How A Blockchain Token May Be Regulated.
Highlights from the securities law framework
A Blockchain Token (BCToken from hereon) is the term used to define a digital unit of value (often with the same properties as Bitcoin)
It’s is issued by a company/team of developers who want to raise money for their idea in exchange for a number of benefits which vary from project to project (In theory/promise)
A fully functioning BCToken which “delivers” per se is yet to emerge.
FinTech thought leaders recently collaborated on publishing a framework which outlines:
- The definition of a security or investment contract under the Howey test.
- A securities law analysis by Debevoise and Plimption
- Best practices for BCToken crowdsales
If you’re want to raise money over frictionless payment systems, it might be wise to consider where your company stands as far as U.S law is concerned.
It’s likely for some stipulations to apply in other jurisdictions too. None of it is legal advice.
Take the Howey Test
The criteria by which BCTokens may be considered a security are:
- An investment/Provision of Money
- In Common Enterprise: Shared ownership of an enterprise’s resources
- With the expectation of profits from the efforts of others.
Here is a 100 point spreadsheet to assess whether a BCToken is a security.
Follow The 6 Principles of a DAPP token sale:
- Publish a white paper and have it independently reviewed by experts and members of the community. While popular community participants might not be “experts” but wild ideas may be abound.
- Have a clearly defined development roadmap, display an ability to chart a course towards the proposed vision.
- Publish all your code for review. The permissionless blockchain community continues to prove its anti-fragile nature and so should your Dapp
- Justify your tokens price, in my observations, there really isn’t a “best way” to do this, despite discourse, tokens have proven to over perform. Consult the community.
- If tokens are being set aside for your development team, publish terms under which these tokens are distributed. ex: IF project milestone A is achieved as per the dev roadmap, THEN x tokens are handed over to the core team.
- Do not market the token as an investment, this is my favorite principle. Nothing in the Dapp space can be certified as a “tried and tested” method, avoid projecting any expectations which suggest your token is a path to riches.
From what I’ve witnessed though, the slightest mention of the token to be “the next big blockchain thing” results in a token sales that exceed expectations.
Summary of the Debevoise and Plimpton Analysis
See 3 Principles Of The Howey Test Above
D&P outline a non-security BCToken while observed through the lens of The Howey Test mentioned earlier:
Does it require an investment of money?
Turns out, it’s not just cash and assets which fall under the definition of being money. Goods, services and promissory notes do too. Since the definition of “money” is broad, BCTokens satisfy the criteria of “Investments of Money”
Does a Common Enterprise (CE) exist?
There are 3 tests to determine whether CE can be attributed to an investment
- Horizontal Approach: CE is deemed present when multiple investors pool funds towards an investment and share profits with other investors. BCTokens can broadly be considered to have CE as per The Howey Test.
- Narrow Vertical Approach: If investor profits are tied to a “Promoter” or if the sales person of an investment profits off of having sold an investment product, CE is deemed to exist.
- Broad Vertical Approach: If investors rely on “Promoter” expertise or as I gathered, the council and knowledge of an individual/entity to generate profits, CE is deemed to exist.
Under approaches 2 and 3, CE does not exist for BCTokens because of the decentralized nature of Blockchain, through means of mining or otherwise, BCToken holders are less reliant on the efforts of promoters and more on themselves.
Whether BCToken holders are actually less reliant on promoters/development teams of a blockchain project is what makes the analysis of CE presence a challenge
If a blockchain project was reliant on investor funds to get developed, the BCToken may fulfill the criteria of Common Enterprise.
If a BCToken holder may directly exploit the system for their own creative purposes or to produce a good or service, Common Enterprise may not be attributed to the token/investment.
Is there an Expectation of Profit?
D&P asserts “Profit” on an investment security/contract is generally considered to be the return passively earned by investors through the efforts of others, as in, Zero input from the share holder with the the exception of some voting rights
Just because there is an expectation of profit, an investment should not be deemed a security. The assessment hinges on whether the profits are generated solely through the efforts of others.
BCToken holders may expect profits because they have certain rights to the system BUT in their case, the BCToken itself grants the holder permission/license to use the system for whatever its designated function may be, usage of a BCToken alone may signify the holder makes a contribution to the system.
Ex: Every Ether transaction on the Ethereum blockchain come with a minor cost, this “fee” is handed to miners/transaction validators on the network, thereby, ether transactions contributes towards network security and integrity which preserves overall network value.
It’s inconclusive as to whether BCTokens may be called securities on the basis of whether courts would scrutinize the profits to be generated solely from the efforts of others. Time will tell…
Applied Rationale To Common Definitions
D&P states; BCTokens may be observed as these contractual arrangements:
Licensee: When You and I agree to the Terms and Conditions of a software/app, lets take Microsoft for example. Microsoft (Licensor) grants You (Licensee) a certain degree of rights to their application
In the case of BCTokens, the issuer may act as Licensor and the token holder may be considered a Licensee with a portion of rights to the protocol or system.
For example: Ether grants the right to execute contract code on the Ethereum system.
Franchisee: If You (Franchisee) wanted to franchise your favorite international restaurant (Franchisor) and expose it to your local community, the terms of engagement will tend to include the grant of franchise rights and other disclosures, this is because the franchisee spends capital and other contextual effort for the franchisor.
This can be analogous to some BCToken sales.
A token holder invests capital to acquire the token, their contextual efforts can be defined as use/acceptance the token as a unit of value or as a functional part of a blockchain system.
Its concluded to advise…
Inform token holders of their system rights and demonstrate the token in use at the time of issuance.
I am yet to see the demonstration of token use, it’s advice that Dapp developers should take more seriously.
Many Thanks to everyone over at Consensys, USV, Coinbase and Coincenter for their work on this paper. It has offered me a wider perspective on the analysis of current and upcoming token sales.
This summary only reflects the areas which stood out to me the most, It’s possible that some of it was misunderstood, If you’re deeply entrenched in this industry, the paper can be found here.
Please let me know if you feel any corrections need to be made.
