Security Tokens Versus Utility Tokens

This seems to be the subject of every conversation in the Crypto Space this year.  The reason that it has become relevant lately is that representatives from the Security Exchange Commission (“SEC”) have declared that most every token that they have analyzed is a Security Token.  These statements come after two years of crypto based companies all claiming that their tokens are Utility Tokens.

So, who is right?  As nothing is absolute, we believe that the discussion should be based around the actual use case and the how the token is used.

That being said, what is now getting an even greater buzz is how to define the various terms that are being discussed.   The confusion as to token classification and definitions is what is causing people to debate. The terminology is misleading and has caused many a user to invest in a token which is subject to SEC regulation.

So, what is an ICO? STO? Utility Token? Security Token? The terminology in the space has failed us.  It may be that the terms have been tainted as a result of the bad actors and improper definitions. This is especially true when many of the users out there are trying to craft definitions which would allow their tokens to avoid SEC regulation. Just do a simple search for the definition of a Utility Token and you will find wildly inaccurate definitions.

Bad terminology is causing tokens to be mislabeled and improperly classified. Improper classification of a token leads to problems with the SEC. Especially since the SEC thinks most tokens are in fact Security Tokens. Further, bad terminology leads to distrust. For example, ICO’s, or Initial Coin Offerings, have garnered a poor reputation because most, if not all, of the tokens offered via ICO are in fact Security Tokens and are subject to SEC regulation. This has led to investigations by the SEC and loss of capital for users and a negative effect on consumers.

As a space, we must come to a common agreement regarding terms and definitions. If we are to build a solid and untarnished reputation, the Crypto Space must settle on accurate definitions which are both informative and in accord with the SEC. We must cut loose terms which have been tarnished, such as ICO. We must replace these terms with accurate terms that build confidence. For example, ICO should be replaced with Security Token Offering (“STO”). STO more accurately reflects the true nature of what is being offered (a Security Token) and helps to better inform the average user.  It is almost like a do over as it relates to naming.

So, how do you get past the bad terminology and the self-serving definitions? How do you know if your token is a Utility Token or Security Token? You must know how the SEC views tokens and how they have defined Utility and Security Tokens. You must get past the inaccurate definitions and look to the tests established by the Courts and the SEC to determine the true nature of your token.

Fornaro Law and the Crypto Space

Before I get into the topic at hand and explain the difference between Utility and Security Tokens, I find the need to share the profound effect that the Crypto Space has had on Fornaro Law and myself.

From a legal perspective, the world of cryptocurrency is an unbelievable opportunity to work on something that is cutting edge.  This is clearly the first time in my career where I was able to get into an area of the law and a world of which very few are aware.  As an attorney, I am always looking to provide proper guidance and to protect my client.  The world of Crypto has presented new and novel challenges and exciting opportunities.  I have been inspired by Crypto since I first was introduced to it in June 2016, by a friend and client. Since then, I have thought of little else. However, I digress.

The concept of an Initial Coin Offering (“ICO”) and the tokens that were being sold was one of the first challenges that faced our clients.  During 2016 and 2017, the ICO and tokens became popular topics and novel opportunities.  Companies that wanted to raise money, simply sold tokens to individuals in exchange for fiat money, Bitcoin and altcoins.

The goal of an ICO is to raise money to advance a project or use case using an underlying DLT (i.e. Blockchain).  A token offering through an ICO is simply a fundraising effort.  This is no different than any other start-up company wanting to raise capital.  The difference being a crypto start-up and a start-up company that is not connected to cryptocurrency, is that the non-crypto company has to follow the SEC regulation process. These securities must be properly registered or they must seek an exception to the regulation before raising funds.  Current exceptions to the Regulation are Reg D, Reg CF and Reg A.

Because the SEC and other governmental entities had never been exposed to tokens, blockchain and fund raising in this fashion, they did not necessarily know how to respond.  As such, the market developed without regulation.

As the ICO market exploded and large amounts of money was raised, the government and the lawyers realized that what these new start-up companies were trading and selling, were securities.  After all, people are buying these tokens with the hopes of a rise in price of the token and the chance at future profits.  It is pure speculation.

