But I have a ‘utility token’ not a ‘security token’
The words “utility token” and “security token” are terms I hear a lot. I have clients tell me that they have a utility token and not a security token, or that they want to offer a security token and not a utility token. Most likely, if you are selling a token to U.S. purchasers in the United States (or are a U.S> company selling a token abroad) for the purpose of raising capital for your company and purchasers are buying based upon speculation that the token will increase in value, you need to treat that offering as the offering of a security and comply with applicable regulations, regardless of whether you call it a utility token or a security token.
In December 2017, SEC Chair Jay Clayton published a statement on cryptocurrencies and said “(b)y and large, the structure of initial coin offerings that I have seen promoted involve the offer and sale of securities and directly implicate the securities registration requirements and other investor protection provisions of our federal securities laws.”
In January 2018, the Securities and Exchange Commission (SEC) halted an initial coin offering (ICO) by Munchee, Inc., a California blockchain based food review service. In the order, the SEC focused on the manner of sale as well as the investment intent of purchasers of the Munchee coin in its determination that the offering constituted a non-compliant sale of securities.
The SEC has indicated that regardless of what it is called, or what the token actually does, the offering of the token will likely be the sale of a security based upon the manner of sale, the investment objectives of the purchasers and the actual usefulness to the purchaser. With regards to Muchee, the SEC focused on the following:
“the company and other promoters emphasized that investors could expect that efforts by the company and other would lead to an increase in value of the tokens. The Company also emphasized it would take steps to create and support a secondary market for the tokens. Because of these and other company activities, investors would have had a reasonable belief that their investment in tokens could generate a return on their investment”
In light of this, the offering of just about any token should be treated as an offering of a security and should be done so as to comply with securities laws. This means that the offering must either be registered pursuant to Regulation A+ or on Form S-1, or it should be offered pursuant to an exemption such as Regulation D, Regulation CF or an intrastate exemption.
In late 2017, I helped a number of clients structure the offering of equity or debt coupled with “bonus” future tokens. These offerings were made pursuant to exemptions under both Regulation CF as well as Regulation D and in addition to the offering of debt or equity securities, the issuers included bonus tokens that would be provided at some future date upon the token generation event. In addition, others have been structured as the sale of tokens which are tied to or designated as a separate class of equity in the issuer, or that have revenue sharing rights similar to a revenue sharing contract.
Recently, some offerings have been structured as the sale of a “unit” which constitutes a preferred equity interest, equity token, or “dividend” token together with a number of utility tokens, which have utility and functionality (either present or future) in the issuer’s distributed ledger network. This structure has been suggested by other securities attorneys and I believe provides a solution to those that have a token with future utility but wish to sell tokens as a means to raise capital. The unit would be a restricted security and would not be transferrable or tradeable on an exchange without registration or an exemption. However, the “equity token” could be traded on exchange pursuant to Regulation 144 after the expiration of the holding period and the “utility token” could be used within the ecosystem to gain access to goods or services, participate in the ecosystem and otherwise fulfill its utility. However, it is uncertain how these tokens could be separated and treated differently. It is important to note that neither the utility token nor the equity token could not be immediately listed on an exchange because of the restricted nature of such securities. In this case, both tokens are “security tokens,” even the “utility token.”
The biggest downside of this is the lack of an immediate ability of the issuer to sell the units or tokens on an exchange. This goes against the efficiencies of the blockchain and stymies innovation. I’m sure I’m not the only securities attorney who has felt the frustration of clients trying to navigate the current landscape.
The other question which I receive when proposing the equity token/utility token model is whether they can exchange one type of token for another. As stated above, I’m not sure how or if the tokens or “rights” could be separated. Because the tokens are both regarded as restricted securities, any such exchange would constitute a “transfer” of that security and would need to be done in compliance with applicable regulations. So, in other words, yes, but it’s difficult. I think the easier conversion would equity tokens for utility tokens, but again, this would have to be after the applicable holding period.
Is the Utility Token Dead?
The SEC has indicated that theoretically, an issuer could sale a token which does not constitute the sale of a security. Lawyers and others have employed the Howey Test, or Reves v. Ernst & Young for guidance on whether the their token offering constitutes a security offering or something akin to selling trading cards. The analysis lies not only in the purpose of the offering and how the offering is conducted but also the expectation of the purchasers.
In light of this, there have been issuers which have heeded the advice of counsel and taken steps to make sure that their token sale objectively fails the Howey Test and does not otherwise constitute the sale of a security. The issuers have an existing ecosystem in which their token has immediate utility, the tokens are not listed or sold on an exchange and in some cases are tagged to a fixed value. Purchasers of the tokens can use the token to download apps, access content, purchase services or redeem such tokens for goods or services. Please note that such issuers have not received a legal opinion of their offering nor have they received the blessing of the SEC; however, I believe they have taken steps to avoid the pitfalls of other issuers. The problem with such offerings is that they have not seen the financial success that other non-compliant offerings have received. Turns out most token purchasers are just purchasing based upon speculation that the token will increase in value. Who knew?
This discussion purposefully does not address all of the technical requirements and the legal elements that must be built into the smart contract, the requirements of the issuer to conduct KYC and the conflict with the anonymous nature of the blockchain and many other issues. First things first.
In conclusion, I believe that if you wish to sale tokens in the US, most likely that sale will have to comply with federal and state securities regulations. Current regulations are workable but not ideal. Although this is not the topic of this post, I believe the SEC needs to take a serious look at the current regulations in light of innovations in distributed ledger technologies and make changes which will facilitate continued innovation.