ICOs: Utility Tokens or Securities?

And Why Does it Matter?

I just attended Block Con. Ninety percent of the talks described different applications of tokens in blockchains, but the speakers who interested me the most were the lawyers and accountants who were on a couple of panels. It’s easy to get swept up in the hoopla of these new, shiny things, but if you are going to dive into the cryptocurrency space, do your due diligence by hiring strong legal and accounting consultants. If you don’t, it will probably cost you.

Blockchain talk: wendy jackson and Grant Fondo, George Li, Scott Morgan, Cameron TeitelmanBeing an accountant, I was particularly interested in what Wendy Jackson, an “accointant” (I “coined” that term) at Deloitte had to say. Among a bunch of other things, she advised that blockchain entrepreneurs construct a clear description of their business so that they can give a well-articulated plan to these accounting and legal advisors. Sounds like a no-brainer, but that simple statement was worth heeding. Besides the fact that you’re paying premium hourly rates for premium professional counsel so you want your talks to be as efficient as possible, the clearer your plan is to the advisor, the better they can advise you.

This area is new to everyone, even the experts. They have to constantly be keeping themselves abreast of the latest regulations and rulings. Precedent is what happened yesterday. And what got the wheels in my head turning was a statement from Nancy Wojtas, a legal partner at Cooley LLP. She said that she doesn’t take cases that involve securities tokens. That thought pinged around in my grey matter the rest of the night, because I realized I wasn’t sure what she was talking about. A common feeling in this space.

My understanding had been that cryptocurrencies were things like bitcoin and ether. The “currency” part makes this category the easiest to understand. They are alternatives to FIAT, which is a fancy acronym for what we’ve known of as moolah for the past few hundred years.

Blockchain Convention, Block-con 2017: Stan Miroshnik, Nancy Wojtas, Eric Doyle, Vinny Lingham, Alan SoucyThen there are “utility tokens”. These make up the bulk of the cryptocurrencies exploding on the scene. Or, at least, I thought they did. A utility token, the way I’d understood it, was a kind of “sub” currency that could be used on a particular decentralized application. In other words, on a blockchain app. For example, a new decentralized insurance company might come out with “shur” tokens that could be spent and earned on their blockchained insurance platform. Or a new virtual reality game could have “threds” as a currency that could be used to buy cool threads for your avatar. There are many possibilities. Whether some of these businesses actually should create a cryptocurrency, that’s another article.

Securities tokens, I’d thought, were tokens that basically represented your share of an asset, and the purchasing of that asset was for investment purposes. These coins weren’t used in order to do things (like buy clothes for your avatar). For example, you can buy coins that represent percentages of venture capital funds. You can even buy derivatives and futures contracts of coins on blockchains. Those are, for sure, securities tokens.

But then, in July, the Securities and Exchange Commission (SEC) issued a report declaring that they considered many utility tokens to be securities.

The main purpose of blockchains is to decentralize processes, and get away from governing bodies and their regulations. Power to the people! Blockchains are fantastic for currency transactions – bitcoin, ether, that sort of thing – because this is an area that we don’t need intervention from middle-players like banks. There is no stopping this decentralization movement. And it’s wonderful. But what about all these ICOs? What about these “sub” cryptocurrencies? For example, the tokens that run on ether. Is there a need for them? Does it help to decentralize their function? Do they benefit the consumer other than as a security? If not, aren’t some of them, at least, a de facto security? This is what the SEC and legal eagles are discussing.

Marco Santori, Juan Benet, and Jesse Clayburgh wrote a whitepaper called The SAFT Project which stated that some tokens which will be used in a utilitarian sort of way – not in the greater good sense, but in the being used to do something sense – could be considered utility tokens after the business has actually launched its product or service, but, prior to launch, Santori believes these tokens are, effectively, securities. And I agree.

The SEC has been using the Howey test, from a 1946 case, SEC v W. J. Howey, to determine if a token ought to be considered a security. An investment contract is a type of security, and the Howey test determines that if a person enters an arrangement in which the following four elements exist, then the arrangement is a security.

1) An investment of money
2) In a common enterprise
3) With an expectation of profits
4) Based on the efforts of the promoter or a third party

The fourth element means that if the efforts of the people selling the token have a significant impact on the value of that token, and if that impact is the predominant force affecting the token’s price, then the token is a security. And Santori, Benet, and Clayburgh say that any token sold before the launch of the company is a security, because the efforts of the promoter are the primary force affecting the price of the pre-launch token.

Using our previous example, the Howey test is saying that if I buy threds before the online VR game goes live, I’ve performed a securities transaction. But if I buy threds after the game has launched, I’m just buying utility tokens, because the increase in value of my threds, post-launch, can’t be attributed predominantly to the efforts of the promoter of the coin.


Work with the IRS and the SEC when starting an ICO or decentralized application or cryptocurrency
The bottom line, in my opinion, is that if you are going to launch an ICO, get excellent legal and accounting counsel. Personally, I wouldn’t be afraid of classifying your coin as a security, and complying with whatever the regulation of the day is. We have a fear of dealing with agents from the SEC and the IRS, but they aren’t out to get us. They are people, too. In my experience, calling them and being nice to them ends up in pleasant, helpful conversations. And they don’t charge a billion Satoshis per hour. Many of them actually want to help you. Think of them as your friends, seek out their counsel as well as that from your professional team, and flow with the process instead of trying to fight it.