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 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.