A quick scan of any popular cryptocurrency forum will reveal numerous announcements for crowdfunding campaigns intended to support the launch of a new altcoin or decentralized application.
In these crowd sales, digital tokens associated with the application (called “appcoins”) are sold to early adopters in an effort to raise capital for the new project. The hope of many who purchase appcoins in a crowd sale is that the price of the coin will go up significantly if the application becomes widely adopted.
In response to these crowdfunding campaigns, some have warned that certain appcoins seem to have the characteristics of a security that may be subject to regulation by the Securities and Exchange Commission (SEC). Although many, including the developers, may prefer to ignore these warnings, they do so at their own risk. The SEC’s regulatory powers apply broadly and are very restrictive, and recent reports indicate that the SEC has already started to turn its focus to the so-called Crypto 2.0 marketplace. This article provides a basic overview of the legal definition of a security and then discusses the aspects of appcoins that may trigger the SEC’s interest.
The legal definition of a security
Securities offered in the U.S. generally must be registered with the SEC and meet many legal requirements. As a threshold matter, the securities statutes define the term “security” very broadly. The definition covers a list of specific instruments, like stocks and bonds, but also covers more vague concepts like “investment contracts” and “instruments commonly known as securities.” This broad definition has been interpreted to mean that what is considered a security is not limited only to formal instruments traded on securities exchanges. Rather, according to the U.S. Supreme Court, the legal definition of a security also extends to “uncommon and irregular instruments,” which generally fall within the following accepted framework:
- Any investment of money
- in a common enterprise
- with the expectation of profits
- based solely on the efforts of a promoter or a third party
A point of clarification is that an instrument is generally not considered a security when the purchaser is motivated by the desire to use or consume the item purchased.
There have been numerous court cases decided over the years that address when a specific financial instrument does or does not meet the legal definition of a security. Any individual team developing a new coin that has features like a security and that will be issued to U.S. customers should be working with a securities lawyer to determine how their product fits within the historical precedent of these cases. To be clear, there have been several new coins or tokens advertised as equity shares in a company that clearly violate the prohibition against offering unregistered securities in the U.S. Conversely, the rise of appcoins designed to be essential to the use of new decentralized applications presents a more difficult case requiring a more nuanced analysis.
The debate about when an appcoin is a security
Several new decentralized applications have recently raised capital from early adopters through a crowdsale of appcoins. In the past year, Maidsafe, Ethereum, Storj, and a host of other projects have all conducted some form of crowdsale before launching their applications. In addition, an industry of platforms, like Swarm and Koinify, which promise to promote and manage these crowd sales, has sprouted up to aid development teams looking to go the crowdfunding route.
The purpose of these crowdfunding campaigns can be varied, but typically the goal is to raise money to pay the developers, initially distribute coins fairly amongst a large group, and perhaps most importantly to this discussion, entice early adopters by offering appcoins at a perceived discount well-below their potential future value.
From this description, the parallels between an appcoin and a security should be obvious. Like stock sold during an initial public offering, appcoins are sold to raise capital for a common enterprise. Unlike participants in a Kickstarter campaign who may have charitable intentions and hopes of a free t-shirt, investors are attracted to the crowd sale of appcoins by the allure of profits. Profits are possible because the appcoins have a fluid value that is, at least partially, tied to the success and popularity of the underlying project being funded.
On the other hand, this discussion does not fully address all the characteristics of some appcoins that may make them different from a typical security. For example, most appcoins do not give the holder any traditional legal rights accompanying a security, such as control over ownership or an entitlement to dividends and to assets upon liquidation. Instead, appcoins are often described as software-defined contracts that are integral to how consumers use the network application.
For example, an appcoin like Storjcoin X is touted as necessary to incentivize participants to offer unused disk space to the Storj network, which in turn is necessary to create this new form of cloud storage. Because of the functional use of appcoins, some equate them to a product or something akin to frequent flyer miles and other proprietary currencies that companies issue. And if these descriptions seem incomplete, perhaps the truth is that appcoins can only be viewed as a completely new form of asset class that the SEC will need to decide if and how to regulate.
