Understanding Securities and Utility Tokens
In April, the United States Securities and Exchange Commission (SEC) reported that it charged the co-founders of CTR Token of running a fraudulent initial coin offering (ICO).
“The SEC’s complaint alleges that Sohrab ‘Sam’ Sharma and Robert Farkas, co-founders of Centra Tech. Inc., masterminded a fraudulent ICO in which Centra offered and sold unregistered investments through a ‘CTR Token’,” the press release reads. “Sharma and Farkas allegedly claimed that funds raised in the ICO would help build a suite of financial products. They claimed, for example, to offer a debit card backed by Visa and MasterCard that would allow users to instantly convert hard-to-spend cryptocurrencies into U.S. dollars or other legal tender. In reality, the SEC alleges, Centra had no relationships with Visa or MasterCard. The SEC also alleges that to promote the ICO, Sharma and Farkas created fictional executives with impressive biographies, posted false or misleading marketing materials to Centra’s website, and paid celebrities to tout the ICO on social media.”
This action reflects a growing trend worldwide of regulators cracking down on “securities tokens.” This, however, is a controversial issue and a difficult one for the new investor to understand. In light of this, this article will look at the differences between securities and utility tokens and point out what investors need to know before investing in these devices.
Cryptocurrency can be defined as being either coins or tokens. Coins are cryptographic devices where the primary purpose is to convey or transfer a monetary value. There may be a utilitarian purpose attached to the coin, but the coin’s primary function is to serve as digital money. This would include bitcoin, Litecoin, bitcoin gold, monero, Dogecoin, and bitcoin cash.
Tokens, on the other hand, has a primary function of serving some function on their platform. They may be devices used for smart contracts on the network, transfer protocols from and to the platform’s blockchain, or proof of ownership of the platform or the platform’s assets.
Tokens of the last type are known as security tokens. A security token is a token that represents ownership of either equity or debt. For example, a real estate platform that manages a portfolio of houses for the purpose of collecting rent would offer security tokens if tokenholders were shareholders in the platform.
Security tokens are treated like securities in the various countries. This would mean that special licensing and reporting requirements must be adhered to. As a fungible, negotiable financial instrument that could be exchange for monetary value, firms that issue or trade securities tokens must be registered as securities dealers in nations that have American-styled securities laws and must file the appropriate disclosures.
This can become complicated in light of initial coin offerings, or ICOs. An ICO is a crowdsale where a company sells tokens for an upcoming blockchain project in order to raise seed money. These tokens can be utilitarian and can only grant the right to use the platform or could be equity-bearing and grant partial ownership to the platform or the platform’s assets. In either case, however, the tokensale can represent debt restructuring, in which case the tokens are a security (as they now represent debt), regardless of the original intent.
“If you are thinking about participating in an ICO, here are some things you should consider,” the U.S. Securities Exchange Commission wrote in an investor bulletin. “Depending on the facts and circumstances, the offering may involve the offer and sale of securities. If that is the case, the offer and sale of virtual coins or tokens must itself be registered with the SEC, or be performed pursuant to an exemption from registration. Before investing in an ICO, ask whether the virtual tokens or coins are securities and whether the persons selling them registered the offering with the SEC.”
“If the virtual token or coin is a security, federal and state securities laws require investment professionals and their firms who offer, transact in, or advise on investments to be licensed or registered. Ask what your money will be used for and what rights the virtual coin or token provides to you. The promoter should have a clear business plan that you can read and that you understand. The rights the token or coin entitles you to should be clearly laid out, often in a white paper or development roadmap. You should specifically ask about how and when you can get your money back in the event you wish to do so. For example, do you have a right to give the token or coin back to the company or to receive a refund? Or can you resell the coin or token? Are there any limitations on your ability to resell the coin or token?”
The Securities Test
In the United States, the test for determining if an investment is a security is known as the “Howey Test.” Named after the U.S. Supreme Court case SEC v. W.J. Howey Co., which defines a security as a “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party,” the Howey Test” was proposed as a way to define investment responsibility in regards to investment contracts. This was left vague in the securities laws on the book.
As stated in the Supreme Court opinion: “The test of whether there is an ‘investment contract’ under the Securities Act is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others; and, if that test be satisfied, it is immaterial whether the enterprise is speculative or nonspeculative, or whether there is a sale of property with or without intrinsic value.”
What this boils down to is the opinion that a security must be an investment where any and all capital gain comes despite the investor’s effort. An example of this is stocks: the investor buys the stock at a price where he/shed has no role directly in setting, it grows (unless the investor has a stake in the company) in no way because of the investor shy of the actual buying of the stock, and the stock will be sold at a price beyond the seller’s control. Stocks are a measure of ownership in an enterprise that does not require the investor’s “sweat equity.”
Property, such as homes and vehicles, is not a security in the sense that its future value is a reflection of the maintenance and care provided it and the nature of its service and sale. In other words, your property’s future value is up to you, and this is what makes it not a security.
