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Considerations for Token Qualifications as Securities

December 26, 2017
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Dozens of startup tech companies are utilizing Initial Coin Offerings (ICOs) to raise millions of dollars in funding, oftentimes from unsophisticated investors.  As result of the current cryptocurrency mania, many individuals are buying these ICOs with little regard or understanding of the underlying tokens they are purchasing.  This level of excitement is creating a manic investment environment that is ripe for fraud.  The Securities & Exchange Commission (SEC) is investigating this, and charged two individuals and companies with defrauding investors related to ICOs on September 29, 2017.  While fraud will always be an issue, regular law-abiding companies need to use due care to avoid running afoul of the SEC.

In an ICO, a company (the “issuer”) creates its own cryptocurrency (referred to as a “token”), and sells it to investors for another cryptocurrency (usually Bitcoin or Ethereum).  Generally the issuer creates a “whitepaper”, which states the purpose of the ICO, the maximum number of tokens to be issued/sold, the price, type of cryptocurrency accepted, length of time for the ICO, the purpose of the token, etc.  The issuer can then liquidate the proceeds to fund operations, fund software or product development, pay employee salaries, etc. 

The ICO name itself is reminiscent of an Initial Public Offering (“IPO”).  An IPO has burdensome reporting requirements, such as registration statements, annual 10-K and quarterly 10-Q filings, proxy/voting rules, etc.  ICOs were originally devised as a way to avoid the legal regulations associated with IPOs.  However, on July 25, 2017, the SEC issued a report on a token referred to as the “DAO” token.  In that report, the SEC found that DAO tokens were in fact securities, and as such are subject to the SEC regulations. While the SEC chose not to pursue enforcement action in that particular case, they have clearly outlined that they will regulate tokens going forward.

There have been no new US federal laws related to token issuance, and the Federal Accounting Standards Board has not issued any new pronouncements.  As such, all of the old rules still apply.  The “token” is merely a technology to implement an offer, sale or agreement - nothing more.  For the issuer, it’s their accountant’s job to navigate the same old laws that have existed for years, focusing on the actual business transaction that underlies the specific token. 

Tokens can vary widely in their uses.  There are essentially three main categories of tokens:

  1. Protocol Tokens - exist solely to reward the system participants. The best example of this is Bitcoin.  Without miners, no one would be able to buy, sell, or transfer a Bitcoin.  Bitcoin miners are incentivized to secure the blockchain with the reward of additional mined Bitcoin tokens.  In this case, there is no underlying asset that backs the cryptocurrency, and no right is conferred upon the owner of the token.  Instead, the protocol token is the end unto itself and has value based purely on the mining support and cryptographic security underlying the Bitcoin blockchain as a whole.

 

  1. Utility Tokens – provide the holder with a right or privilege within a specific computer program or distributed ledger. The most well-known utility token in use today is Ethereum.  The Ethereum computing platform allows companies to create their own cryptocurrencies.  Utilizing the Ethereum computing platform requires payment or transaction fees.  These payments are made utilizing Ethereum.  As such, Ethereum is a utility token that provides the spender with the right to process a transaction on the Ethereum network.

 

  1. Security or Investment Tokens – confer a right to profit or provide a royalty to the holder of the token. Essentially, this type of token takes the place of a stock certificate.  The previously mentioned DAO token is a clear example of this.  The SEC, in its July 25, 2017 report referenced a court case entitled SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946).  In this court case, the “Howey Test” was established.  Essentially, the “Howey Test” indicates that an investment contract exists if 1) a person invests their money 2) in a common enterprise 3) with an expectation of profits 4) based on the efforts of others.

Clearly Bitcoin or a simple protocol token is not an investment contract or security.  In the case of investment tokens, the SEC has declared the DAO token to be a security. 

Utility tokens however, provide a mix of both utility and service with the potential for a profit in the event the token is re-sold or redeemed at a higher price.  As such, utility tokens operate in a gray area, and the SEC has not taken a position to date.  One could argue that a utility token would appear to represent a prepayment for services, rather than an investment contract.  In that case, from a tax standpoint, prepayments for services are taxable revenue, but that revenue can be deferred as per Rev. Proc. 2004-34, 2004-1 C.B. if the services are expected to be performed in the following tax year.

Each token must be analyzed on its merits, and legal counsel should be consulted when performing an ICO as to applicability and potential exemptions from securities laws. 

If you wish to read a more in depth legal analysis on the topic, Coinbase and Debevoise & Plimpton, LLP have created a securities law framework for Blockchain tokens that discusses relevant information to consider.  Additionally Forbes has published a relevant article. 

 

 

 

This article does not constitute legal advice and should not be relied upon by any person.  Developers and users should consult their own counsel in connection with any ICOs.