The primary challenge for web projects today is the lack of unified legislation across different countries, resulting in situations where tokens can be classified as different types of assets in different jurisdictions. However, for a default global web3 project planning to operate in different countries, it is always advisable to adopt the highest standard for token compliance, which is the US standard. Let's take a look at the timeline and the previous development in the US regarding tokens and the strategy used to determine whether tokens are deemed securities.
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Timeline of the different stages and criteria
When it comes to US legislation regulatory frameworks for tokens, there are three stages for token legal qualification that came into place. We will talk about each stage and the criteria that came into place and additionally give summaries of the specific cases that were investigated.
2017 - Stage 1
Criteria 1: The Howey Test
The first stage was in 2017 when the HOWEY test was first applied to tokens. The HOWEY test is a simple three-criteria test:
The three prongs are:
- (1) an investment of money - This criterion involves determining whether an asset involves an investment of money. If there is no investment of money, then the asset cannot be a security.
- (2) in a common enterprise - This criterion involves determining whether investors' fortunes are linked together with the fortunes of the promoter or other investors. If they are, then it is likely a common enterprise.
- (3) with an expectation of profits predominantly from the efforts of others. - This criterion involves determining whether there is an expectation of profits from the investment. If there is, then the asset may be a security.
This ruling set an important precedent for how token projects would be evaluated under U.S. securities law, and it has since been used as a guide for subsequent investigations and regulatory actions.
Case Summary: The DAO
2018 - Stage 2
Criteria 2: Distribution and marketing of the tokens
In 2018, regulators added a new criterion to determine whether tokens qualify as securities. It focuses on the way tokens are distributed and marketed, in addition to the three criteria outlined in the Howey Test.
Distribution: The way tokens are distributed refers to the process by which they are offered and sold to investors could be a violation of securities laws. Examples are:
- if the token is sold through an initial coin offering (ICO) that is not registered with the SEC
- if the distribution of tokens is limited to a small group of investors who have the ability to control the market price of the token, this could be considered a violation of securities laws
Marketing: In regards to how tokens are marketed it includes promoting the tokens through advertisements, social media, or other marketing channels, and making false or misleading statements this could also be a violation of securities laws: Examples are:
- If a company markets a token as having a specific use case or function, but fails to deliver on those promises, this could also be considered a violation of securities laws.
- If an issuer provides false or incomplete information about the token sale, such as the number of tokens being offered, the price of the tokens, or the total amount of funds that will be raised through the sale.
- Making statements about the potential value or future performance of the token. For instance, if a company markets a token as a surefire investment opportunity that will generate high returns, without providing adequate disclosure about the risks involved, this could be a violation of securities laws.
- If the marketing suggests that the tokens are expected to appreciate in value or generate a profit and are marketed in this way, that suggests that investors are expecting to make a profit from the efforts of others, which is one of the key criteria in the Howey Test.
The SEC is concerned that issuers of tokens may engage in marketing campaigns that tout the potential for high returns, while downplaying the risks associated with investing in the tokens. Such marketing campaigns could be misleading and may violate securities laws if they create unrealistic expectations about the potential returns that may impact the ability of investors to make informed investment decisions.
The SEC has taken enforcement actions against several issuers of tokens that engaged in such practices such as the following two examples.
Case Summary: Block.one
Case Summary: Kik
Criteria 3: Secondary Trading
Secondary Trading is an important consideration in determining the classification of tokens as securities. This criteria can be split into two parts, the first one being the preliminary one:
The “promise” of Secondary Market Trading
So, while the actual trading of the token on secondary markets is relevant, the focus is primarily on the promises and marketing surrounding its potential secondary trading. The SEC looks at whether a project's founders make promises or actively promote the token's future listing on trading platforms or exchanges, which implies the potential for liquidity and secondary market trading. If the founders emphasize the token's tradability and the potential for it to appreciate in value through secondary trading, it indicates an intention to create a tradable financial instrument and suggests an expectation of profit derived from the efforts of others.
This being said, the criteria of secondary trading primarily focuses on the promises and marketing efforts made by the project's founders regarding the token's potential for trading on secondary markets and its potential for value appreciation.
The SEC views the promise of secondary trading and the creation of a tradable financial instrument as indicators that the token may be classified as a security.