In the case of the namesake of the “Howey Test,” William John Howey owned large tracts of citrus-growing land in Florida, of which he sold of half to finance future developments. Via a resort hotel he owned, Howey marketed the land to would-be investors – the majority of them were not farmers or even residents of the states – and would then offer his company to lease the land back and manage, grow, harvest, and market any citrus it grows on the land. Howey would retain “full and complete possession of the land and all crops harvested, with Howey being required to pay the lease fees to the land owners.
As Howey did not register his business with the SEC, he was found in fault. Howey provided a service that offered an investment opportunity where the investors need not do anything short of buy in to profit. This, according to the Supreme Court, made Howey an unlicensed securities provider.
“The transactions in this case clearly involve investment contracts, as so defined,” the Supreme Court ruled. “The respondent companies are offering something more than fee simple interests in land, something different from a farm or orchard coupled with management services. They are offering an opportunity to contribute money and to share in the profits of a large citrus fruit enterprise managed and partly owned by respondents. They are offering this opportunity to persons who reside in distant localities and who lack the equipment and experience requisite to the cultivation, harvesting, and marketing of the citrus products. Such persons have no desire to occupy the land, or to develop it themselves; they are attracted solely by the prospects of a return on their investment.”
“Indeed, individual development of the plots of land that are offered and sold would seldom be economically feasible, due to their small size. Such tracts gain utility as citrus groves only when cultivated and developed as component parts of a larger area. A common enterprise managed by respondents or third parties with adequate personnel and equipment is therefore essential if the investors are to achieve their paramount aim of a return on their investments. Their respective shares in this enterprise are evidenced by land sales contracts and warranty deeds, which serve as a convenient method of determining the investors’ allocable shares of the profits. The resulting transfer of rights in land is purely incidental.”
“Thus, all the elements of a profit-seeking business venture are present here. The investors provide the capital and share in the earnings and profits; the promoters manage, control, and operate the enterprise. It follows that the arrangements whereby the investors’ interests are made manifest involve investment contracts, regardless of the legal terminology in which such contracts are clothed.”
Regarding ICOs, the realities of all of this is that any ICOs that offer a coin that does not have a purely utilitarian purpose can be held as a security in the United States. Worse, if a token is bought with the expectation that the blockchain platform will be successful and the token will gain value on the token market, it is possible (but unlikely) that the token could be ruled a security despite the intentions of the ICO.
Different ICOs have different strategies for dealing with this. Some limit their crowdsales to countries that have non-American styled securities rules while others limit their crowdsales to accredited investors. Accredited investors are a special class of investors recognized under SEC rules as being capable of purchasing unregistered or unregulated securities. Under the assumptions accredited investors are “wise enough” to dodge the dangers of an unregulated investors or situated to absorb the fallout, accredited investors have specific income requirements (earned income exceeding $200,000 in each of the last two years or $300,000 for a couple or more than $1 million in net worth, excluding the value of one’s main residence or more than $5 million in the case of a trust not made to specifically purchase the securities in question).
The final possibility is to register the ICO as a security. Examples of SEC-regulated tokens include tZERO and PolyMath. For some, registering is problematic because the SEC and other securities watchdogs worldwide have taken on an attitude of stopping fraudulent ICOs. As ICOs, in general, have limited accountability requirements, and as the law offers nearly no recovery options for those subjected to a fraudulent crowdsale, the position of the SEC and others is to proceed with extreme caution.
“On July 25, 2017, the SEC issued a Report of Investigation under Section 21(a) of the Securities Exchange Act of 1934 describing an SEC investigation of The DAO, a virtual organization, and its use of distributed ledger or blockchain technology to facilitate the offer and sale of DAO Tokens to raise capital,” the SEC bulletin reads. “The Commission applied existing U.S. federal securities laws to this new paradigm, determining that DAO Tokens were securities. The Commission stressed that those who offer and sell securities in the U.S. are required to comply with federal securities laws, regardless of whether those securities are purchased with virtual currencies or distributed with blockchain technology.”
This leaves the field of what is and is not a security token murky for the time being. For some coins like ICONOMI, this means existing in ambiguity. It is hoped as the technology improves, so will the rules defining its use as an investment tool. As an investor, it is important to recognize that the term “utility token” does not necessarily excuse the platform from securities liability.
When investigating a coin or token, one must ask:
- Does this coin convey ownership of any type of any asset?
- Am I clear about the legal liabilities in purchasing this coin?
- Do I know what this coin does and why it is important?
- Are you buying a coin that will be tradeable later or are you buying a “placeholder” non-secured coin that will be traded for the tradeable coin once the platform is running?
- What were the factors that determined the coin’s pricing?
- Why do you have to do personally to make this coin work as intended?
A final question regarding securities is the problematic one of is bitcoin a security? As bitcoin has clear monetary value, it is arguable that it is; however, unlike forex or bonds, that value is not a clearly-defined amount of fiat currency.
The truth is that the regulators are as unsure about this as anyone else. The IRS and other regulators have ruled that currency-typed cryptocurrencies like bitcoin are simultaneously commodities and money. This means that those dealing with bitcoin and other currency-type cryptocurrencies are classified as money transmitters and are held to a higher regulatory standard than securities dealers. However, most countries draw the line at money and deny bitcoin-like coins the distinction of being legal tender or currency acceptable for the payment of governmental and legal debt.