Classifying Security Tokens and the Associated Implications
This following is an expansion upon a previous piece. It is recommended to first read the introductory post: An Introduction to Security Tokens.
This article will go into further detail regarding the processes of classifying a security token and the resulting implications.
The Howey Test - What is a Security?
The traditional method used by the SEC to determine if an asset is a security is the Howey Test. In part one of this series, we touched upon the SiaFund Token and its classification as a security. Now we will expand upon each point in order to provide a more comprehensive understanding.
To be considered a security, the asset in question must pass each part of the Howey Test.
1. It is an Investment
Merriam-Webster defines an investment as “the outlay of money usually for income or profit.” Traditionally, ICOs have accepted like-kind contributions during their fundraising efforts – contributors send ETH or BTC and receive the token in question – and use those funds for development. This exchange of assets in hopes of return satisfies the first requirement of the Howey Test.
One way that some ICO issuers have tried to get around this is by claiming that the proceeds, as well as the tokens themselves, are “donations.” This does not disqualify the ICO as a security, as seen similarly with Tezos.
2. The Investment is in a common enterprise
This portion of the definition is also fairly straightforward. For the sake of cryptoassets, we will consider the horizontal definition of a common enterprise. Investors money is pooled together, sharing in the successes and/or failures of the venture together. ICOs are offered to qualified individuals – historically there have been no requirements – with each contributor sharing in the risks and rewards associated with their investment . The structure of these investments almost always satisfies this requirement.
3. There is an expectation of profits from the investment
4. Profits come primarily from the efforts of the promoter/a third party
These two are a little more complex. Due to some rulings on the Howey Test in the past, these are often considered to be paired with each other. First, we will address these separately.
Those putting the money forth expect to be able to turn a profit on their investment, whether by profit sharing aspects of ownership of the token (like that of SiaFund Token holders receiving 3.9% of fees from all transactions on the network), by the tokens representing a form of equity/ownership of the project, giving status as a creditor or lender, giving rights to interest payments or repayment of purchase price, or a claim in bankruptcy as a equity interest holder/creditor. These methods are all directly related to performance of promoters/sellers/third parties involved in the project, and will (almost) always satisfy this portion of the test. However, these are often not true for many tokens that consider themselves “utility” tokens.
The expectation of profits must also be primarily from the effort of promoters/third parties. As mentioned above, those methods rely on persons affiliated with the project to cause the profits to come forth. Although not explicitly stated that the third parties must be affiliated with those offering the tokens for sale, the current rulings have only ruled offerings as securities in cases where the third party was affiliated with the enterprise making the offering. A small influence on the project by others or token holders is not enough to cause the token to fail this portion of the test, so those relying on some contributions for open source software, bug bounty programs, or a distributed mining system would most likely not be exempt.
Tokens claiming to be offering a utility – trying to refute a security classification – can still be classified as a security. For example, when investors buy a token with the intention to hold it and later resell it for a higher price, the so called “utility” token is acting as a security. In this situation however, the purchase of the tokens with an expectation of selling for profit at a later date must be the primary reason for purchasing the token. Otherwise, the token can still hold its stance against being classified as a security. This is where most “utility” tokens attempt to disqualify themselves from being considered a security. If it can be reasonably inferred that the tokens were purchased to gain access to using the platform (e.g. as a currency on the platform to be exchanged for services) then the token may be exempt. The possibility of selling the asset for profit on a secondary market (that is not affiliated with the issuers of the token) is not enough in and of itself to qualify it as a security, as was shown by past rulings on commodity futures contracts.
Despite these ways to disqualify a token as a security, the SEC operates on a principal of “substance over form” meaning that even if the token is designed with some functionality, it can still be considered a security if in practice it is not being used for those reasons. When considering these things you should consider if those buying the token are primarily motivated to use it as intended on the platform, or to hold and resell to obtain a profit on the investment. SEC Chairman issued a public statement in December saying “merely calling a token a ‘utility’ token or structuring it to provide some utility does not prevent the token from being a security.” Thus many of the popular “utility” tokens that were offered in an ICO could still be classified as a security and should be examined with extreme scrutiny before purchasing.