The SEC sat on the sidelines watching in 2016 and 2017.   Unfortunately, because some of the ICOs were fraudulent, the SEC stepped into the game in 2018, when it issued approximately 80 cease and desist letters against ICOs in February 2018.  This also had the unintended effect of causing distrust of ICOs.

There was a period in 2017 and 2018 when our clients were ignoring our legal advice, because we were advising them that the token that they were developing, and selling, were securities and that they should consider treating them as such.  The client’s marketing teams would not have it.  We were consistently told that our advice would stifle sales and would destroy the project.  We were also told that the token that was being sold was a utility.  We were informed that there was no regulation yet, so none had to be followed.

Those discussions came to a head and companies that were raising money began struggling because of the cease and desist letters from the SEC and general uncertainty as it related to regulation.

That being said, it is time to describe the very important distinctions between Security Token and a Utility Tokens.

What is a Token?

A token is a unit of value. It is a right to an asset or a commodity, on a blockchain network. One should not underestimate the profound effect that Tokens have on the blockchain space and the world in general. Tokens provide a bridge between the world of finance and the blockchain. Further, some tokens speed up traditional finance. With tokens, a transaction which would traditionally take days can now be accomplished in mere hours. Tokens also expose their users to expanded markets and a bigger pool of investors than would be available in traditional finance. Another benefit is that tokens prevent institutional manipulation and corruption by middlemen by eliminating these elements from the transaction. Finally, as licensed trading platforms are developed, tokens will have an ease of liquidation not currently present in traditional financial transactions.

Utility vs. Security?

There is a lot of confusion as to the definition of a Utility Token. One need only do a quick google search to get a variety of wildly different definitions. Many of these definitions are merely wishful thinking. Fortunately, the SEC has provided some guidance. The SEC has said that at its most basic, a Utility Token is simply a token which grants a right to participation. It has no inherent value, no promise of investment potential or future profitability. It is simply a permit to utilize a certain platform. Utility Tokens do not have a central “enterprise.” There is no promise of future goods or services. SEC Chairman Jay Clayton has stated that “Tokens and offerings that incorporate features and marketing efforts that emphasize the potential for profits based on the entrepreneurial or managerial efforts of others continue to contain the hallmarks of a security under U.S. law.” This starkly contrasts with the attempts by promoters to classify their tokens as Utility Tokens. These attempts have proven to be futile. The SEC has said that simply calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security.

The SEC has observed “in order to raise money to develop networks on which digital assets will operate, [promoters] often sell the tokens or coins rather than sell shares, issue notes or obtain bank financing. But, in many cases, the economic substance is the same as a conventional securities offering. Funds are raised with the expectation that the promoters will build their system and investors can earn a return on the instrument – usually by selling their tokens in the secondary market once the promoters create something of value with the proceeds and the value of the digital enterprise increases.” Accordingly, the SEC has found that most tokens which are labeled “Utility Tokens” are, Security Tokens.

A Security Token derives its value from an existing, outside and tradeable asset. This is in stark contrast to a Utility Token which is really a coupon for future use with no existing and tradeable asset. To really understand what a Security Token is, one should understand securities. Securities are basically tradable financial assets. These can be stocks, bonds, notes, shares, etc. A security is a way to own something without taking possession of the item. Securities are a way for companies to raise money from a pool of investors in the capital markets. These investors then are promised a return on their investment. When these things are accomplished through a token, the token is a Security Token.

The Howey Test.

When securities are involved, the SEC regulates them. How does a token become subject to SEC regulation? By meeting the criteria of the Howey Test. The Howey test was established by the Supreme Court of the United States to determine when a certain arrangement between parties involves an investment contract (security) which would be subject to SEC regulation. What is the Howey Test?

The Howey Test examines three criteria to determine if a token is a security for purposes of the SEC; (i.) there is an investment of money, (ii.) money is invested in a common enterprise and (iii.) the buyer expects to profit from the efforts of others. Depending on the facts and circumstances of each individual ICO, tokens offered or sold may be securities, and, in fact, most have been determined to be securities by the SEC. “I believe every ICO I’ve seen is a security,” SEC chairman Jay Clayton declared during his testimony before Congress. As always in life, there are of course exemptions.

