Raising capital through tokens, whether it’s an investment strategy or a form of “Kickstarter” type sale of future products, is currently not even a novelty. Yet, surprisingly enough, World Blockchain Forum’s panel discussions, the recent publications and blogs, reveal the tendency of abandoning the very idea of utility tokens because of their alleged incompatibility with the United States securities laws. Furthermore, it appears the fear of utility tokens has been formed of somewhat wrongful conclusions and misinterpretation of the perfectly reasonable and anticipated activity of the United States Securities and Exchange Commission (the “SEC”).
Consequently, I would like to contribute to the discussion that a lot of blockchain startups are currently involved: “security vs. utility” token offerings. The stylishly insouciant debate about the advantages and disadvantages of a particular type of token is often accompanied by a false predicate notion or question: which token offering is better, “safer,” or more “fashionable.” Astonishingly, said misconception regarding the approach to choosing the right instrument for financing products or a start-up is fairly common. Ergo, this abstract is a humble attempt to make things clearer without the usage of overly complicated categories.
To begin with, the word “token” is somewhat hyped. It is just a unit of representation. Simple as that, token can be anything (a symbol, a computer code, a tangible object) that is used to represent quantity, quality, or another characteristic. Undeniably, “token” sounds trendy (much more impressive than “a unit” or “a share of common stock”), especially combined with such words as “ledger,” “blockchain,” or “crypto.” Nevertheless, tokenization does not per se mean a creation of a security or commodity (and overall, doesn’t give any additional meaning to the object of tokenization). Certainly, a token may become a security if it is used as such. Various types of token offerings allow entrepreneurs to sell different digital assets to general public: in the form of cryptocurrencies (just a measure of exchange), in the form of a key or access codes to certain goods or services, or in the form of an investment in the issuing company. Each category of tokens determines a completely different marketing strategy, the behavior of the issuer, and has distinct legal and financial consequences.
Since tokenized offerings of any form are fairly new to the regulatory bodies, they justifiably received a considerable amount of attention, including the quick reaction of the SEC. The recent outbreak of SEC scrutiny (which is well-justified in light of the necessity to protect investors) lead some “crypto-attorneys” and “experts” to a conclusion that any tokens are securities, and that the offerings should be structured accordingly.
Simply put, a mere usage of a term out of ordinary parlance does not create a security. In order to illustrate that it’s not just my position, I would like to quote one of the very recent federal court decisions showing that the analysis of the offering goes far beyond answering the question of whether it uses the words “token” or “coin”: “[m]erely writing “Blockvest” or “coins” on their checks is not sufficient to demonstrate what promotional materials or economic inducements these purchasers were presented with prior to their investments. Securities and Exchange Commission, Pl., v. Blockvest, Llc and Reginald Buddy Ringgold, III a/k/a Rasool Abdul Rahim el, defendants, 18-CV-2287-GPB(BLM), 2018 WL 6181408, at *8 (S.D. Cal. Nov. 27, 2018).
It is abundantly clear that neither issuers nor investors should presume that a token is some kind of magic word that turns an asset into a security. No, it doesn’t: again, a token may be a security depending on the offering strategy. The fear that the utility token is actually a security under U.S. law or in accordance with the SEC’s policies might be emotionally justified, but lacks legal or logical foundation. Furthermore, the SEC itself merely pointed out that new technological solutions in the areas of crowdfunding will not allow circumvention of federal securities laws: “the automation of certain functions… does not remove conduct from the purview of the U.S. federal securities laws.” (See https://www.sec.gov/litigation/investreport/34-81207.pdf). Overall, the SEC did not declare all tokens to be securities, and even, arguendo, if it had, such onerous position, I believe, would be overturned by the courts.
