Security Law Issues – Pre-Functional Consumer Token Sales
One of the most prominent issues in blockchain, crypto and defi is whether a project, currency or token is a security/investment contract regulated by the SEC. Generally speaking, it’s never a good idea to attempt to thwart the ever expanding grip of the SEC, but, needless to say, multiple early blockchain projects attempted to do just that. The majority of the current case law surrounding blockchain and crypto relates to investors suing the project and requesting damages due to the project’s failure to register as a security or individual federal prosecutors shaking down companies for their failure to comply with regulations. This tends to come up during Pre-Functional Consumer Token Sales, which are considered the sale of tokens to fund an Active Participant’s development of a blockchain project. Considering pre-functional consumer token sales involve the sale of an investment instrument they most likely fall into the category of an investment contract. This is not always the popular opinion, and it wouldn’t be fair to make such an opinion without fully divulging that a Pre-Functional Consumer Token Sale can be a security one day and then subsequently reach a point of decentralization where it no longer requires registration.
In determining whether a pre-functional consumer token is an investment contract requiring registration with the SEC, the Howey test controls the conversation. Specifically, the Active Participant’s efforts and role within the sale are reviewed through the eyes of Howie. Unfortunately the analysis rarely comes into play until after a lawsuit is filed.
One issue that consistently arises in pre-function token sales is the failure to disclose the status of the underlying tokens and the impact of the pre-sale offering on the marketing of the underlying token. It’s very hard to market a token pre-sale as an investment opportunity without marketing the investment value of the underlying token. It is borderline impossible to market tokens to investors without representing that these investors are purchasing the tokens for investment purposes. Further, once the pre-sale offering is completed, the purchasers are allowed to either use the tokens for their respective purposes or sell them for profit.
There are two cases providing guidance related to whether a pre-function token sale is a securities transaction as opposed to consumer token launch. The Gary Plastics order, stands for the proposition that: a broker dealer who creates and maintains the sole marketplace for trading a CD (Certificate of Deposit), which they manage and maintain can transform anon-security into an investment contract. In other words, an investment combined with a program for profiting from the investment can transform a non security into a security. The Munchee Order, which stands for the proposition that: despite the utility design features of the tokens, the manner in which the digital assets are offered to prospective investors, and the presence of investment intent on the part of participating investors, will be material factors for the SEC in determining that the offering was a securities offering subject to the US federal securities law. Both orders support the token sale as a being a securities transaction. They argue in favor of the proposition that a token launch with delivery of tokens is a securities transaction, not a consumer token launch.
This decision to register almost always requires an attorney to help ask the right questions. Is it ok to market the token as an investment? Is it ok the investors are investing with investment intent? Is it ok that the tokens are delivered to investors prior to the offering/launch.
The risk is and always will be that if you don’t register with the SEC you may catch a lawsuit when it matters most. That being said, it is tempting to avoid significant disclosures and compliance when you’re attempting to build an empire in a crowded space. This better safe than sorry approach is more than just compliance via disclosures, in fact, the fun doesn’t stop with registering with the SEC. US Securities Laws often require the existence and registration of an intermediary broker dealer/exchange, which brings with it a whole new set of problems, particularly whether a blockchain related token would be supported by any currently available broker dealers.
The SEC and any federal agency attempting to regulate Pre-Functional Consumer Token Sales faces a difficult task. It would be challenging to concoct sufficient disclosure in such a circumstance where the entire investment proposition is subject to this level of uncertainty. For example, when the entire investment decision is based on the availability and functionality of the underlying token, the viability and timing of the consumer token sale raises liability for appropriate disclosures to investors and risks for issuers.
Recent examples of the unintended consequences of using token presale instruments is evident in the SEC’s actions against Kik and Telegram. Kik and Telegram each offered and sold pre-functional tokens to accredited investors in private placements incompliance with applicable regulations via token pre sale agreements. Despite their good faith compliance, the SEC’s view was that the private nature of the sales of tokens under the token presale instruments was destroyed because these sales were part of schemes that involved token sales to the public and thus constituted a single plan of financing that did not qualify for the private placement exemption from registration under SEC guidelines. The SEC noted that “Kik sold the Kin as part of a single plan of financing, for the same general purpose, at about the same time, without creating different classes of Kin.” Similarly, in halting the delivery of Telegram tokens to the initial purchasers, the Court found that “the delivery of Grams to the Initial Purchasers, who would resell them into the public market, represents a near certain risk of future harm, namely the completion of a public distribution of a security without a registration statement.” The SEC’s actions prove that climate and perspective affect compliance and that token presales can be eaten alive by evolving regulation.
Recent guidance from the US government and current case law that a digital asset originally issued as a security could subsequently cease to be a security once the network is sufficiently decentralised. Ironically, the risk is not whether the token is a security, it is whether the token is deemed a security by the SEC. Where do we draw the line? Where does the line begin an end? At Quattrochi and Torres we can help you weed through the ever changing laws surrounding Blockchain and help your project make an informed decision regarding their status as a security.