Actual Secondary Market Trading
The actual trading of tokens on secondary markets is relevant to this criteria in the sense that if the tokens are actively traded on such markets, it may contribute to the perception that they are being treated as securities. If the tokens are traded in a manner that resembles traditional securities trading, with speculative buying and selling for profit, it can strengthen the argument that they meet the definition of a security. The actual trading activity serves as supporting evidence for the SEC's analysis, but it is not the sole determinant in assessing whether a token qualifies as a security under this criteria.
So, while the actual trading of the token on secondary markets is relevant, the focus is primarily on the promises and marketing surrounding its potential secondary trading.
The SEC is concerned that some token issuers may market their tokens to investors as a way to make a profit rather than as a means of accessing a particular product or service, hence the token existing for the purpose of being utility and used within the network. This type of marketing strategy can cause investors to view the tokens as an investment rather than a utility, which would require the token issuer to comply with securities laws.
In other words, if the tokens are marketed as an investment with an expectation of profit, then they may be deemed securities by the SEC.
Case Summary: Telegram
2021 - 2022 Stage 3
Criteria 4: Token Minting protocol
The investigation began in response to concerns that the founders of token projects might have undue control over the minting and distribution of tokens, which could potentially make them more like traditional securities that are subject to securities laws.
Regulators investigated whether the token minting protocol was controlled by the founders, or whether it was deployed by validators of the decentralized network and the tokens were minted in a decentralized way. They also looked into whether the founders controlled the initially pre-minted token treasury and whether it was distributed in a centralized or decentralized way using smart contracts that were built into the token minting protocol.
The SEC views the above criteria as critical because they are used to determine whether a token is a security or not. According to the Howey Test, a security is an investment contract in which a person invests their money in a common enterprise with the expectation of profits that are solely derived from the efforts of others.
With regard to the token minting protocol, if the founders control the protocol and can mint new tokens at their discretion, it suggests that the token is not truly decentralized. In this scenario, the token may be viewed as a security since investors are essentially placing their money into a common enterprise with the expectation of profits that are solely derived from the efforts of others, namely the founders who have the control.
Criteria 5: Initial Token Price
Another crucial criteria investigated was whether the founders determined the initial token price. If regulators could establish that the founders were responsible for the initial token price, then they would be accountable for all other token-related activities, including initial token minting, distribution, and more.
Regarding the initial token price, if the founders set the initial price of the token (e.g. through a SAFT agreement, a public listing or sale) and control the supply, it suggests that the token is centralized and the investment is dependent on the success of the founders. When founders may be held accountable for other token-related activities if they determine the initial token price is because it could suggest that they have control over the token's value and performance. This would mean that investors may be purchasing the token based on the founders' statements or actions, rather than the underlying technology or market forces, and could potentially be misled about the token's value or potential return on the investment. This scenario may also indicate that the investors' profits are solely derived from the efforts of others, and as a result, the token may be classified as a security.
Case Summary: TRON
While the Howey test provides a foundational framework to determine if an investment contract qualifies as a security, the additional criteria introduced by the SEC specifically address the unique characteristics and considerations associated with blockchain-based projects and digital tokens. These criteria provide further guidance and clarification on how the SEC evaluates tokens in the context of securities laws through the aspects such as the distribution and marketing of tokens, secondary trading, token minting protocol, and initial token price which oftentimes meet one of the prongs of the Howey Test. Therefore, these additional criteria help the SEC assess the specific features and circumstances of blockchain projects to determine whether the tokens being offered or traded should be considered securities.
For crypto projects, it is crucial to navigate these criteria carefully to ensure compliance with securities regulations. By understanding and addressing each criterion, projects can take measures to mitigate the characteristics of securities and demonstrate the utility, functionality, and decentralized nature of their tokens. This involves emphasizing token utility, providing transparent disclosures of risks, fostering community participation, avoiding promises of profit, considering the token minting process, and pricing the token based on its utility value rather than as an investment opportunity and essentially make sure that instead of a single entity having the control, the network is sufficiently decentralized.
Ultimately, the goal for crypto projects is to design and operate in a manner that reduces the likelihood of their tokens being classified as securities. How to do so and what measures can be taken we'll explore in the following article