Digging a little further down, the creation of consumable tokens designed purely for facilitating goods or services within a given network is not likely to be deemed a solicitation of securities. It is worth mentioning, that the main argument of the proponents of such an idea comes with the so-called “economic realities” of the offering, when purchasers of the tokens buy them just because they can later re-sell them for a higher price. Even when this is actually the case, this is neither what the law (the Howey test and related case law – which I will discuss it in future publications in detail) provides, nor does this idea reflect what the reality should be. Admittedly, a significant portion of customers may elect to purchase utility tokens of an issuing company not to avail themselves of the product, but in a hope of profiting on resale. It’s not worth speculating on why people are doing so, and whether this is a new “economic reality.” The fact remains that unless a new regulation is issued specifically for tokens or if there is a new test adobted by the Supreme Court (for instance, the Court elected to do so in case of promissory notes in Revs v. Ernst & Young, 110 S. Ct. 945 (1990)), the current position that a customer’s or market’s behavior is the determinative factor to turn a token into a security is somewhat ridiculous.
To prove the point, I will present a situation without tokens. If a video game company is selling end-user licenses in the form of an access code or a key for a future game with some special content (for instance, in-game items giving multiple bonuses to an RPG character), a fraction of consumers may be motivated to buy a license, not to play the game, but rather to resell the access key later (if the game is a great success, and the items offered are limited). I hope that the described presale does not lead the reader to the conclusion that the company is offering securities. The analysis should not change when the video game company decides to offer tokens instead of the license keys/codes.
Likewise, “forever” stamps of the United States Postal Service can be purchased because a consumer plans to resell it for a profit. The demand for the stamps here is not relevant for the analysis as to whether stamps are a security. An analogous situation may be observed with the purchase and resale of tickets for various events when particular customers purchase the tickets with intent of resale at a higher price. As per my best knowledge, no one has ever tried to investigate whether “forever” stamps or Comic-Con tickets are securities (hopefully, not just because they are not distributed through a blockchain system). Hence, it seems that an idea that the magic word “token” is able to convert a commodity into security is, to put it softly, naive.
Undeniably, the situation when “utility” tokens are created to circumvent securities laws and are de facto securities should be distinguished from the aforementioned analysis. In this regard, tokens are not the first instrument that might be used to disguise the true nature of the legal relationship of the parties – in already mentioned Howey, the U.S. Supreme Court dealt with real estate contracts for ownership parcels of land with citrus groves in connection with leases and service contracts. Therefore, any civil or criminal consequences for issuers of “utility tokens” that chose to disregard the U.S. securities laws are not the indication of any drawbacks of utility tokens. Rather, it’s an indication that one is not allowed to present securities as “utility tokens,” thus, no surprises here. Finally, it should be added that the ICO-boom of the year 2017 and the common lag between the phenomenon and the regulator’s reaction to it created an illusion that a public offering of securities through utility tokens was allowed before. In reality, such practices have never been allowed, but it takes time for governmental authorities to analyze a relatively new concept and to adequately react.
Sadly, a great number of attorneys choose to force clients to regard any tokens as securities for the purpose of “safety” and avoid regulatory scrutiny, instead of giving a thorough analysis of the projects: some start-ups may find it beneficial to utilize security tokens, others may need to go with utility tokens or even use both utility and security tokens for a different purpose. In fact, it may be extremely detrimental for an issuer to present what is, in reality, a utility token as a security.
Overall, the popularity of blockchain technology and tokens, together with its rapid development, created an illusion that initial token offerings are a novelty that exists in a legal vacuum, and the regulator’s time lag to respond strengthened such an impression. When the imminent happened and the SEC adequately reacted to intentional or negligent cases of violations of securities laws, the feedback of the community turned out to be blaming the SEC or utilities tokens an instrument. But at the end of the day, no matter how emotional it gets, utility tokens remain a viable instrument, if used properly.
Kirill Nikonov, Esq. is an attorney at Carmel, Milazzo & DiChiara, LLP.
This article is available for educational purposes only as well as to give readers general information and a general understanding of the relevant securities laws, not to provide legal advice of any kind.