When a token is regulated as security

05 Apr 2023

Recently, the US regulator the Security and Exchange Commission (SEC) has been actively fighting against crypto projects. The latest example of such policy by the SEC was the recognition of the BUSD as a security. Regulators in other jurisdictions are also looking to regulate the crypto-sphere.

Why is it important to understand when a token that you issue comes under regulation as a security? The securities must be registered and comply with disclosure and reporting requirements, including providing investors with information about the security's risks, financial condition and conflicts of interest. Securities must also be offered and sold through registered broker-dealers or registered offerings, commonly known as IPO. Violations of securities laws can result in fines and criminal penalties.

When a token qualifies as a security? The approach to the definition of a security differs from country to country. This forces us to look separately at what is meant by a security in any particular country.

The most relevant is the U.S. approach: in order to know whether a token will be regulated as a security, the Howey test must be performed. It has become so universal that it is used when evaluating any token. We can see famous examples of the application of this test in the cases of SEC v. Ripple Labs, Inc., SEC v. LRBY, Inc. and others.

The Howey test allows us to determine whether a token is consistent with the nature of an investment contract. Here's what the SEC notes about it:

‘This definition was uniformly applied by state courts to a variety of situations where individuals were led to invest money in a common enterprise with the expectation that they would earn a profit solely through the efforts of the promoter or of someone other than themselves’.

So, a token will NOT pass the test if it satisfies 4 elements:

Investment of money.

Satisfaction with this prong is inevitable if tokens are sold for value.

Common enterprise.

This prong is satisfied if a common enterprise has been set up to produce the token. In general, this is almost always the case. Sometimes a common enterprise may not formally exist, but it is implied based on the intentions of the parties involved. The participants engage in similar or common activities, work together to make a profit, share profits among themselves, are exposed to the same or similar dangers, etc. The approach of the courts may vary from case to case, but the presence of this aspect is almost always found.

Reasonable expectation of profit derived + 4. From the efforts of others.

The following characteristics of a token can indicate the satisfaction of this prong:

If the marketing campaign uses a token-related vocabulary and terms like "Initial Coin Offering".
If a token provides an investor with traditional rights to shares, debentures, etc.
If the token has no real practical function.
If the value of a token depends on the manual actions of someone outside the network.
If the token is sold before the code is deployed on the blockchain.
If the collective decision of token holders cannot affect the development team's access to funds raised through the crowdsale.

In the Ripple Labs and LBRY cases, the court accepts any evidence that the investment expectations are based on the words or actions of the issuer (for example, even correspondence with a potential investor where the defendant in the case points out the possibility of profit from the sale of the token).

One can parse these four elements of the Howey test by looking at the SEC v. Howey case itself. W.J. Howey Co. William Howey's company sold parcels of orange groves in Florida, offered to care for the groves, harvested and sold oranges. All the contracts could be signed at the same time. It was possible without seeing one's plot of land to receive passive income from Howey's work. The services were provided for money (1) by Howey's general enterprise (2). Citizens invested money in the enterprise, but did not cultivate the orange plantations, but expected solely a profit as a result of the seller's activities (3+4). What we have before us is an investment contract.

To find out in advance whether a token falls under the category of a security, you can ask a lawyer for a Legal Opinion. If the similarity to a security is detected at this stage, there are two options:

Changing the functionality and other aspects of the token according to individual legal advice.
Obtaining the appropriate permission from the local regulator and compliance with the established requirements for the issuance of securities.

Get more insights on Legal Compliance for Crypto Projects at:

LinkedIn: https://www.linkedin.com/in/andrey-tugarin-9044a5166/
Telegram: https://t.me/gmtlegal
Website: https://gmtlegal.com/en/

Rock’n’Block’s team is not limited to development. We can help with:

⚡️NFT and NFT marketplaces development

⚡️NFT 10K generator

⚡️Staking platforms

⚡️Vesting platforms

⚡️Farming platforms

⚡️Crowdsale development

⚡️Cross-chain solutions

⚡️White label launchpad development solutions

⚡️Tools development