BLOCKCHAIN: Is My TGE a SECURITY or UTILITY Coin?
I am frequently asked the question “If I do a TGE— Token Generation Event — in the United States or for U.S. Investors, will it qualify as a regulated security or an investment contract that needs to comply with the SEC (Securities and Exchange Commission)?” The answer to this question is not simple and requires a deeper explanation, as it seems there is a lot of confusion around this subject.
First and foremost, DISCLAIMER: I am NOT A LAWYER, AND DO NOT INTENT to provide legal advice to anyone. After researching and listening to various lawyers on the subject I am presenting the information below just for “entertainment purposes.” Thus, please (for your own good and safety) seek proper legal counsel before thinking of launching a token project.
THE 2 DIFFERENT TYPES OF TGEs:
To start, there are 2 types of TGEs. Utility and Security TGEs, and for the purpose of simplifying our discussion, let’s consider the terms Tokens, ICOs, Coins, etc. all the same thing — a Token Generation Event! In order to distinguish one from the other, let’s think of a security token as “Disney Stock” issued by The Walt Disney Company, a tradable asset class that can be found in markets like the NYSE. On the other hand, we shall think of a non-security or utility token as “Disney Dollars,” a currency that can give you access to the products and services of the amusement parks and Disney Company such as access to buy ice cream, rollercoaster rides, and other goods and services at the Disney Resorts and Parks.
Howey Test:
In order to find out if an investment — specifically a TGE in this case — is or is not an investment contract, we can use the example of a U.S. Supreme Court case, SEC vs. Howey. This is known among legal crypto folks as the “Howey Test!” This case established the standard test for whether an arrangement qualifies as an investment contract, which is a type of security, and therefore needs to be regulated by the SEC.
The U.S. vs. Howey case established that the following 4 elements must be met in order for an investment to qualify as a regulated security:
1. An investment of money
2. An investment of funds in a common enterprise
3. An investment with an expectation of profits
4. Predominantly from the efforts of others
Assuming all 4 elements are present, the offering can be considered a sale of securities, as defined by the Securities Act of 1933, and may require SEC registration or exemptions.
The textbook definition of a “security” is:
A security is a fungible, negotiable financial instrument that holds some type of monetary value. It represents an ownership position in a publicly-traded corporation (via stock), a creditor relationship with a governmental body or a corporation (represented by owning that entity’s bond), or rights to ownership as represented by an option. — Investopedia.com
However, in this case, the “Howey Test” specifically focuses on the term “investment contract” within the definition of security. The “Howey Test” basically considers several variations of a contract, transaction, or scheme whereby an investor gives out money with the intent to secure income or profit from the use of that cash (or cryptocurrency).
Thus, marketing a token as a speculative investment, or drawing comparisons to existing investment processes, may mislead or confuse potential buyers. It may also increase the likelihood that the token is considered a security in the eyes of the US Supreme Court, FINRA, and or SEC.
Furthermore, many experts believe that a Blockchain Token with one or more of the following 7 investment characteristics likely will be considered a Security Blockchain Token if:
1. Ownership interest in a legal entity, (LLC, Corp., General Partnership you name it…)
2. Equity interest
3. Share of profits, losses, assets, and/or liabilities
4. Status as a creditor or lender
5. Claim in bankruptcy as equity interest holder or creditor
6. Holder of a repayment obligation from the system or the legal entity issuer of the Blockchain Token
7. A feature allowing the holder to convert a Utility Blockchain Token into an instrument with investment interests
It should be noted here that an ownership interest in a fund or other legal entity vehicle that buys utility tokens would still constitute ownership of a security, even if the fund would not be deemed to own any securities.
To make things more complex, there is also the “Reves Test” that can also be considered in the evaluation of whether a token is a security or not.
Reves Test:
An alternative test, known as the “Reves Test,” (Reves vs. Ernst & Young) may also be used to test if a TGE is truly a security. This test considers whether an investment may be viewed as passive and relies on the efforts of others to establish whether or not a token qualifies as security. Specifically, this test looks at four factors:
1. Whether funds are being raised for a business venture or enterprise
2. Whether the transaction is offered indiscriminately to the public at large
3. Whether the investors are substantially powerless to affect the success of the enterprise
4. Whether the investor’s money is substantially at risk because it is inadequately secured
It is crucial to consider the manner in which the sale of a Blockchain Token occurs, particularly the promotion and marketing! For example, if the language used to promote the Blockchain Token includes words like “investment,” “returns” or “profits,” the purchasers of the Blockchain Token may be more likely to expect profits from the efforts of others than if the Blockchain Token is promoted on the basis of the usefulness of the rights attached to the token. Disney Stock (DIS — NYSE) vs. Disney Dollars!
Therefore, the essence of a non-security or utility Blockchain Token is that they are for commercial use rather than investment, and a security Blockchain Token is for any kind of investment contract and transaction.
Now if you consider that utility Blockchain Tokens will allow for the exploitation of the system by the holder, much like a licensee has rights to commercially exploit the license. One may see the non-security or utility Blockchain Token holders as active participants, like franchisees of McDonald's or licensees of software like SAP.
On the other hand, having or not voting rights confuses many people. So, similar to the argument above, the existence of voting rights itself should not define a Blockchain Token as a security or a utility token. The focus here should be whether the holder and or purchaser of the token would or would not be viewed as one who is passively relying on the efforts of others. Given that holders of non-security or utility Blockchain Tokens play a more active role by using, contributing to, or licensing the platform, it is less likely that having the right to vote on the future of the project will constitute the token as a security. Likely, as a metaphor, Disney could start asking people to vote on how many new roller coasters the new parks and resorts should build or have.
My Opinion — SECURITY ICO vs. UTILITY TGE:
Based on the above, it is my opinion (remember I am not a lawyer nor want to provide any kind of legal advice to anyone) that an appropriately designed Blockchain Token that consists of rights, and does not include any investment interests, should not be deemed to be a security token, subject to the specific facts, circumstances and characteristics of the Blockchain Token itself.
On the contrary, token projects that have any aspect of an investment contract should be SEC-compliant under SEC regulations such as, REGULATION CF, D506C (D506B) or REG A/ REG A+ in order to operate within the United States and be able to sell tokens to U.S. citizens! Remember, it only takes 1 (only one) U.S. investor in your TGE to force you to comply with U.S. securities laws.
It seems to me that the SEC will most likely see any TGEs as securities tokens unless the issuer can prove otherwise. It makes sense that the regulatory government agencies will try to protect U.S. investors from fraudulent investments by making the TGE issuer responsible for doing everything that is necessary to release utility tokens and not security if they choose to do so.
Given the SEC’s recent actions concerning TGEs, I would strongly suggest that companies considering TGEs and promoting them to U.S. investors should be very careful and compliant with U.S. securities laws, requirements, and regulations.
Further, I would advise that it is useful to consider the extensive use of disclosures, both to inform token holders of their rights (e.g., voting rights and other systems rights) and to demonstrate the nature of the Blockchain Token, at the time of the issuance of the tokens.
I hope this post was entertaining and please feel free to comment below or DM me, as I am happy to share my opinions on the subject (for entertainment purposes only!).
Cheers,
-AN
Alex Nascimento
IG: @7alexnascimento
