by Josh Lawler
What do the Securities and Exchange Commission and a Clownfish have in Common? [1] Neither should regulate “utility” tokens — and neither of them has to.
The Basic Dilemma
By highlighting the potential investment aspect of a token purchase, the SEC focuses on the tail rather than the dog. The result is that many token projects, exchanges, and other participants flea.[3] Unfortunately, when these projects “flee,” they are taking the “dog” with them. That dog is named “Innovation.”[4]
Defining Characteristics of a “Utility”[5] Token:
1) It is a digital representation of a possessory right to something.
2) It serves a purpose in an economic system associated with the provision of a good (which may be intangible) or service.[6]
3) It provides a form of liquidity that fosters direct peer-to-peer transactions. without the need for a trusted intermediary.
4) It can be fractionalized into very tiny portions.
5) Application developers can utilize it in a limitless variety of ways.[7]
6) When issued in limited supply to support a market use with growing demand, it will increase in value (and lacking demand will drop in value).
It is number 6, above, that fomented the United States’ regulatory response to run amuck. Creative developers realized that they could raise capital by selling tokens that would presumably increase in value.[8] The sale of tokens based on little more than a white paper spread globally like wildfire.
Massive presale discounts to large investors who then dumped tokens almost immediately on unregulated “exchanges” almost ensured our current predicament. The common-man fraught with FOMO[9] and dreams of flying Lambos “to the moon” plunged into ICO[10] purchases. The SEC, with visions of October 29, 1929, revisited, leaped (albeit somewhat tentatively) to the rescue, and so the rise of the Howey Test.
Don’t Throw a Child Wearing a Duck Costume into a Pond . . .
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The SEC decided that what looked like a duck, quacked like a duck and waddled like a duck was, in fact, a duck, or in this case, an “investment contract.”[11] The SEC was not entirely wrong in their analysis, the sale of tokens in ICOs almost certainly includes the requisite elements. Here’s the thing: a utility token is more than that. Imagine that the SEC’s “duck” was in fact a small child in a duck costume. Put mildly, throwing that “duck” into a pond would be . . . problematic.[12]
Better Ideas for Regulation of Children in Duck Costumes . . . I mean Utility Tokens
Utility tokens serve many different purposes. To understand what appropriate regulation would look like, it helps to have a clear utility token use case. Here’s how a royalty micropayment use case might look (using the completely made up “Duck Token” or “DT”).
1. Developers create a web portal where content creators can post content for viewing by the public on a pay-per-view basis with payment then directly distributed to the content creator and any other parties who have a profit interest.
2. System requirements include:
(a) Content owners can easily post content and set their own prices;
(b) No distributors (who ordinarily take the majority of the revenue);
(c) Allocation and payment of revenue directly to all entitled persons (royalties);
(d) Facilitate micropayments (payments to small to be practical with current payment systems); and
(e) Eliminate trust issues, escrow/guild payment systems or audits.
3. The customer experience is as follows:
(a) Customer selects content (it might cost $1.00 to view for 24 hours);
(b) Customer pays either in $US 1.00 or an equivalent amount of DTs;
(c) If customer paid with $US, the platform through either the developer or a market maker[13] converts the $US to DT;
(d) The platform, based on a smart contract,[14] allocates and pays the DT received to the person(s) entitled thereto;
(e) The recipients of the DT, desiring to pay their taxes and buy their groceries, transfer the DT to their account on a cryptocurrency exchange and sell the DT at market prices;
(f) Based on a finite supply of circulating DT, as the volume of commerce on the platform grows, each DT must increase in value to facilitate the growing volume of transactions. Since the DT fractionalize (Bitcoin can divide to 8 decimal places), our content may still be priced at $1.00.[15]
Stop that Duck; it May Be Innovative, but it’s Not Providing Required Public Disclosures
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The Duck Token does not function unless it can be transferred freely between (i) content purchasers, (ii) the platform, (iii) content owners and (iv) third-party sources of liquidity (to convert from DT to $US, for example). The functionality of this system is additive to any aspects of the DT that would indicate transactions subject to securities regulations. If the DT are regulated as “securities:”
1. The issue by the platform of DT to anyone may be viewed as an issuer sale of securities.[16]
2. It would be illegal for an exchange to list the DT[17] without the required FINRA[18] licenses, and a holder of such licenses cannot list the DT unless the platform[19] provides the required public disclosures.[20]
3. The market makers that facilitate DT liquidity would also need to be subject to FINRA regulations, and cannot make a market in securities (the DT) unless the platform provides the required public disclosures.
