Thus
the SAFTs that were sold in the Filecoin ICO encumber the Filecoin tokes as securities. Thus the Filecoin tokens are useless and can’t be actually used decentralized (
unless hypothetically the common enterprise ceases as explained below).
[…]
Here are the narly details from an attorney:
The question here is whether a token issued pursuant to the terms of a security/investment contract (i.e. the SAFT) is itself also an investment contract. (Which, to this week’s SAFT offering’s credit, is briefly acknowledged in the PPM).
[…]
There is no way to convert a security into a non-security (
except as aforementioned the common enterprise ceases), because that would circumvent the entire point of the law. The investors are not investing in SAFTs but in the Filecoin tokens they receive for the SAFTs. Without the Filecoin tokens, the SAFTs are worthless. The Howey Test states it will always look at the economic reality and ignore any tricks that attempt to obfuscate the economic reality.
It is difficult to divorce the money and exchange component from “utility tokens,” as app-coins are sometimes called, particularly in the context of a speculative ICO where the token allocation is pre-sold to persons who could not possibly consume them all and are purchasing the coins with the expectation of profit on re-sale.
…
For this reason, my personal view is that most ICOs – even the “utility coins” – are unlikely to escape regulation by jurisdiction-appropriate rules regarding public offerings, financial promotions and unfair trade practices. I have held this view since 2014 but then again I’m pretty conservative.
[…]
[…] the blockchain industry’s thinking has over-emphasized complying with regulations that govern the initial issuance of tokens, and has neglected to address the impact of all of the regulations that apply on a continuing basis.
I’m reviewing the
arguments for the SAFT which I had previously discussed in the context of Filecoin, as excerpted above.
The above quoted argument against fully-functional tokens because of a dominating profit expectation, is rebuked in the following SAFT white paper. I was pleasantly surprised to read their logic about free market preponderance, but the problem is the court is going to interpret this, unless the developer has entirely ceased activity before the tokens are issued.
Here are some excerpts from the white paper which I find particularly noteworthy:
Common Enterprise
Direct token presales often admit of a common enterprise. Courts are split on what is the correct threshold for finding the existence of a common enterprise. The majority of courts apply the so-called horizontal commonality test.²³ Under this approach, a common enterprise exists where multiple investors pool assets and share together in the profits and risks of the enterprise.²⁴ A minority of courts instead apply the vertical commonality test. There are two variations on the vertical commonality formulation. Under the narrow vertical commonality variation, a common enterprise exists where the fortunes of the investors are bound up with the actual fortunes of the promoter or issuer of the security.²⁵ Under the broad vertical commonality variation, a common enterprise exists where the fortunes of the investors are bound up with the mere efforts of the promoter or issuer.²⁶
[…]
Vertical commonality is rarer. To be sure, token purchasers might rely on the efforts of the developers to create the network, but that fact might support the “efforts of others” prong of the Howey test, not the broad variation of the vertical commonality prong, in which the fortunes of the investors must be bound up with the efforts of the issuer. Likewise, narrow vertical commonality is rare, since
the purchasers’ profit from the token sale is rarely dependent upon the ultimate profitability of the developers or their entity. The value of a truly decentralized network is decoupled from the financial success of the original developers. Moreover, the mission of many developers’ entities is to expend all of its resources to develop an open, permission-less network that acts as a public good,
slowly and expectedly entering insolvency as it does so.
The above quote really opened my eyes as to how easily it is to avoid the vertical commonality definition of the common enterprise. And of course the more frequently cited horizontal commonality definition requires the developers pool the funds.
Expectation of Profit
How much expectation of profit is permissible before the arrangement satisfies this prong? In United Housing Foundation v. Forman,³¹ a purchaser of shares in cooperative housing almost certainly expected to sell the shares for more than the purchase price. So, without a doubt, that a profit motive is present is insufficient. Still, Forman can teach us more: It stands to reason that the purchaser likely would not have purchased the shares at all if he expected to lose money or merely break even upon resale. After all, what purchaser would buy a home knowing that it would be underwater when he decided to sell? Even if profit was a necessary outcome of the transaction for a prospective purchaser, it would be insufficient to satisfy this prong of Howey.
To satisfy this prong, the purchaser’s expectation of profit must predominate the expectation of using the thing purchased.³²
The above is supporting the notion that if users are obtaining the token for use, i.e. they actually need to use it, even though they will still have a profit expectation, it doesn’t meet the Howey test.
From the Efforts of Others
Thus, an
already-functional utility token is less likely to be a security for two independent grounds. First, it is more likely that purchasers have bought them to use them (since, unlike pre-functional utility tokens, they can be used immediately to satisfy
imminent needs). Second, purchasers who buy them with an eye toward profit upon resale can expect those profits to be determined by a variety of market factors that predominate the efforts of the seller in updating the token’s functionality.
