This is the first in a series of posts critical of the SEC’s approach to analyzing so-called “utility tokens” under the federal securities laws.

For purposes of these posts:

  • A “utility token” is a blockchain-based coin or token that
  • has no rights associated with it other than the right to use the coin or token to purchase goods or services from the token issuer;
  • does not carry any claim on the assets of the token issuer (whether on liquidation of the token issuer or otherwise); and
  • does not entitle the token holder to any voting or similar rights or any rights to receive income, dividends or other distributions.[i]
  • An “investment contract” is a contract, transaction or scheme whereby:
  • (1) a person invests money
  • (2) in a common enterprise and
  • (3) is led to expect profits solely from the efforts of the promoter or a third party.

Section 2(a)(1) of the Securities Act of 1933 (the “Securities Act”), and Section 3(a)(10) of the Securities Exchange Act of 1934 (the “Exchange Act” and, together with the Securities Act, the “Securities Acts”), define the term “security” in slightly different terms, but the Supreme Court has concluded that they should be treated as “essentially identical in meaning.”[ii] Each section defines the term “security” to include an “investment contract.” Neither section defines the term “investment contract.” In SEC v. W. J. Howey Co., 328 U.S. 293 (1946) (“Howey”), the Supreme Court articulated the three-prong test set forth above for determining whether a particular instrument is an “investment contract,” and the courts have essentially followed that test ever since.[iii]

Part I: The Problem

Recent enforcement actions brought by the Securities and Exchange Commission (“SEC”),[iv] as well as recent guidance provided by the SEC staff[v] and certain high-ranking SEC officials:[vi]

  • fail to distinguish the “investment contracts” pursuant to which utility tokens are offered and sold to purchasers, on the one hand, from the utility tokens sold to purchasers pursuant to such “investment contracts,” on the other hand; and/or
  • take the position that, under the Howey test, a utility token can be an “investment contract,” and therefore a “security,” in its own right.

The SEC’s[vii] position that, under Howey, a utility token can be an “investment contract,” and therefore a “security,” in its own right confuses or conflates (1) the contract, transaction or scheme pursuant to which the utility token is offered and sold to purchasers (which, depending on the types of marketing and promotional efforts involved, may or may not be an “investment contract”) with (2) the utility token sold to a purchaser pursuant to such a contract, transaction or scheme (which in essence represents a consumptive item in the form of a right to acquire goods and services and therefore, in and of itself, is never an “investment contract”).[viii] Unfortunately, but not surprisingly, this error has hindered, not advanced, the development of a sound and clear conceptual framework for analyzing the status of offers and sales of utility tokens under the federal securities laws.

The SEC’s conflation of (1) contracts, transactions or schemes pursuant to which utility tokens are offered and sold to purchasers with (2) the utility tokens sold to purchasers pursuant to such contracts, transactions or schemes, finds its highest expression in the Gary Plastic Remarks. While at one point in those remarks, Director Hinman appears to endorse the idea that there is a clear distinction between an “investment contract” pursuant to which a utility token is offered and sold, on the one hand, and the utility token itself, on the other hand, he ultimately conflates the two:

“…[in] the ICOs I am seeing, strictly speaking, the token – or coin or whatever the digital information packet is called – all by itself is not a security, just as the orange groves in Howey were not. Central to determining whether a security is being sold is how it is being sold and the reasonable expectations of purchasers. When someone buys a housing unit to live in, it is probably not a security...But under certain circumstances, the same asset can be offered and sold in a way that causes investors to have a reasonable expectation of profits based on the efforts of others. For example, if the housing unit is offered with a management contract or other services, it can be a security…Similarly, when a CD, exempt from being treated as a security under Section 3 of the Securities Act, is sold as a part of a program organized by a broker who offers retail investors promises of liquidity and the potential to profit from changes in interest rates, the Gary Plastic case teaches us that the instrument can be part of an investment contract that is a security. The same reasoning applies to digital assets. The digital asset itself is simply code. But the way it is sold – as part of an investment; to non-users; by promoters to develop the enterprise – can be, and, in that context, most often is, a security – because it evidences an investment contract.”

Insofar as Director Hinman was addressing the status of utility tokens under the Securities Acts, case law suggests that he got it right when he reasoned that a utility token, which is not itself a security, can be part of an investment contract that is a security, and got it wrong when he suggested that a utility token can “evidence an investment contract.” To say that a utility token “evidences an investment contract” is to conflate a consumptive item, on the one hand, with the “investment contract” pursuant to which it was offered and sold, on the other hand.[ix] Director Hinman also got it right when he asserted that “[c]entral to determining whether a security is being sold is how it is being sold.” Unfortunately, as discussed below (and as will be discussed in greater detail in a subsequent post), later pronouncements of the SEC staff unduly de-emphasize the manner in which a utility token is sold and unduly emphasize factors – such as the subjective motivations of token purchasers, the free transferability of tokens and the existence of vibrant secondary markets for tokens – that should have little or no relevance to determining whether an “investment contract” exists.

