Typically, cryptocurrency tokens are considered either utility tokens or security tokens. There is a huge difference between the two as the latter falls under the purview of numerous SEC regulations.
Lately, the SEC has taken the approach that any ICO is a security unless the issuer can prove otherwise. This is because the SEC goes by the philosophy of “substance over form” and looks at the way they are actually used rather than the way they were intended to be used. This might lead to many projects being classified as securities even though they initially set up their tokens as a utility, just because the economic reality is that the contributors invest primarily because of anticipation of profits.
Thus an appropriately designed token should use extensive disclosures, both to inform token holders of their rights (e.g., voting rights and other systems rights) and to demonstrate the nature of the token at the time of the issuance of the tokens. In December 2017, SEC Chairman Jay Clayton provided a useful example of a utility token versus a security token:
For example, a token that represents a participation interest in a book-of-the-month club may not implicate our securities laws, and may well be an efficient way for the club’s operators to fund the future acquisition of books and facilitate the distribution of those books to token holders. In contrast, many token offerings appear to have gone beyond this construct and are more analogous to interests in a yet-to-be-built publishing house with the authors, books and distribution networks all to come.
On February 6, 2018, Chairman Clayton testified before the Senate Committee on Banking, Housing, and Urban Affairs on the issue of virtual currencies. Importantly, Clayton noted that indeed some ICOs and tokens are not securities. He also mentioned the difference between the two:
While there are cryptocurrencies that, at least as currently designed, promoted and used, do not appear to be securities, simply calling something a ‘currency’ or a currency-based product does not mean that it is not a security. To this point I would note that many products labeled as cryptocurrencies or related assets are increasingly being promoted as investment opportunities that rely on the efforts of others, with their utility as an efficient medium for commercial exchange being a distinct secondary characteristic. As discussed in more detail below, if a cryptocurrency, or a product with its value tied to one or more cryptocurrencies, is a security, its promoters cannot make offers or sales unless they comply with the registration and other requirements under our federal securities laws.
The SEC’s guidance supplements the standard for determining a security that many cryptocurrency attorneys were using prior to SEC’s participating – the Howey Test. The Howey Test looks at three elements to determine whether an investment qualifies as a regulated security:
1. Is it an investment of money or assets?
2. Is it an investment of money in a common enterprise?
3. Is there an expectation of profits from the investment from the sole work of others? This is the key element, which is proven by Clayton’s mention of it before. Thus, if a token were scrutinized by the SEC then the focus would be on the materials distributed to investors and how the coin is being promoted such as what the investors are being offered or promised in the future, how the coin is distributed, and the economic inducements.
It’s imperative for crypto entrepreneurs to contemplate the legality of their token sale before posting any materials on an upcoming ICO. Unsure how to proceed? Use our Get Started Form to talk with an attorney.