Critics of sales in this category might argue that the expectation of profit from resale on a secondary market is just speculative activity seeking capital appreciation. These critics might cite myriad federal court decisions holding that an expectation of mere “capital appreciation” on a secondary market, is sufficient to satisfy the Howey test.³⁴ This oft-repeated criticism does not stand up to scrutiny. At heart, the criticism collapses the “efforts of others” prong into the “expectation of profit” prong. It does so by relying on decisions which do not actually turn on the secondary market appreciation issue, and do not analyze it in much depth. Decisions that do so repeatedly hold that an expectation of profit from the mere increase in value on a secondary market is not from the “efforts of others.” In Noa v. Key Futures, for example, a case involving a forward contract for silver bars, the Ninth Circuit found no expectation of profits from the efforts of others because once the purchase of silver bars was made, the profits to the investor depended primarily upon the fluctuations of the silver market, not the managerial efforts of Key Futures.³⁵ SEC v. Belmont Reid, a case involving a forward contract for gold coins, held similarly because profits to the coin buyer depended primarily upon the fluctuations of the gold market, not the managerial efforts of others.³⁶ In another case involving a futures contract for sugar, a federal court in New York held the presence of a speculative motive on the part of the purchaser or seller did not, on its own, evidence the existence of an investment contract.³⁷
To be sure: Gold, silver, and sugar are different from tokens in important ways. For example, in the case of a token sale, the seller may continue to improve the network and the secondary market price of the token may appreciate as a result. This characteristic is not shared by precious metals or sugar. So should utility tokens really be treated similarly?
For already-functional utility tokens, we think so. Because there is no central authority to exert “monetary policy,” the secondary market price of a decentralized token system is driven exclusively by supply and demand. Supply and demand can be
due to a variety of factors. One of those factors could be the efforts of the development team creating the token’s functionality; but once that functionality is created, any “essential” efforts have by definition already been applied. It
would be difficult to argue that any improvement on an already-functional token is an “essential” managerial effort.
Furthermore, the market effect of a mere improvement on an already functional utility token is likely dwarfed by the multitude of other factors that act on it. For example, the value of a token that powers a decentralized market for buying and selling graphics processing power in real time would likely fluctuate depending upon, among many other factors, the retail or wholesale availability of high-powered professional graphics cards.³⁸ The value of a token that entitles a token holder to one box of the
seller’s razor blades might fluctuate with the popularity of beards in the company’s target markets.³⁹ The value of a token that permits users to store encrypted passwords conveniently on a blockchain might increase when a high-profile data breach
is announced or decrease when a major keylogging botnet is disabled.⁴⁰ Indeed, the value of bitcoin, another (mundane example of an) already-functional utility token, often fluctuates with changes in global geopolitical instability. The forces that could affect supply and demand for a functional utility token are countless. Supply and demand for functional tokens are affected by a variety of forces that determine the price on a secondary market—just like demand for gold in the commodity cases. It is no coincidence that blockchain tokens have been referred to as “digital gold.”⁴¹
[…]
Likewise, the secondary market price of a
pre-functional utility token could also be determined by a great variety of factors. However, the application of the technical and managerial efforts of the seller is likely the
predominant factor in the price of a pre-functional utility token until it transitions to being a functional utility token. The purchasers of a pre-functional utility token are, by and large, reliant on the efforts of the seller to develop functionality. These sellers have not yet expended their “essential” efforts. Those efforts are still required to deliver functionality, and therefore profit
Regarding the above, in my research I remember reading jurisprudence case law arguments that collapsing the “from efforts of others” into the “expectation of profit” prongs of the Howey test is not valid. So their argument above is compelling that once the token is trading then its free market driven price is susceptible to many market factors, not just the efforts of the developers of the decentralized ledger. I also confirmed with a securities attorney that the securities law generally gets out of the way when the free market is in control.
Although a similar argument could be formed about company shares trading on exchanges, being driven by many free market factors, the distinction being made above is that of a commodity wherein I had defined a commodity:
Commodities don't have to be physical. A commodity is defined to be a fungible good whose supply is not controlled by any one entity:
"A reasonably interchangeable good or material, bought and sold freely as an article of commerce."
"A commodity is a basic good used in commerce that is interchangeable with other commodities of the same type"
"a good or service whose wide availability typically leads to smaller profit margins and diminishes the importance of factors (as brand name) other than price"
[…]
Duh, Bitcoins are fungible, so they can qualify as a commodity. Non-fungible digital content such as MP3s can not be a commodity.