I do not disagree with the proposition that where (1) an issuer of utility tokens offers, sells and issues utility tokens that are not fully functional at the time of issuance to raise funds for the purpose of developing the platform on which such tokens can be used in the future (“Non-Functional Tokens”), and (2) in connection with making such offers and sales, makes promises or representations that, analyzed from an objective standpoint, would lead prospective purchasers to expect profits resulting from an increase in value of the tokens attributable to the managerial or entrepreneurial efforts of the issuer or others, those promises and representations, considered together with the agreement relating to the sale of the tokens to a purchaser, constitute a contract, transaction or scheme that bears all of the hallmarks of an “investment contract” (and thus a “security”) within the meaning of the Securities Acts. In that case, offers and sales of the “investment contract” (as opposed to the utility tokens offered and sold thereunder) must be registered under the Securities Act, unless an exemption from the registration requirements of the Securities Act is available.

Nor do I disagree with the view that, where an issuer of utility tokens makes the types of promises or representations described above in connection with offering and selling Non-Functional Utility Tokens, uses the proceeds of the offering to develop the platform on which such tokens can be used and then issues such tokens to investors only when the platform is functional (“Fully Functional Tokens”), those promises and representations, considered together with the agreement relating to the sale of the tokens to a purchaser, constitute a contract, transaction or scheme that bears all of the hallmarks of an “investment contract.”

At the same time, I do not believe that it can credibly be argued that a utility token is an “investment contract” in its own right. A utility token is, by nature and design, a consumptive item, not a security.[x] It entitles the holder of the token to purchase goods and/or services on the related platform. In the case of a Non-Functional Token, the token represents a future right to purchase goods and/or services on the platform, once the platform becomes functional. In the case of a Functional Token, the token represents a present right to purchase goods and/or services on the platform. In either case, that right, in and of itself, does not constitute an “investment contract” or any other type of “security,” because the right, in and of itself, does not contain, and is incapable of making, any promise or representation that would lead prospective purchasers to expect profits resulting from an increase in value of the token attributable to the managerial or entrepreneurial efforts of the issuer or others. In that regard, a utility token is fundamentally and qualitatively different from a digital asset (or a non-digital asset such as stock or bond) that, by its very nature and design, carries with it a promise to pay dividends, income or other distributions.[xi] There is, in short, nothing inherent in a utility token that would induce a prospective purchaser to buy it as an investment. Such an inducement must necessarily be voiced by a person “outside” the token – that is, as part of and in connection with a contract, transaction or scheme under which the token is offered and sold.

Thus, even if one concludes that a particular contract, transaction or scheme involving the offer and sale of a utility token is an “investment contract,” that “investment contract” is distinct from the utility token offered and sold pursuant to it. One could, of course, argue that a utility token is a contract in that it confers a right on the holder of the token to acquire goods or services, and obligates the issuer of the token to redeem such token for such goods or services. But that does mean that it is an investment contract. The “investment contract” (if one is to be found through application of the Howey test) is the contract, transaction or scheme in which: (i) the token issuer offers tokens to the purchaser, (ii) makes certain promises or representations to the token purchaser in connection therewith, (iii) enters into agreement with the token purchaser to sell and issue (or agree to issue) tokens to the purchaser and (iv) the purchaser pays the agreed-on consideration to the issuer in exchange for such tokens. That “investment contract” is separate and distinct from the contractual rights represented by the token issued pursuant to the “investment contract.” Although the contract, transaction or scheme under which a utility token is offered and sold may, under certain facts and circumstances, be an “investment contract,” the utility token issued pursuant to that contract, transaction or scheme is, by its very nature, a consumptive item and is no more an “investment contract” than any other right to acquire goods and services, such as a gift card.

