing on The DAO ICO, the SEC issued an investigation report concluding that The DAO tokens constituted securities, and warning that similar offerings of unregistered blockchain tokens could, depending on the circumstances, constitute illegal sale of unregistered securities.
Conceptually, the difference between a utility token and a security is simple: A utility token allows its holder to trade the token, or otherwise use the token, in return for some sort of service offered by the issuing company (a utility); a security grants its holder rights in the future success of the company.
The legal difference is not, however, quite so simple. How, for example, does a token holder’s expectation of using a service that a company will only offer at a future time differ from holding a right in the future success of the company? Is the right to use the future service not the same as holding a stake in the company’s success and, by extension, its ability to provide that service?
Enter SEC v. W.J. Howey Co., the seventy-year-old case used by the SEC, and lately every ICO legal advisor, to analyze whether a service contract would constitute an “investment contract” (a.k.a. a security). Step one in the legal support of any coin offering is the generation of a Howey Memo, a legal opinion analyzing the proposed token against the Howey ruling, as well as other fact-specific caselaw, to decide whether it would constitute a security.[ii]
If your token “fails” the Howey analysis, then it’s not a security. Go forth and crowdfund. If your token passes, things get tricky. The Securities Act of 1933 offers a number of exemptions to the registration requirement, the most popular (and probably most relevant to crowdfunding) is codified in Regulation D Rule 506(c): A company may generally solicit and sell unregistered securities to an unlimited number of “accredited investors” so long as it follows certain other, relatively minor, requirements. The accredited investor requirement tends to be the major stumbling block for would-be token issuers because many undertake the ICO model in the first place to avoid restricting their token sales to a specific class of wealthy investors.
Unfortunately, not all that sits on a blockchain is gold. I spend several hours a week explaining to potential token entrepreneurs that calling their security a “token” and issuing it on a blockchain will not keep them safe from the SEC’s ire — the SEC all but shouted this in July.
Fortunately, many blockchain token models are legitimately structured as utility tokens. The key to this model is to kill the token holder’s expectation of “profit[ing] primarily from the efforts of others” (the 3rd and 4th factors necessary to pass a Howey analysis). Relevant securities caselaw has made clear that receiving the utility of a service in exchange for your hard-earned money is not the kind of profit that Howey had in mind when defining the investment contract. As such, issuing tokens that do not grant the buyers a piece of the company’s future profits, or ones that buyers do not reasonably expect to resell at a premium, would likely pass the SEC’s scrutiny.
As of now, the SEC has yet to provide a clear, bright-line rule on which types of tokens would face federal action and which would not, but Howey (as well as a dose of common sense) provides significant guidance for prospective token issuers. Of course, as a lawyer, I’ll leave the reader with the obligator disclaimer (but not legal advice!) to always consult with independent legal counsel.
[i] The Securities Act of 1933 makes it illegal for companies to sell securities unless they have first been registered with the SEC or unless they are sold pursuant to an exemption under the Act.
[ii] To avoid reinventing the wheel in summarizing how the Howey analysis works, I’ll link to two excellent white papers (here and here) by the talented attorneys at Debevoise & Plimpton LLP (together with Coinbase) and Cooley LLP (together with Protocol Labs), respectively.