Proving ownership over a quantity of Bitcoins does require possession of a specific pattern of bits. Which is analogous to proving ownership over gold is having possession of a quantity of gold.
[…]
While it is true that shares of bearer stock equity certificates of an individual issuer company are fungible (i.e. there is no name associated with the certificates so they can be freely bought and sold), they are not divisible, not tradeable in an unregulated exchange markets, and are not a fungible money because the value of the stock fluctuates w.r.t. to the performance of the company, i.e. a form of 3rd party liability. Whereas, Bitcoin like gold has no 3rd party dependence, nearly infinite divisibility, trades on unregulated exchange markets.
Since tangibleness and perishableness are not properties that are shared by all commodities, then they are not attributes of commodities. To reiterate, commodities are fungible goods in which no one entity has control over the supply. They key attributes that distinguish commodities from other goods is that they are fungible and that their supply is not a 3rd party dependency, i.e. we don't depend on any one company to get pork bellies, but we do depend on Microsoft for supply of the Windoze operating system. And for money it is most ideal if the supply is inelastic, which is another minor reason Bitcoin is better than gold for money.
Another difference is that the capital appreciation of company shares are usually tied to a dividend expectation (as evident by the popular P/E metric), which obviously relies on the performance of the company to deliver. Whereas, if token pays no dividend, the capital appreciation is not likely coming mostly from the performance the developer if we’re only talking about maintenance upgrades. However, for significant protocol upgrades such as for example recent hype about various Ethereum developments, it’s not entirely clear that the expectation of profits is independent of Vitalik et al. Although one could possibly argue that the capital appreciation of Ethereum has been more do to the efforts of various free market ERC-20 ventures.
FinCEN has published guidance to clarify whether a person dealing in cryptocurrency (which it terms “convertible virtual currency” or “CVC”), would fall under the definition of a money transmitter. In its guidance, FinCEN has stated that users of CVC are not money transmitters, but those who both issue and redeem CVC (administrators) and those who exchange CVC for either fiat or other CVC (exchangers) who accept and transmit funds as a business would be deemed money transmitters.⁵⁴
[…]
Thus, FinCEN now arguably takes the straightforward position that a person can create a CVC and then sell it on its own account without being a money transmitter. The potential application of this reasoning to tokens is obvious. Yet, FinCEN has consistently maintained that “[a]n administrator or exchanger that (1) accepts and transmits a convertible virtual currency, or (2) buys or sells convertible virtual currency for any reason is a money transmitter.”⁶¹
Well selling on a FinCEN compliant exchange likely removes any culpability for being a money services business.
Ripple was directly selling and buying virtual currency from various users which thus always makes them a MSB.
The Federal Tax Laws
Tokens, whether CVC or other kinds of blockchain tokens, are generally treated as “property” for U.S. federal income tax purposes.⁶³ Consequently, proceeds from a token sale (whether pursuant to a SAFT or a direct presale) are taxable to the entity⁶⁴ selling the tokens. […] Other taxes, such as sales taxes and the alternative minimum tax may also apply. […] This income can be offset with operating losses (if any) incurred in the year of the token sale (or prior to the year of sale, to the extent carried forward). In addition, the seller of tokens may be able to carry back to the year of sale operating losses incurred in the two years subsequent to the token sale to offset the income incurred in the year of sale.
The above could also be contrasted with a model where the investor instead invest in shares of company (or their own sole proprietorship in joint venture with other such entities) and receive back tokens earned by an app development company that earns tokens from users. In this case, the investment is tax-free (and the issuance of the tokens is not in any way connected to the investment shares), but if all the revenues are going to be paid out to individual contractors any way, then there is hardly any tax difference except for any sales tax and AMT.
If the SAFT so qualifies as a forward contract for tax purposes, then the transaction’s first taxable event does not occur until the tokens are delivered to the investors and the SAFT terminates.⁷⁸
Yet it seems they failed to note that since the token must be fully-functional, then it will have a market price and thus I think the SAFT investors have to pay income taxes for the difference between market price and the purchase price of tokens, because the market price value of the non-securitized tokens has been distributed to the SAFT investors, unlike in the SAFE (on which the SAFT idea was modeled) where a security is delivered and thus is perhaps not an immediately taxable event.
In short, the SAFT provides investors with the right to fully-functional utility tokens, delivered once the network is created and the tokens are functional. The SAFT is very likely a security, namely an investment contract. Once the tokens have been imbued with utility and are genuinely functional, the SAFT investors’ rights in the SAFT automatically convert into a right to delivery of the tokens. For the now-functional utility tokens, there is a very strong argument that the tokens themselves are not securities.
The same should apply to any ultimate sale of the tokens to retail purchasers, whether by the SAFT investors or by the seller.
