This paper is an interesting and informative guide for determining whether a particular cryptocurrency is a security or not.
What does that mean? Within the United States, the IRS already determined that cryptocurrencies like Bitcoin, Ethereum, etc. are property. In other words, whenever you use cryptocurrency to purchase goods or services, it triggers capital gains tax for the “sale” of the cryptocurrency. But there is a further question: Is my cryptocurrency a security, thereby potentially subjecting me to SEC regulations? This question is mostly but not solely relevant to groups offering a new cryptocurrency, through avenues like an Initial Coin Offering.
That’s what the paper attempts to answer. A warning before I start posting excerpts: While my firm has a lot of experience in securities litigation, securities law is really complicated. Nothing on this blog should be considered legal advice. But please, especially in this area, consult a legal professional if you’re getting remotely close to these issues.
With that said, some excerpt that caught my attention, and my comments:
The US Supreme Court case of SEC v Howey[, 328 U.S. 293 (1946),] established the test for . . . an investment contract. . . . In the context of blockchain tokens, the Howey test can be expressed as three independent elements . . .
1. An investment of money
2. in a common enterprise
3. with an expectation of profits predominantly from the efforts of others.
While it’s too extensive to include here, more interesting is the “risk score” spreadsheet they created for analyzing the Howey test. The spreadsheet includes interesting discussions for risky / less-risky / not risky behaviors related to each element. But then it calculates a “risk score,” determining your overall likelihood to meet the Howey elements. This seems problematic. I’m not aware of any empirical evidence or, more importantly, court decisions, that assign risk percentages to these different behaviors.
Next, they list some “best practices” in token sales:
Principle 1: Publish a detailed white paper
Principle 2: For a presale, commit to a development roadmap
Principle 3: Use an open, public blockchain and publish all code
Principle 4: Use clear, logical and fair pricing in the token sale
Principle 5: Determine the percentage of tokens set aside for the development team
Principle 6: Avoid marketing the token as an investment
The paper explains each principle. From my reading, they can be summed up in one conclusion: Be transparent and honest. But the paper doesn’t really cover what happens when plans inevitably go off track. While it seems obvious, I think the same advice applies: Be transparent and honest. Explain what changed, why it changed, and how it affects the overall plan. I can’t emphasize the honest part enough. The FTC and State Attorneys General understand when plans change due to reality, but they don’t understand when companies “shade” the truth.
The remainder includes a legal analysis by Debevoise Plimpton, who conclude (with caveats) that “appropriately designed Blockchain Tokens would not be deemed to meet the definition of security and, accordingly, that the federal securities laws would not apply to the initial distribution and subsequent trading of such Blockchain Tokens.” But they stress the “appropriately designed” part. They divide the universe into “security Blockchain Token[s]” and “non-security Blockchain Token[s]” based on differing characteristics. They suggest these characteristics indicate each type:
B. We generally believe that a Blockchain Token with one or more of the following rights likely should not meet the definition of security (nonsecurity Blockchain Token):
- Rights to program, develop or create features for the system or to “mine” things that are embedded in the system;
- Rights to access or license the system;
- Rights to charge a toll for such access or license;
- Rights to contribute labor or effort to the system;
- Rights to use the system and its outputs;
- Rights to sell the products of the system; and
- Rights to vote on additions to or deletions from the system in terms of features and functionality.
C. We believe that a Blockchain Token with one or more of the following investment interests likely should constitute a security Blockchain Token:
- Ownership interest in a legal entity, including a general partnership;
- Equity interest;
- Share of profits and/or losses, or assets and/or liabilities;
- Status as a creditor or lender;
- Claim in bankruptcy as equity interest holder or creditor;
- Holder of a repayment obligation from the system or the legal entity issuer of the Blockchain Token; and
- A feature allowing the holder to convert a non-security Blockchain Token into a Blockchain Token or instrument with one or more investment interests, or granting the holder an option to purchase one or more investment interests.