We have posted many blogs and made available several webinars and presentations here regarding the need and complexity of complying with Federal and State securities laws when engaging in the sale and issuance of cryptocurrencies, digital tokens and other blockchain technologies.
Due to the cost and complexity of complying with U.S. Securities Laws, people are always looking for a “way around” having to comply with these laws while, at the same time, issuing what the SEC would likely find to be a security in order to raise capital. What we often advise our clients is that if you are asking the question, “Is it a security?”, then the answer is probably “Yes” (or, more accurately, the SEC will believe the answer is “Yes” and trying to convince them otherwise is a losing proposition). As the Supreme Court stated in SEC v. Edwards in 2003, a security “encompass[es] virtually any instrument that might be sold as an investment.”
Given that a “security” is so broadly defined, certain companies (believing their approach is clever and new) have determined that they may be able to “get around” complying with securities laws by avoiding the second part of the application of securities laws – it must involve a “sale.”
“Airdropping” digital tokens has gained popularity this year partly due to the inaccurate assertion that by giving digital tokens/cryptocurrencies away for free, a violation of securities laws cannot occur as there is no “sale” of a security. One such company, Tomahawk Exploration LLC (Tomahawk), was issued a cease-and-desist order that included a lifetime ban and a $30,000 fine for employing fraudulent marketing strategies to raise funds in connection with its “free” issuance of its TOM Tokens.
In the cease-and-desist order issued on August 14, 2018 (click here for a copy), the SEC restated its long established position that “Free” doesn’t mean “Freedom” from complying with securities laws:
The distribution of TOM … constituted sales under Section 2(a)(3) of the Securities Act, which applies to “every disposition of a security or interest in a security, for value.” The lack of monetary consideration for “free” shares does not mean there was not a sale or offer for sale for purposes of Section 5 of the Securities Act. Rather, a “gift” of a security is a “sale” within the meaning of the Securities Act when the donor receives some real benefit. See SEC v. Sierra Brokerage Servs., Inc., 608 F. Supp. 2d 923, 940–43 (S.D. Ohio 2009), aff’d, 712 F.3d 321 (6th Cir. 2013).
As the SEC views it, a person receiving “airdropped” digital tokens provides a service (i.e., pays value) to the company giving away the airdropped tokens. The people receiving the tokens are essentially marketers and promoters, spreading the popularity of a particular token in the hope that the value will rise.
This is very similar to a trend during the height of the Dot.Com Bubble, where companies would give their securities (actual shares) away for “FREE” to people who visited their websites. Back during the Dot.Com Bubble, “eye-balls” visiting a company’s website equaled real value (which in the end, ended up being “Fake Value”). While many companies did this with the incorrect assumption that “Free” meant “Freedom from Compliance”, one company, SimplyStock.com asked for “No-Action Letter” from the SEC that issuing shares for “free” wouldn’t be deemed a “sale” of securities. The SEC responded, however, that “the issuance of securities in consideration of a person’s registration on or visit to an issuer’s [I]nternet site would be an event of sale within the meaning of section 2(a)(3) of the Securities Act of 1933.” Therefore, the stock offerings would trigger the Securities Act of 1933’s registration provisions unless an exemption was available.
So…., while “Airdropping” initially appeared to be a clever end “run around” the securities laws, history shows that it would not prove to be the case. The SEC will deem a “give-away” under many circumstances (especially where the digital token given away would be deemed to be a security – See our blog post on this topic “SEC Provides Guidance on the Applicability of Securities Laws to ICOs and Sales of Digital Tokens – The Beginning of a ‘Safe Harbor’”) the sale of a security and require that the issuer comply with applicable securities laws.
Due to the limited “harm” imposed on the investing public, claims brought by the SEC where securities are given away for free are generally limited to where other frauds were perpetrated or where the SEC needs to make an example case. Companies, therefore, may believe the risk of flying under the SEC’s RADAR is worth the reward. However, in additional to potential criminal liability (fines and jail time), issuers, together with their officers and directors on a personal liability basis, also face civil damages in connection with a rescission offer. While the return of an investment (free) is an easy damage to pay – the legal fees due to the investors can pile up. Seeking rescission damages for “airdropped” digital tokens may become a cottage industry for the plaintiffs’ bar since attorney’ fees are included as recoverable damages by statute. See: “So What If My Digital Token is a Security? Personal Liability in Claims made for Rescission Damages”.
As with any securities issuance, however, the analysis is limited to the specific facts and circumstances of each particular matter. Not all “airdrops” will be a violation of securities law, the key take away is that an analysis as to whether or not securities laws apply should be made by a qualified securities legal practitioner.