So vaporware ICOs are securities. Fully-functional tokens if have sufficient free market factors other than just ongoing developer efforts, are probably not securities.
Moreover, since the tokens are not securities and the SAFT is non-transferrable, the investors do not, merely by purchasing the SAFT, risk being deemed underwriters if they resell their tokens.⁷⁵
⁷⁵ Investors are participants in the distribution of the utility tokens following conversion of the SAFT, but the token is not a security. Though the SAFT is a security, they do not distribute it. The definition of underwriter under the Federal Securities Laws is limited to the participation in a distribution of a security, thus SAFT investors need not fall within the definition or risk exposure associated with being deemed an underwriter. See Securities Act Section 2(a)(11), 15 U.S.C. § 77b(a)(11).
So by the above logic, a token which was issued and sold as a security (e.g. pre-functional vaporware ICO), would not necessarily become a non-security when it is sold by investors later when it is fully-functional and has sufficient free market factors other than just ongoing developer efforts, i.e. when the “from ongoing efforts of others” prong of Howey is no longer satisfied. Because the investors could be considered underwriters if they had not held the token for some reason other than to distribute it, which as I had pointed out upthread may require up to a 3 year hold before selling.
The separation of the issuance into a security that has rights for a token (instead of issuing a pre-functional token or promise) and separate issuance of the fully-function token is argued that the investors in the former (e.g. a SAFT) had no intention to distribute a security because the fully-functional token is argued to not be a security because it fails the “from ongoing efforts of others” prong of Howey. Whether the issue of the former security (which can be traded for a fully-functional platform token later) was legal is a separate issue, with for example EOS’ issuance being very suspect of not complying with securities regulations.
Some utility tokens, due to their particular facts or circumstances, may pass the Howey test despite being already-functional. How might this happen? In at least three ways.
First, a seller might weaken its defense against the third prong of Howey by selling tokens predominantly to purchasers who could never put the token to its intended use. This weakens the token’s position as a non-security because it eliminates the consumptive use defense entirely. That is, it concedes the “expectation of profits” prong. For example, consider a network that is only usable by members of a particular industry, like the apparel trade. Perhaps the network ensures genuineness of an article of clothing by tracking its provenance from fabric mill to design house to distributer to retailer , and the token acts as a unique per-item identifier.⁸¹ If the token’s sellers sold that token to the public at large, it would be highly unlikely that members of the public bought that token predominantly to use it. After all, a relatively small portion of the token-buying public operates fabric mills or apparel distributorships. Without more, a plaintiff could argue that token buyers made their purchases predominantly to profit, satisfying the third prong of Howey.
Regarding the above, someone had asked me if they could issue collectible cards in an ICO and I said not unless you only sell them to collectible card collectors and not predominately to investors in tokens. I said any disclaimers will not help, because Howey looks at the economic reality.
Second, a seller might weaken its defense against the fourth Howey prong when the seller significantly over-promises in its sales materials. In such a circumstance, the seller’s efforts to imbue the token with greater utility might still predominate the variety of other market forces acting upon the token’s price. A profit-seeking purchaser might predominantly rely upon the efforts of the seller, even post-functionality, where the seller makes bold promises of developing more sophisticated functionality beyond that present at issuance. Purchasers might rely on those promises and expect to profit from the resulting increase in functionality, thus satisfying Howey’s final prong.
Ah the above might even endanger the EOS Platform tokens as being securities!
A final policy benefit of a robust SAFT framework: Potentially eliminating the impetus behind the mass exodus of crypto developers to foreign jurisdictions. To be sure, the rise of token networks is a global phenomenon.
[…]
Put simply, this is a forfeiture of intellectual capital - a categorical loss for the U.S. and other countries like it, which seek to lead the world in technology innovation.
The SAFT wants to eliminate the utility token argument. Many tokens are NOT securitites and are more like metrocards and software licenses, however the SAFT doesn't care and essentially creates a securities where there is not. As Cooley admits, the token is often not the security while the SAFT always is. So then why add such a regulatory burden and why limit the amount you can raise and who you can offer to (only Accredited Investors (i.e. high net worth)? (rhetorical question)
Furthermore, what protections do the SAFT provide once the tokens are delivered? Are the tokens now treated as restricted securities, meaning that you must hold your tokens for a year or more before selling them? That seems like a major drawback for anyone buying tokens for short to medium term investing.
The quoted portion is ignorant and incorrect bullshit.
The SAFT white paper clearly explains that the SAFT is a way of avoiding issuing a pre-functional token, which is likely to be classified as a security. The functional token that is ultimately issued must be a non-security.
The SAFT shares are the security, not the token.
Poll
