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Understanding Web3.0 Legal Issues - Utility vs Security - Issue #4

Understanding Web3.0 Legal Issues
Understanding Web3.0 Legal Issues
In this issue, I’m welcoming Sena to deep dive into an important decision: Is my token a utility token or a security token?

Photo credit: Medium
Photo credit: Medium
To begin with, I would like to thank @Mümtaz for giving me the opportunity of being a part of this newsletter. I believe every contribution matters as the ecosystem still struggling with the legal aspect of digital tokens.
As arguments are still going on about whether SAFTs are investment contracts or not, let’s focus on the most important thing everybody is missing: If SAFTs are investment contracts, what does this tell us about secondary sales of SAFTs and the tokens lying underneath in respect of the SEC regulations?
The main deal about the SEC regulations is that all securities issued in the United States must either be registered with the SEC or fall under a registration exemption: either a class of securities exemption (government bonds) or a transactional exemption (private sales to accredited investors). Therefore, before even concerning about whether there is an exemption that we could benefit (which we might dive into later), we should consider whether there is a security to be offered in the first place.
Amongst all category of securities, the investment contracts received the most clarity through the U.S. Supreme Court’s opinion in the case of SEC v. Howey Co. The jurisprudence of this case remains mostly unchanged in over almost eighty years. Since this is the case, I do not intend to review the application of the Howey test to SAFT here, and also @Mümtaz has a whole episode about this. But, note that many SAFTs were based on the legal theory that, although the SAFT itself was a security which would be sold to investors in a private placement exempt from the registration requirements, the tokens, once they are generated, would not be securities. By creating SAFT, the intention was to separate the token from any pre-launch determination of whether the token is a security. Therefore, the theory here is that it is the SAFT that is sold with the ‘expectation of profit’, not the underlying utility token. However, in a number of cases, the SEC and courts have found that the tokens underlying SAFTs were securities in the first place.
Under the SAFT, rather than delivering a ‘non-functional’ token to a user, the company sells a security in the tokens to be developed and the tokens are delivered when the network is functional. Whether on network launch, the token morphs into a utility, a commodity, or something other than security, is irrelevant for purposes of initial sale (i.e., the sale of SAFT itself is a security). However, whether the digital tokens attached to the SAFTs are securities, or not, is still very arguable. Let me tell you why this is important to know.
Even though in most cases the SAFTs are subject to contractual transfer restrictions that prohibit the assignment of the SAFT contract or any rights thereunder to a third party without the prior written consent of the issuer; there are still cases that this might happen. This gets us to the central questions that we still do not have all the answers for: (i) do the transfer restrictions apply to transfers of the underlying tokens (if such tokens are accepted as securities) or only the SAFT itself; and (ii) do the transfer restrictions encompass transfers of the economic rights under a SAFT? To start with let’s take a further look at some of Howey test criteria as applied to digital tokens by the SEC.
Let’s keep in mind that Howey is not a black-and-white metric for security status, especially when you use this metric to determine the security status of tokens regardless of whether they are utility or security tokens. It is a highly variable facts-and-circumstances test. I would also like to remind you that the SEC does not only consider the Howey test but also the economic realities of each token ‘sale’ when deciding. So, let’s dive into the tokens and what the SEC thinks about them, shall we.
 -       Investment of money
One element of the Howey test is the investment of money. Many purchasers of digital tokens use BTC, ETH, or other similar cryptocurrencies, rather than fiat currency. Well, the jurisprudence is clear here, purchases of new digital tokens, by means other than fiat currencies, would still qualify as an investment of money. Since this criterion applies for both security and utility tokens, we can say there is an investment of money in both cases.
-       Common enterprise
In the DAO Report, the SEC makes an open statement that token purchasers were investing in a common enterprise. The focus of the common enterprise element is tied to a pooling of funds in complementation of the expectation of profits, which I will be addressing in the next criteria.
-       Expectation of profit: intent to use v. intent to profit
Is the purchase of a future token, even a token that once launched can only be used within its established network, a security under this criterion?
Now, this is where things get interesting. As I mentioned above, Howey metric is not the only thing when the SEC decides whether there is a registration requirement. The SEC also makes economic reality assessment regarding the tokens’ purposes.
Is it usable solely within the network environment which it is created on and for; or is it fungible and tradable such that its value may increase with the growth or success of the company?
Let’s take a quick look at the SEC v. Howey Co. case. The investors were purchasing interests in orange groves, where oranges to be cultivated were not for personal use but for resale and profit. Following this logic, digital tokens sold for use in established networks that only have utility within those networks, such as game tokens, loyalty points, and such other utility tokens, might appear less likely to be considered as securities. SEC Chairman Clayton disagrees and suggests that merely calling a token utility token or structuring it to provide some utility does not prevent a token from being a security. In comparison with Chairman Clayton’s opinion, there is also a strong belief of if the motivation is focused more on investment, creating a secondary market for token sales, rather than functional token use or ‘utility’, creating a community, building a market for the product and developing network participation, it is more likely that the token will be considered as a security and subject to the SEC regulations. Your token based on its use and functionality may not be a security, but actively listing those tokens on an exchange that creates a secondary market may reverse the situation in the eyes of the SEC.
This and all of the things I mentioned so far gets to us to the main question that every entrepreneur must answer honestly before even beginning the token sale via a SAFT or an ICO, - what is the motivation for holding a token sale and how central and crucial is the token to the use of the Company’s products.
As for what happens now, since there is not any blanket, bight-line rule across all scenarios, it seems that’s up to the community. After all, as noted by those involved, a framework is only as useful as its adoption.
Cheers,
Sena
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Understanding Web3.0 Legal Issues
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Co-Founder @ClemtaSupport | Working on Flip-Ups, Data Privacy and @StartupHukuku | Passionate about Web 3.0, LegalTech & Gastronomy | Forbes 30 Under 30

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