This doesn’t even take into account the problem of getting the DT out to the content buying public in the first place. If all DT are initially sold to “Accredited Investors”[21] in a private sale, in addition to the mandatory one year holding period, how long would it take for Accredited Investors to resell the DT to persons who would use the platform to buy content? Especially if the DT is not listed on exchanges because doing so would be illegal.
Who Wants a Complicated Duck? What do we really need here?
The securities regulations, though certainly protective of the public, do not function with respect to facilitating token use cases. It’s no wonder that American token project developers leave the USA for friendlier regulation.
One need look no further than Australia[22] to find a shining example of a system that actually works.[23] The material difference? For tokens that are not classified as “financial products” (traditional definition), Australia requires compliance with consumer protection laws rather than securities laws.
Utility tokens are, by definition, goods or services (hence the term “utility”). We have an administrative body that oversees the sale of goods and services in commerce. The Federal Trade Commission.[24]
Transactions in utility tokens should be regulated by the FTC
According to the FTC’s website, the FTC protects consumers by stopping unfair, deceptive or fraudulent practices in the marketplace. It conducts investigations, sues companies and people that violate the law, develops rules to ensure a vibrant marketplace, and educates consumers and businesses about their rights and responsibilities.
Sounds pretty good. As applied to tokens:
1. Protect the public from fraud and at times its own unfortunate FOMO.
2. Foster fair and efficient marketplaces for commerce.
3. Allow access to the general public who desire to be market participants.
I could see a future where the FTC creates a reporting system based on a tokens supply and demand economic information. Possibly an SRO[25] that could provide independent third-party disclosures.[26]
Of Dogs and Ducks
Going back to the ever so innovative Duck Token:
For the initial sale of DT, the developers publish a white paper that includes mandatory disclosure appropriate to an investment in the DT.[27] A discussion of circulating supply, platform market demand, and system governance would be central. They post it on a website and sell DT.[28] Assuming it looks like a worthy project, an exchange (utility token exchange) not subject to securities regulation lists the DT and market makers (not licensed by FINRA, but possibly licensed by the FTC) take note, then they start providing the market liquidity required for the use case to function properly.
Periodically the development team, if still relevant, (or an SRO), compiles and publishes information relevant to the valuation of supply/demand value-driven commodities.[29]
That’s it. Go forth and facilitate micro-payments and the sale of content, etc.
[1] Viewers of Finding Nemo might recall Nemo’s father Marlin (played by Albert Brooks) playing the role of the ultimate helicopter parent. As an unfortunate result, Nemo, the focus of his protection, is scooped up by a SCUBA diver and whisked away to Sydney, Australia. As it happens, Australia takes a very elegant approach to regulate digital assets. An approach I’d like to see in America. Coincidence? I think not.
[2] This article is limited in scope to digital assets that are not traditional financial products (digitized assets that are, or have features of stocks, bonds, fractional ownership interests, entitlement to royalties, etc. We’ll get back to royalties, they make a great edge case).
[3] Yes, that is intentional — — I did mention I have kids right.
[4] The Token Taxonomy Act of 2019, proposed by Rep. Darren Soto [D-FL-9], Rep. Josh Gottheimer [D-NJ-5], Rep. Ted Budd [R-NC-13], Rep. Tulsi Gabbard [D-HI-2], Rep. Scott Perry [R-PA-10], Rep. John W. Rose [R-TN-6], and Rep. Eric Swalwell [D-CA-15] which is currently under consideration by the House Financial Services Committee, would remove utility tokens from the definition of a “Security” for purposes of the relevant securities laws, and expressly confirms that the regulation of tokens under commodities law and consumer protection laws. Hopefully, congress recognizes an elegant solution when it sees one.
[5] The term “utility token” exists as a counter to the term “security token.” The term “security token” is actually a misnomer because it assumes that the token does not have a use. A fundamental misunderstanding at the core of the unfortunate American over-regulation of tokens that are not financial products. Also, every rule has exceptions and it would not be hard to name utility tokens that don’t conform to this description but consider this typical.
