This is the all important question you should be asking if you are thinking about creating your own token and you would like your token to be available to the US.
If your token is a security:
1. You have to abide by US securities law
2. You have to register your token as a security with the SEC
3. You cannot allow unaccredited investors in the US to purchase your token or receive your token (without registering your token as a security with the SEC)
4. You lose a lot of flexibility over the methods with which users can use, receive, or interact with your token.
In summary, you DO NOT want your token to be a security.
Technically, you could just block unaccredited investors in the United States from buying or receiving any of your token, and then you wouldn’t have to deal with US securities laws. However, this is challenging and undesirable for many reasons, so let’s just create tokens that are not securities.
Now, the logical question is, “How do I determine whether my token is a security?” The answer is using something called the Howey test.
The Howey Test
In 1946 in Howey vs SEC, the supreme court decided the following:
“The test is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others. If that test be satisfied, it is immaterial whether the enterprise is speculative or non-speculative or whether there is a sale of property with or without intrinsic value.”– SEC v. Howey Co., 328 U.S. 293 (1946)
[start-rant] Isn’t it depressing that we are still using the Howey test from the 1946 Supreme Court ruling about Orange groves to determine whether something is a security or not? And then based on the results of that test, you either have to (1) jump through a ton of legal hoops (which may ultimately ruin your token before it even gets off the ground), or (2) do nothing at all. And then, the test uses vague and hard to understand language making it difficult to determine whether something is a security or not… [end-rant]
Moving on… let’s digest The Howey Test in plain English. A token is a security if it passes each of these conditions:
1. An investment of money
2. In a common enterprise
3. With a reasonable expectation of profits
4. From the efforts of others
These are the 4 prongs of the Howey test and this is what is used to determine whether a token is a security or not. In fact, even if something is not called a token it can still be a security. The nature of the investment is more important than the name of the investment.
Let’s dig in to talk about the legal nuance of each condition.
An Investment of Money
This has been interpreted fairly liberally to mean any investment of any kind: money, crypto, services, or other efforts. This is a pretty broad interpretation that includes almost any kind of effort whatsoever.
In a Common Enterprise
This is related to whether token holders share increases/decreases in the value of the token or receive fees for holding token. The common term for when this is the case is “horizontal” commonality.
Reasonable Expectation of Profit
This includes aspects such as the intent of the token, the marketing of the token, and the planned efforts to go into the token application or community.
Common questions center around whether token holders get a return of some sort (interest, dividends, rewards, buybacks), whether the token was marketed with language commonly used with securities that could indicate an expectation of profit, or suggesting the token value may go up due to effort to increase the value of the token.
From the Efforts of Others
Remember that in order to qualify as a security, the token has to pass all 4 of the Howey prongs (meaning each of these criteria is true for the token). So even if there is a reasonable expectation of profit, it has to be “from the efforts of others”.
“From the efforts of others” focuses on whether the project is fully developed (you can’t rely on the efforts of others as much if the product is already fully functional) and whether the product is used by many unaffiliated parties. So the more decentralized the product or community the better for this prong.
The “Is My Token a Security?” Questionnaire
Even breaking down these 4 Howey prongs in plain English still doesn’t give us a lot of clarity on whether a token is a security or not. The legal language is vague and hard to interpret, especially for complicated technical projects.
So let’s dig deeper!
I found an excellent questionnaire that you can fill out for your token to provide guidance as to whether your token may be a security or not. The questionnaire was retrieved from here, and you can read more about the framework here. The questionnaire PDF was still a little complex to use, so I ported it over to an easy to use spreadsheet and automated all of the calculations. Because of copyright restrictions I can’t widely share this spreadsheet (I’m working on getting permission but it might not happen). If you would like a copy of the spreadsheet version of the framework, send me a message and I can share with you privately.
The questionnaire is long and the questions are intense, so don’t go into this process half-hearted. In fact, have multiple team members take the questionnaire independently and then come together and discuss the results. Note that this framework is meant to be a guide to help you think more critically about whether your token is a security. The actual determination of whether something is a security rests with the SEC (in the US).
Remember that even if you get a score in the 3s or 4s it doesn’t mean your token is a security. If you get a 3 or 4 it means there are similarities between your token and a security, but there are still persuasive legal arguments for why your token is not a security. If you get a 5, your token is likely a security (although a 5 is still not certain), which means you should follow up with appropriate legal authorities, perhaps register your token with the SEC, or make some changes to your token to avoid legal restrictions.
We still don’t have a widely accepted token standard yet on the Internet Computer, so we all still have time to determine whether we will raise money with a token sale, do an airdrop, or integrate tokens into our applications. When you start to think about your tokenomic model or raising money through a token sale, make sure you come back and fill out the “Is My Token a Security?” questionnaire to stay on the right side of US securities law.
Note: this is not legal advice and I am not a lawyer. This questionnaire is meant as a guide and may not be sufficient to determine whether your token is a security or not. Please seek your own legal counsel to more fully determine whether your token is a security.
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