If a token is deemed a Security Token, this is not necessarily a death knell for the token. The SEC provides specific exemptions for certain Security Tokens which allow these tokens to avoid registration with the SEC. The SEC allows exemptions under Regulation D, Regulation S, Regulation Crowdfunding, and Regulation A for issuing securities without the need to register the same. While an explanation of these exemptions is beyond the scope of this article, know that there are options to avoid registration with the SEC for a business whose token would qualify as a Security Token.

In addition to the Howey Test, the SEC has issued a list of questions that it considers in determining if a token is subject to SEC regulation:

1. Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?
2. Are independent actors setting the price of is the promoter supporting the secondary market for the asset or otherwise influencing trading?
3. Is it clear that the primary motivation for purchasing the digital asset is for persona, use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent?
4. Are the tokens distributed in ways to meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?
5. Is the asset marketed and distributed to potential users of the general public?
6. Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?
7. Is the application fully functioning or in early stages of development?

A token that passes these tests is deemed a security token for purposes of SEC regulation.

The Push for Regulation!

It is imperative that you know that the SEC is classifying the vast majority of tokens as “Security Tokens.” How does this affect your token? Your investment? The simple answer is greatly. However, there are benefits inherent in SEC regulation which will benefit the Crypto Space in the long-run.

Over the past year we have seen a great push, in the U.S. and overseas, for increased regulation of tokens. This is largely due to the nature of the token in relation to the financial industry. Truly, not since the invention of services such as mobile banking has there been such a revolution in the finance industry.

With great change, regulation is inevitable. Understanding new and disruptive technologies has never been a strong suit of government. However, regulation is inevitable given the effect on consumers in this space. One need only look at the wild swings, and fraud, associated with ICOs for an example of the growing pains associated with tokens. Governments are now attempting to address the rampant fraud and scams which are prevalent in the ICO markets. While there is great concern as to whether governments will be able to correctly regulate the space, there are some advantages to regulation.

Why is this important if you are a casual investor in tokens? If a token is classified as a Security Token there are heightened legal risks, duties and obligations that the issuer must consider. Compliance with these processes is a costly proposition. Accordingly, if you have invested in an ICO, and the issuer has not classified the token as a “Security Token,” then your investment is in trouble because your ICO token is most likely a Security Token. SEC Chairman Jay Clayton appears to believe that every ICO he has seen is a security, remarking that he wants “to go back to separating ICOs and cryptocurrencies. ICOs that are securities offerings, we should regulate them like we regulate securities offerings. End of story.”

This is exactly why a switch from the term ICO to STO is vital. If a user is informed in advance that the token they are investing in is a Security Token and subject to SEC regulation, they will be more informed and aware of the risks associated with investing in securities. After all, the average user is more aware of how securities are traded than cryptocurrency. Further, once classified as an STO, the user will know that the Security Token is properly classified and registered with the SEC.

How Much Regulation?

There is a lot of confusion as how aggressive the SEC will be in regulating Security Tokens. Preliminarily, we must remember that the SEC is not looking to stifle innovation. They are looking to protect the public. Therefore, it is important to the SEC to monitor and control the explosive growth of the Crypto Space.

The SEC and the Congress have taken a proactive and pragmatic approach to regulation of Security Tokens and a commitment to the growth of the Blockchain and other distributed ledger technologies.  During my recent visit to meet with the SEC, the CFTC and 12 different Congressional aides, I am happy to report that I saw nothing to indicate that these entities would work to stifle the growth of the technology.  To the contrary, they were very open to doing what they could to advance the Crypto Space.

Regulation of Security Tokens is not all bad. A review of the history of traditional securities indicates that regulation takes a big bit out of corrupt practices by issuers. Regulation will help to protect the consumer from scams, fraud and other corruption which are prevalent in the current ICO markets. This legitimizes the space while protecting consumers. Security Tokens will provide credibility to a space that has been suspect in the past. This is a net positive for regulation.

Our Conclusion

Whether you are contemplating a blockchain business or are an investor in tokens, it behooves you to understand the difference between Utility and Security Tokens, their regulation and the effect on the Crypto Space. Security Tokens are the next profound step in the development of the space. They are subject to regulation, but that regulation serves to legitimize the space and fight against fraud.  Whether you are a casual observer, or a dedicated blockchain business, you must know and understand Utility Tokens and Security Tokens.

Original Article Source – https://cryptoconsulting.substack.com/