In November 2017, Chairman of the Securities and Exchange Commission (SEC) Jay Clayton said he has “yet to see an ICO that doesn’t have a sufficient number of hallmarks of a security.” This statement, along with a marked uptick in regulatory action at both the state and federal level have caused many to speculate that a true ‘utility token’ ICO is either extinct, or a mythical unicorn. It is likely they are partially correct.
The most obvious approach to this address the Chairman’s concerns is to treat a token pre-sale like a security. Regulation A+, Regulation D Regulation S, Rule 144, etc. offer a way to launch a token as a security without conducting a Public Offering. However, if a token is a security at the time of pre-sale, is it always a security? More importantly, if not, how can companies convert their securities to utility tokens?
This is hugely important. Publicly held equity securities (held by 500+ unaccredited parties of record) require that the company comply with ’34 Securities Exchange Act and Sarbanes Oxley requirements. They can be traded “over-the-counter” which requires a market maker; or on regulated exchange. T0 may one day be the first, but today there is no legal way to list certain security tokens for retail sale on a public exchange in the US. This isn’t the #1 topic today because security tokens often have a one year lock-up period, but this will be a huge concern when security tokens are freed. A token which cannot be publicly traded on easily-accessible exchanges will always have impaired value and functionality.
There is hope, though. Secretary Clayton did also say, “just because it’s a security today doesn’t mean it’ll be a security tomorrow, and vice-versa.” If the tokens which start as securities can become utility tokens. The question is, how?
Several options have been proposed for how security tokens can evolve into utility tokens; however, none has been proven.
- Start with Simple Agreement for Future Tokens (SAFT). Here, fiat or common crypto is exchanged for traditional paper documents that will be converted or exchanged for utility tokens upon certain conditions being met. The SAFT is considered an ‘Investment Contract.’ and therefore falls within the definition of a “security” under section 2(a)(1) of the ’33 Securities Act. One advantage of this approach is that tokens are not issued until the platform is live, increasing the possibility that the token would not be considered a security under the Howey Test. In addition, Investment Contracts fall within a known and predicable regulatory framework.
- Start with a security token which evolves into a utility token: This includes:
- Issuing the ICO outside of US jurisdiction, and opening sales to US persons when the tokens qualify as utility tokens;
- Issuing the ICO under Regulation S or Regulation D (or theoretically Reg A+), and at such time that the lock up period has expired, and the tokens qualify as utility tokens, allowing retail sales to US persons or persons in the US.
Compliance with SEC exemptions may also require the ability to restrict token sales on the secondary market. Those familiar with ERC-20 tokens know this is not currently possible.
It’s easy to assume that when Clayton said “The use of a [utility] token evolves over time. The use can evolve toward or away from a security” he means that he is looking for functioning platform. However, there’s more to it than that. Recently he stated “If I have a laundry token for washing my clothes, that’s not a security. But if I have a set of laundry tokens and are offered to me as something I can use in the future and I’m buying them because I can sell them, that’s a security.”
In this laundry example, the laundry network is built, but he still considers this a security. Probably because the tokens are bought for appreciation and not usage. Likely then that the Chairman believes utility tokens do exist, but are few and far between. If it is possible to issue a token that evolves from security to utility, a central requirement will be that a legitimate utility token is contemplated as the end result, which means taking into account all four Howey test elements.