For more help determining if a token is a security or a utility token, Coinbase has created a helpful framework for judging the likelihood a token is a security. Although not definite by any means, it should help give you a good idea of the risk that the token is later classified by the SEC as a security token.
What Does This Mean for Those Tokens Ruled as Securities?
Any tokens ruled as securities – whether the ICO has been conducted already or not – are going to suffer immensely if they are ruled to be securities by the SEC.
Those that have not yet disbursed their tokens will be forced to take action to prevent them from being prosecuted for securities fraud. This could include refunding investors money that has been paid for undisbursed tokens or halting the ICO until it has been registered with the SEC as a security offering. This is a complicated and time consuming process that will heavily delay any eventual ICO. If/when the ICO is conducted, one of two things will happen.
If offered publicly, the tokens can be sold to “qualified clients” who must meet one of the following qualifications:
- 1Has $1,000,000 or more of assets under management with the investment adviser after the investment in the fund
- 2Has a net worth of $2,100,000 prior to the investment in the fund (excluding the value of his or her primary residence)
- 3 Is a “qualified purchaser” or
- 4 Is an officer or director of the fund manager or is an employee who participates in the investment activities of the investment adviser and has been doing so for 12 months.
In a new amendment to regulation D – rule 506(c), the SEC also allows publicly offered securities to “accredited investors” as long as the company takes extra steps to verify the client’s status as an accredited investor (definition below).
If offered privately, only to individuals known by those offering the security tokens, then they can be an “accredited investor” by meeting one of the following qualifications:
- 1Has a net worth (along with his or her spouse) that exceeds $1,000,000 (excluding the value of his or her primary residence)
- 2Income in excess of $200,000 (or joint income in excess of $300,000 with spouse) in each of the two most recent years with a reasonable expectation of reaching the same income level in the current year.
An entity is an accredited investor if it:
- 1Is owned exclusively by accredited investors
- 2Is not formed for the specific purpose of acquiring the interest in the fund and has total assets in excess of $5,000,000.
In the amendment to regulation D mentioned above – rule 506(b) – the SEC allows privately offered securities to be sold to up to 35 non-accredited investors given that investors are provided with extensive information on the issuers of the security.
This is a huge change to how most ICOs are run now. Most have been trying to position themselves as “crowdfunding campaigns” – offering investment opportunity to the general public regardless of investor status. The impending regulation crackdown will significantly change the structure and way that ICOs are conducted, severely limiting those who can participate. Historical free market dynamics in this space have fostered unforeseen innovation, yet the guidance of the SEC to protect main street investors is the next step in taking the blockchain space mainstream. A recent post by the SEC took a light hearted stance on this situation, promoting a fake ICO named the “Howey Coin.”
We created the bogus HoweyCoins.com site as an educational tool to alert investors to possible fraud involving digital assets like crypto-currencies and coin offerings.
– The SEC
Tokens that have already been disbursed will be nearly impossible to feasibly reclaim, and the companies that have issued their tokens and used the money already could be subject to heavy penalties by the SEC. This could very well bankrupt many cryptoasset projects, cause the development of the project to cease, and result in the tokens’ value decreasing enormously. In addition to this happening to the issuers of the tokens themselves, exchanges listing these tokens that are not registered with the SEC may be subject to fines and thus most likely will cease to list the tokens on their exchange. As you can imagine, this also will be devastating to the price of the underlying cryptoasset and could cause investors to lose their investments.
One can hope that the tokens underlying these extremely promising projects do not end up being classified as securities. Even the most popular “utility” tokens are at risk of meeting these standards. In these instances, the projects themselves would be at risk of failure, most likely resulting in token holder investments substantially depreciating. The ever changing regulatory landscape intertwining cryptoassets and securities regulation must always be taken into account in every investors risk management strategy.
In a recent interview, SEC Chairman Jay Clayton stated “we are not going to do any violence to the traditional definition of a security that has worked for a long time.”