As will be discussed in greater detail in a subsequent post, even a Non-Functional Token must be considered a consumptive item, no less than any consumptive product that is pre-ordered by a consumer but not yet useful because it is not yet produced or manufactured. To say that a Non-Functional Token is an “investment contract” is tantamount to saying that a cow embryo sold in connection with a cattle-breeding scheme is an “investment contract.” There is no inherent characteristic or attribute of a utility token, Non-Functional or Functional – just as there is no inherent characteristic or attribute of a cow embryo or a mature cow – that suggests that it is an “investment contract.” I have been asked: how can a Non-Functional Token not be an investment, since it has nowhere to go but up? My answer takes the form of a question: up to what? Up to the point where it can be sold at a profit? Or up to the point where it can be used on the related platform? My point is that the only thing one can conclude with certainty after examining a Non-Functional Token in its own right is that it is, by nature and design, a consumptive item. Any conclusion that a Non-Functional Token is an investment as opposed to a consumptive opportunity can only be based on an objective examination of the nature of the inducements made to attract purchasers to purchase it – inducements that, as stated above, necessarily must be made “outside” the token itself.

Nor, as we shall see in a later post, does a consumptive item such as a utility token somehow become mystically transformed into an “investment contract” simply because it: (i) is offered and sold pursuant to one and/or (ii) may increase in value over time as a result of the entrepreneurial or managerial efforts of others.

Even if we indulge the SEC's error that a consumptive item involved in an "investment contract" is an “investment contract” in its own right, the SEC compounds its error by failing to follow well-established principles, prescribed by case law, for determining whether a particular contract, transaction or scheme involving the sale of a consumptive item is an “investment contract.” Under that case law, a contract, transaction or scheme involving the sale of a consumptive item will be considered an “investment contract” only if, among other things, the promoter has made promises or representations in connection with marketing and promoting the item that, analyzed objectively, would lead potential purchasers to: (i) expect an increase in the value of such item as a result of the managerial or entrepreneurial efforts of others and (ii) view such profit, as opposed to the actual use and enjoyment of the item, as the primary, principal or predominant inducement for purchasing the item. In short, if an objective analysis shows that a promoter has conducted an offering of tokens in which it made promises or representations to the effect that it (or another party or parties) intends to employ its managerial or entrepreneurial efforts in a manner designed to increase the value of the token, thereby making the token a good investment opportunity, the offering may well constitute an “investment contract.” If, however, an objective analysis shows that a promoter has conducted an offering of tokens in which it markets the tokens primarily as a consumptive item, the offering should not constitute an “investment contract,” even if, as a result of subsequent managerial or entrepreneurial efforts on the part of the promoter (or another party or parties), the token increases in value over time. The SEC, however, downplays the necessity to undertake an objective analysis of the type demanded by the courts, and even goes so far as to suggest that the subjective motivations of token purchasers are an important factor to be considered in determining whether the tokens they purchase are “investment contracts.”[xii] This suggests that the SEC takes the position that if a purchaser of tokens subjectively believes that the tokens are a “good investment,” that belief militates in favor of finding that the tokens are an “investment contract.” Along the same lines, the SEC appears to believe that if a token purchaser purchases more tokens than he can possibly consume, or that if the token is traded in the secondary market, either fact also militates in favor of such a finding.

Finally (again, indulging the SEC’s error for the sake of argument), the SEC fails to explain how a secondary market transaction in a utility token that it considers to be an “investment contract” is itself an “investment contract.” If, for example, a secondary market sale is made on an anonymous basis with the seller making no promises or representations to the purchaser regarding the potential future value of the token, how is the third prong of the Howey test satisfied? How can the “common enterprise” prong of the Howey test be satisfied in the context of a secondary market sale? In that case, where is the “common enterprise” between the seller and the buyer?

Or is the SEC suggesting that once an instrument is characterized as an “investment contract,” it is forever an “investment contract” (at least until such time as it can be said that any increase in the value of the instrument is not attributable to the managerial or entrepreneurial efforts of others), regardless of the number of times it is sold in secondary market transactions? In this connection, is the SEC suggesting that the promises and representations made by the token issuer in the original “investment contract” somehow attach themselves to subsequent resales, thereby satisfying the third prong of the Howey test with respect to such resales? If that is the case, how long does the SEC believe such promises and representations continue to linger? Forever?[xiii] And, more importantly, what if a subsequent purchaser is not aware of those promises and representations at the time of his or her purchase?[xiv] The SEC cites no case law or other authority to support the proposition (principally, I believe, because there doesn’t appear to be any[xv]) – nor does it supply any grounds or analysis to support the proposition[xvi] – that a secondary market sale of an “investment contract” is, necessarily and forever, an “investment contract” in its own right. [xvii]

In my next post, I will discuss the consequences of the SEC’s error for market participants that wish to sell, resell, invest in, broker, provide exchange facilities for the trading of, and provide advice with respect to, utility tokens.

In subsequent posts, I will further discuss the SEC’s approach, suggest an alternative approach and discuss the legal basis, grounded in case law,[xviii] for adopting that alternative approach.