Securities Law: Social & Community Tokens

Reuben Bramanathan
Dec 11, 2020 · 6 min read

2020 saw the rise of personal, social and community tokens — tokens that are connected with an individual, an artist or creator, or a group, rather than a protocol or application.

The most interesting aspect of these tokens is that typically, there is no existing structure for the relationships they seek to define. They are a nebulous collection of promises and intentions that can be molded to fit the different dynamics of each community.

When used effectively, these tokens have the potential to help communities coordinate around their shared purpose and objectives.

This post examines the US federal securities law treatment of social and community tokens. It is intended to help issuers of tokens think through some of the different pathways to non-security status, and to give some practical examples of things that could affect that status. Nothing in this post should be taken as legal advice. There can be no guarantee that a token will not be a security even if all of the positive characteristics in this document apply.

Factors

Practically speaking, there are five broad factors which can affect the analysis:

  1. Distribution

Pathways

Based on the SEC’s digital asset framework, here are three potential pathways which may result in social and community tokens not being classified as securities, along with the factors which are relevant to the pathway. There may also be other pathways.

  • First, if there is no ‘investment of money’ (Distribution)

If a token performs strongly on at least one of the pathways, it is less likely to be a security. In addition, tokens which have more of the positive characteristics across all five factors are less likely to be securities.

1. Distribution

General Principles

  • The less money raised from selling tokens, the better. It is much better if the tokens are never sold, and are only ever given away.

Practical Examples

[Best] Recipients get tokens for free with no strings attached, or for work they previously did without any expectation of being rewarded

  • Free distribution to community members, volunteers, historical supporters & contributors (e.g. a retroactive distribution). Retroactive distributions reward those whose contributions were intrinsically motivated.

[Good] Recipients get tokens retroactively for doing things they would have done anyway

  • Tokens are occasionally given as a bonus to people who have used the product (but not so regularly or predictably that users start to use the product with the expectation that they will receive tokens)

[OK] Recipients can earn tokens as a reward for doing specific tasks

  • Grants and bounties for delivering specific projects

[Bad] Recipients directly or indirectly exchange financial value for the token

  • Public token sale

2. Vesting

  • The longer the vesting for the creator & team, the better. The shorter the vesting for community members, the better.

3. Financial returns

General Principles

A token which delivers, promises or implies the possibility of any financial return is much more likely to be a security

Practical Examples

[Bad] Direct or indirect revenue is paid or promised to token holders

[Bad] A ‘buy and burn’ or similar model which redirects revenue or profits to increase the value of the token

[Bad] Liquidity mining which is designed to increase liquidity of the token.

[Bad] Yield farming which is designed to prop up the value of the token by incentivizing the reduction of circulating supply

[Bad] Holders of the token earn a return for simply holding the token e.g. token holders automatically earn a passive return denominated in stablecoins or other tokens

[OK] Holders of the token have access to benefits which are primarily non-financial in nature, even if those benefits are capable of having financial value e.g. token holders get free access to members-only content or events.

Exceptions

  • If and when a project becomes ‘sufficiently decentralized’ it may be possible to direct revenue to token holders without significantly increasing the securities law risk.

4. Usefulness

General Principles

  • In general, a useful token is less likely to be a security, provided that people genuinely want the token for its usefulness, rather than its financial upside. But there’s a saturation point: cramming extra functionality into a token doesn’t help (‘utility theater’)

Practical Examples

[Good] Token holders automatically get exclusive and free access to content, chats, community groups, events or other perks that are primarily of non-financial value (e.g, anything that is of artistic, cultural, entertainment, or fan value)

[Good] Token holders get direct access to the creator or team’s time

[Good] Tokens can be redeemed for any of the above.

[Good] Token holders perform operational decision making within the project: e.g. curation (note: this is a positive factor for Control too)

[OK] Token holders get discounts on or early access to products, content etc

[Bad] The token has no use or benefits

[Bad] The token’s main purpose is to provide a financial return to the holder

[Bad] The token has trivial or contrived functionality e.g. The creator says that the token is required in order to access exclusive content, but in reality they give that content away for free anyway

5. Control & Contribution

General Principles

  • The greater the voice, influence & contributions of token holders, the better.

Practical Examples

[Good] Token holder voting is required for major strategic and financial decisions about the project. The creator or team cannot unilaterally make these decisions

[Good] Community members contribute value directly to the project e.g. generating new content, collaborating to create new works or products, and these contributions are at least as significant as those of the creator or core team

[Good] Token holder voting is used to determine token rewards and benefits for the community

[OK] Token holders can signal their intent about project direction and decisions

[Bad] Token holders do not have any input, or only have input on insignificant decisions (‘governance theater’)

Again, nothing in this post is legal advice. You should definitely seek legal advice before launching a social or community token.

Thank you to Jason Somensatto, Aaron Wright, Pri Desai, Jess Sloss, Jacob Horne and Brian Flynn for feedback and conversations about this post.

SeedClub

Growing Social Tokens

SeedClub

We work with creators to conceptualize and launch social tokens that drive impact, value and alignment with their community.

Reuben Bramanathan

Written by

Blockchains, cryptocurrency & law. Helping crypto teams solve hard problems. Previously product & legal@coinbase

SeedClub

We work with creators to conceptualize and launch social tokens that drive impact, value and alignment with their community.