Neural Profit Engines

View Original

What Makes a Token a Security?

This is a rewrite of an article that I wrote about a month ago to help alternative investment managers understand the SEC’s definition of “a security.”  I am not an expert on Cryptos, but I do have extensive knowledge of the securities industry.  I am a Chartered Financial Analyst (CFA), a Chartered Alternative Investment Analyst (CAIA), a MBA Finance from NYU Stern, and a 25 year veteran of the financial markets who has been involved in launching several hedge funds.

There has been a slew of recent articles with erroneous definitions for a token as a security and misidentification of the factors that the SEC uses to classify crypto assets as a security.  The most recent misinformation, that I know of, came from an article “8 Important Things To Know About Security Tokens / Token Regulation” by Lukas Schor of The Argon Group in Medium, published on November 22nd, 2017.

Schor’s article discusses the differences between a “utility token” and a “security token” at the beginning of the article.  However, there are other articles making the same erroneous points.  To be specific, I think that Schor’s definition of a utility token and a security token are correct.  However, his example of a utility token is too limited and it leads to erroneous conclusions. Below is a reproduction of his chart graphic.        

Source: “8 Important Things To Know About Security Tokens / Token Regulation” by Lukas Schor of The Argon Group in Medium, published on November 22nd, 2017

The Security Token is the top process and represents investors who buy a token to receive a certain dividend or other cash income stream as a return in the future.  The bottom process represents a utility token since the purchaser will receive some “utility” - benefits or rights to cloud storage in the future.  Schor maintains that the bottom token would not be a security because the payout is in services or goods.  His conclusion based on the information in his diagram is correct, however not all utility tokens are like his diagram and the assumption that a utility token cannot be a security is not true.  Some utility tokens are issued to finance the development of a cloud operation and therein lays the distinction.

To be fair, since Schor wrote his article the SEC has published a few papers and articles to clearly provide the tests for a security.  William Hinman, Director of Supervision of Corporate Finance with the SEC, answered this question with a detailed and logical explanation on June 14th at the Yahoo Finance All Markets Summit in a speech titled “Digital Asset Transactions: When Howey Met Gary (Plastic).”

Source: https://www.sec.gov/news/speech/speech-hinman-061418

WHAT IS A SECURITY?

Hinman says that if you have a crypto-operation that is fully functioning, and you sell tokens only to the owners or participants of that operation for some benefit stemming from that operation, then your token launch probably does not qualify as a security. This would be the case for Schor's Amazon Cloud Service.

However, if you have plans for a future operation and you launch tokens to the general public to finance the development of that operation and the investors who buy the tokens are passive participants who expect a return based on the successful implementation of that operation, then you are probably issuing a security.

I was involved in an attempted token launch that would have qualified as a security and provides an excellent example.  An entrepreneur asked for advice on launching a ERC-20 token for his grocery-based crypto-service that was ready begin operation.  The idea was that the token’s utility would provide some kind of “buyer loyalty” benefit to the owner of the token.  

If the entrepreneur had limited the token to the grocery-based segment of his crypto-service and had sold the tokens only to people who planned to use them in the grocery service, then the tokens probably would NOT have been a security according to Hinman’s definition, since his grocery operation had been developed, tested, and was ready to launch.

However, upon further questioning this entrepreneur revealed more extensive plans; he wanted to start similar but undeveloped crypto-services across several other consumer retail sectors: sports equipment, electronics and more.  In addition, he wanted this token to be one of the biggest and most liquid tokens in the crypto market.

Three aspects of the entrepreneur’s plan turned this planned utility token launch into a security.  First, he was selling the tokens to finance future operations to be developed and the utility of the token (return) would be based on this entrepreneur’s ability to meet his objective – launch the sport-based and electronics crypto service.  The token buyers would thus have a financial interest in the enterprise and the entrepreneur’s ability to meet the objective.  Hinman informed the audience that this is a key test that regulators will be applying to token launches. 

Second, the entrepreneur planned to sell the tokens to the general public and not just to customers: he would have needed to build a retail operation somewhere between the size of Target and Walmart to accommodate the “buyer loyalty” component of the token’s utility based on the quantity of tokens that he planned to sell.  Clearly, some token-buyers would have been expecting to sell the tokens as opposed to cashing them for the buyer-loyalty utility.

Thus, the implicit objective of many of the investors would have been to sell the tokens for a profit in the secondary market after the operation was complete and this brings us to the third component of Hinman’s criteria:

“When we see that kind of economic transaction, it is easy to apply the Supreme Court’s “investment contract” test first announced in SEC v. Howey.[4] That test requires an investment of money in a common enterprise with an expectation of profit derived from the efforts of others.”

Clearly, this planned token launch was a security and would have fallen under SEC regulation. I explained the SEC regulations to the entrepreneur, but I walked away from the deal when he did not want to share financials, write a white paper, or provide any further information about the strategy.

In summary, security tokens are securities by design.  However, a utility token can also be a security and this distinction depends on the design of the token.  A token issue for a service that is already operational, like Amazon’s cloud services, would NOT be a security. 

On the other hand, if the token’s offer utility is not immediately available at the time of sale because the capacity or process to deliver that utility is not yet operational and the utility of the token depends on the issuer to bring the process to operation, then the token is a security.  It does not matter how the payout is structure - cash versus utility.

The purchasers of the token are passive investors and must rely on the token issuer to complete the operation to receive their utility.  This is the SEC’s key test, issuers of utility tokens that qualify as securities must realize that they will fall under of SEC regulations even if they do not need to register their operation.

If you are an entrepreneur and have any questions, it would be best to hire a securities lawyer.  The SEC is watching this area closely. 

Vernon Budinger is a Finance Professional with more than 25 years of experience working with investments.  He is the owner of Neural Profit Engines, a social media company for Financial Advisors, Alternative Investments, and Hedge Funds.