[6] For the purpose of this analysis, Bitcoin (for example) is not a utility token. For American law purposes, it is a commodity. Any token running on a sufficiently decentralized system where no single party (or coalition) can make unilateral decisions will behave as a commodity and should be regulated accordingly (a subject for a different article).
[7] Use cases for utility tokens are boundless, but some of the obvious ones include automated micro-payments; supply chain management; medical (or other private) records storage and controlled access; self-sovereign identity; tracking of non-fungible goods (the list continues forever).
[8] An attractive alternative to funding projects by tediously prancing in front of traditional investors, compliance with securities law and achingly giving away too much value for the limited funds raised. The failure (and fraud) rate associated with ICO projects may indicate that the traditional fundraising process serves a useful weeding out function.
[9] Fear Of Missing Out
[10] To be sure, whoever decided it was a good idea to coin the term “ICO” because it sounds like “IPO” did not do us any favours.
[11] The “investment contract” is the securities equivalent of a catch-all for stuff that otherwise defies definition but does “quack” like a duck. More specifically, applying the now-famous Howey test, the SEC decided that per existing law, the sale of tokens in an ICO had all the elements of a regulated sale of securities.
[12] Not legal advice, but trust me on this one.
[13] A market maker is a single-person, bank, or brokerage company that sells and buys securities for its own account at a price displayed on an exchange’s trading system. The market maker, as a ready buyer or seller of a security plays a key role in maintaining reasonable levels of liquidity for such security.
[14] A “smart contract” is a self-executing contract that automatically carries out a predetermined instruction upon the happening of an event (in this case receipt of payment for viewing of the content).
[15] e.g. The same content that sold for 1 DT last year might cost 0.25 DT this year, reflecting (in theory, a 4X growth of demand for DT). Demand for tokens is usually driven by (i) growth of the market demand for the associated product; (ii) investment/speculation and (iii) in certain circumstances incentives designed to encourage people to hold the tokens for other benefits.
[16] Given the current legal guidance, we would tweak the system so that the platform issues the DT to the content purchaser, who then (without knowing it) transfers the DT to the content owners. Reason being that characterizing the purchase of content as an investment (and therefore the DT as an “investment contract” seems logically impossible, even for the SEC).
[17] Broadly defined by the ’34 Act to include most order book based buyer/seller matching systems.
[18] FINRA stands for the Financial Industry Regulatory Authority.
[19] Assuming for purposes of illustration that the “platform” is run by the developers and is also the “issuer” of the DT.
[20] The usual public reporting requirements (financial disclosure) required by the Securities and Exchange Act of 1934 do not make sense in the context of a utility token with value-driven by supply and demand. Even if it did, the registration and reporting requirements are extremely expensive for a project that may not even be set up to make a profit.
[21] Defined in Regulation D of the Securities Act of 1933.
[22]Yes, I know it is far away, but from a regulatory perspective, they have a common law system, speak English and are nice enough to put out plenty of on-line materials. https://bit.ly/2Yeqm7P
[23] In fairness, I am not licensed to practice in Australia and my knowledge of their system is probably a bit superficial. Like most things, I expect improvements can be made. That said, absent enactment of the Token Taxonomy Act, the Aussies are way ahead of us.
[24]The Federal Trade Commission was created in 1914 for the dual purposes of protecting the consumer and promoting competition. https://bit.ly/2oLywjq
[25] Self-Regulatory Organization (like FINRA, usually comprised of industry participants).
[26] Addressing the fact that certain token systems may be decentralized to the point that there is no issuer to generate and publish the required info.
[27] This “investment” is not a purchase of securities (though it would be under Howey), it is basically a purchase of goods where the DT are more or less widgets to satisfy the needs of the applicable use case.
[28] Still subject to applicable anti-money laundering and know your customer requirements.
[29] The CFTC has a place in this too but beyond the scope of this article.
Josh Lawler, a partner at Zuber Lawler, is an experienced attorney with concentrations in M&A, finance, intellectual property, and general commercial transactions. This is not legal advice and the original article was published at Medium.