The argument that appcoins are unique and distinct from securities is a position not without its flaws though. For one, the functional necessity of an appcoin does not mean that a project must be crowdfunded. Bitcoin, Counterparty, and others have proven that a crowd sale is not required to get a new project off the ground. Additionally, for many decentralized applications, an existing cryptocurrency like Bitcoin could be used to incentivize the network instead of relying on a proprietary appcoin. As a result, the creation of an appcoin may be seen as merely a means to store enterprise value like a security. The argument that appcoins are akin to frequent flyer miles also fails to take into account that frequent flyer miles have limited transferability and a defined value rather than being freely traded at fluctuating prices on an exchange. Finally, as mentioned above, these arguments are not even applicable to the numerous problematic offerings that openly admit to be issuing stocks in a company by issuing tokens on a platform like Counterparty or Colored Coins.
Efforts to avoid SEC scrutiny
Savvy project teams often try to describe an appcoin crowd sale in terms that avoid the suggestion that they are offering securities. For example, before Ethereum’s “Genesis Sale” of Ether, the Swiss entity behind the project put out a legal document detailing the terms and conditions of the pre-sale. This document reads like a prospectus that usually accompanies a typical securities offering, but the Ethereum team was careful not to call it that. In this document and other public statements, the team repeatedly emphasized that the sale was not a securities offering. Instead, the team described Ether as the “cryptographic fuel” needed to conduct transactions on the Ethereum blockchain, and identified Ether as a “software product” under Swiss law. Purchasers of Ether agreed through the terms and conditions that they were not purchasing Ether as a speculative investment.
Ethereum is the exception to the rule, though. Seemingly less sophisticated projects are often more loose with the language of their offerings. Many such projects openly refer to pre-sales as IPOs and to purchases made during pre-sales as investments. Indeed, often pre-sales are not subject to any legal terms or conditions that disclose to investors that the pre-sale is not supposed to be a securities offering.
Despite this, the truth is that the language of the offering is less important than the characteristics of the product being offered. If the SEC scrutinizes any of these offerings, it will definitely look at the terminology used, but will be more focused on analyzing the qualitative factors discussed above. In the end, even the pre-sale of a product like Ether may be viewed by an aggressive regulator as a securities offering. To support such an interpretation, one need only look at the thousands of comments on the Bitcointalk.org forum announcement about Ethereum, most of which debate the potential return of an early investment as opposed to the benefits of the final project. That being said, the teams who are prepared to answer why the crowd sale of their new appcoin does not fit the definition of a securities offering, as Ethereum is obviously positioned to do, are much more likely to dissuade regulatory scrutiny by the SEC.
Offering Crypto Securities that Comply with U.S. Securities Laws
The one approach that has seen very little traction has been for developers of decentralized applications to admit that they are offering regulated securities and attempt to make their offerings comply with the securities laws. The various requirements of the U.S. securities laws are better left to another article, but there are procedures for offering unregistered securities to accredited investors and there are proposed regulations in the pipeline that would legalize so-called equity crowdfunding. For developers willing to comply with such laws, platforms like Counterparty and the proposed Medici project may provide an incredible resource for issuing and trading securities without the regulatory uncertainty.
The truth is that, despite outdated rules and institutional inefficiencies, the SEC serves a purpose in trying to protect investors by mitigating the usually sizable information asymmetry between entrepreneurs and investors. There will need to be a push to have the SEC adapt to the new technologies promised by some of the projects mentioned in this article, and to address the arguments in favor of exempting some appcoins from the definition of a security. On the other hand, there is also a need for development teams to not simply ignore unfavorable regulations as they may be necessary to weed out the numerous pump-and-dump schemes many in the community have already seen.
The article itself is for informational purposes and does not constitute legal advice or create an attorney-client relationship.
Jason Somensatto is a lawyer at Morvillo LLP who focuses on securities regulation and enforcement. He can be reached at [email protected] or [email protected]. Going forward, he will be commenting on regulatory issues facing the Bitcoin and Crypto 2.0 marketplaces at cryptosecuritieslaw.com.
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