Initial Coin Offerings, or ICOs, have generated a lot of buzz recently as a new method by which companies can raise capital to fund their businesses. At the same time, the SEC has been cracking down on ICOs that involved the offer or sale of a security that was not registered or structured to comply with an exemption from registration. For example, the SEC announced last week that it halted a $600 million ICO by AriseBank, which allegedly involved the offering of a coin that was a security without properly registering the transaction. Despite the apparent scrutiny of ICO transactions by the SEC, there’s much uncertainty in the space as to when securities laws may or may not apply to a specific ICO transaction.
Currently, we are seeing two primary types of ICOs – those that involve the sale of a “security token” and that are intended to be offerings of a security and those that involve the sale of a so-called “utility token,” which do not involve the offer or sale of a security. The primary difference between these two types of tokens is that a utility token is designed such that it has some intrinsic value that is not based upon prospective price appreciation. For example, a cloud computing company might sell utility tokens that are redeemable with the issuer for storage space on the issuer’s servers. In this sense utility tokens are not unlike gift cards where a purchaser is acquiring something that can be redeemed for products or services from the issuer in the future. Like gift cards, an incentive to purchase a utility token could be that the token offers a discount to the normal price for the issuer’s goods and services. While a secondary market for the utility token might develop, just like there are secondary markets for the purchase and sale gift cards, issuers usually intend for these tokens to fail the Howey test, which is the test that is used to determine whether something constitutes an “investment contract” (which would be a security) for federal securities law purposes.
The Howey test, named after the case in which the test was first applied, Securities and Exchange Commission v. W. J. Howey Co. et al. is a four-part test that is used to determine whether something constitutes an investment contract. Under the Howey test, an investment contract (for federal securities law purposes) involves (1) a contract, transaction or scheme whereby a person invests their money (2) in a common enterprise and (3) is led to expect profits (4) solely from the efforts of the promoter or a third party. If all four prongs are satisfied the federal securities laws will apply.
Many legal commentators believe that most utility tokens will fail this test because they usually do not satisfy the last two prongs of the Howey test. First, purchasers of utility tokens actually will use them and their primary motivation is consumptive rather than a speculative expectation of profits. Second, several courts have held that the mere development of a secondary market does not, in and of itself, satisfy the “efforts of others” prong. In at least three different cases involving commodity futures contracts, the courts have held that the futures contracts at issue were not investment contracts (and therefore not a securities) because the changes in market price of the contracts were primarily a result of changes in prices of the underlying commodities – not from any efforts of others. By analogy, changes in prices of a utility token would likely be the result of changes in prices of the products or services for which the tokens could be redeemed. Thus, tokens that might be redeemable for cloud storage space might change in value on a secondary market if the cost to rent space from the company also changes.
Notwithstanding the prevailing view among legal commentators that utility tokens do not likely constitute securities, the view of the SEC is less certain. In December 2017, the Chairman of the SEC, Jay Clayton, issued a public statement in which he stated that “[m]erely calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security.” Instead, issuers should look to understand the primary motivation for purchasers. If it is a profit motive due to a potential appreciation in value, then the token (even one that offers functional utility) could nonetheless be a security. The statement goes on to further suggest that it is incumbent upon the “gatekeepers,” including lawyers and accountants, to provide oversight and guidance to clients seeking to conduct token sales.
Any proposed offering of blockchain or distributed ledger tokens should be carefully reviewed by securities counsel to determine whether a proposed transaction will need to comply with the registration requirements under state and federal securities laws (or exemptions therefrom). Failure to strictly comply with these requirements could not only result in the company offering the tokens to reimburse investors for the full amount of their investment, plus interest, but could also result in personal liability for officers, directors, and promoters.