Securities Regulations in the United States

It is no secret that the Securities and Exchange Commission(SEC) of the United States has been cracking down on certain token sales. The SEC wants to regulate and take enforcement actions against companies that are simply using crypto tokens as a way to get around existing regulatory frameworks for conventional capital raises.

There have been some sales, including the infamous DAO sale, that offer tokens which clearly take the place of securities. Each token provides the holder with a right to revenue derived from the company and the right to vote in the organization. This is clearly matching the function of common stock which is typically issued in IPO’s. The SEC saw right through this and issued guidance warning against future sales of the same form. On Jul 25th, they issued an investigative report concluding DAO tokens were, in fact, securities.

Since then, we have seen a migration away from these “stock like” tokens to utility tokens. Utility Tokens seek to avoid being classified as securities by their structure. They typically confer no voting rights. Likewise, instead of providing holders a right to future revenue from a company- a clear hallmark of securities, they given holders the right to purchase future services with their tokens. This is where the “utility” part of their name comes in. Their value lies not in any future claim of ownership upon a company, but in the fact that they have utility- can be used to purchase goods or services. In fact, they can be thought of as a prepayment.

The thinking goes that because they do not bear any of the hallmarks of a typical security they are immune to SEC regulation. However things are not always this clear. Some experts still believe that these tokens may come under SEC scrutiny because they may still be considered to be a security.

This comes down to a key point- what is the definition of a security?

The current gold standard is the so called “Howey Test”. This test is a legal precedent which was created by the US Supreme Court for making clear whether a given transaction constitutes an “investment contract”. If so, these transactions constitute the sale of securities and is thus regulated in the United States under the Securities Exchange Act of 1934. The Howey Test is considered to be passed for a given transaction if:

  1. It is an investment of money
  2. There is an expectation of profits from the investment
  3. The investment of money is in a common enterprise
  4. Any profit comes from the efforts of a promoter or third party

When we examine the DAO tokens from this standpoint, it is clear that there is a strong case for their status as a security. (1) Their purchasers paid with Eth- a digital substitute for money. (2) They expected to profit from their investment in the form of future dividends. (3) The investment of money was in a common enterprise (the DAO). And (4), the profit would come from the investment efforts of the operators of the DAO, a third party and promoter.

When applying this test to Utility Tokens, the case is not so clear cut.

Firstly, money (or a digital substitute) is being sent so statement (1) is passed.

Whether statement (2) is passed is not so clear. In its purest form, a utility token should only be purchased with the intent of purchasing future goods or services. The company would pay out no revenue to token holders which could be construed as profit in the general sense. In fact, sellers of these tokens generally do not make any claims of any potential profits. However, many purchasers may be planning to resell the tokens once the ICO is completed and the tokens are liquid- for profit; this is a completely different form of profit, not one generated by holding the token, but the resale of the token. However, this is their own intentions whether this qualifies as an “expectation” is debatable. Thus, there may be an expectation of profit.

Clearly statement (3) is passed in that the proceeds from the sale of tokens all flow to a common enterprise, the issuing company.

However, Statement (4) is tricky as well; the profit would not come from the efforts of a third party in the same sense of the DAO. The owners of any company selling utility tokens are not actively looking for investments and are not planning to pay out revenue from these investments. However, there is another interpretation that could apply to utility tokens. Some argue that that the relative appreciation of owned tokens will be dependent upon how well the company fairs, which is in turn dependent upon the actions of the owners of the company. Here, the owners are not a “promoter”, but a “third party”. In this case, the actions of this third party will determine if and how much “profit” is derived from any future sale of the token by determining the success of the underlying business. This interpretation gives one way in which utility tokens could conceivably pass statement (4). Still, this is not clear cut- whether the owners actually qualify as the “third party” which the Howey test refers to is unclear and in this case, their actions are not aimed at promoting the business, just making the company succeed.

The upshot is that whether utility tokens qualify as securities is unclear.

For our part, Shardcoin (SDX), the ERC20 token which powers the entire Shardix ecosystem is an example of a utility token. It has no inherent voting power and no claims upon future revenue of Shardix LLC; instead, it provides the holder with the right to purchase future database services. Despite the haziness surrounding the status of such tokens, we will act as though SDX represents a security. This is out of an abundance of caution and to comply with all outstanding regulations to the best of our ability. Thus, we will not be selling SDX tokens to citizens of the United States. This will be enforced through KYC screening.

We wish we could include everyone, in the meantime, we will stay on the safe side. Hopefully the SEC will give future guidance and, ideally, the Howey test be updated to reflect some of the intricoes that we deal with in the new digital world.

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