Blockchain Utility Tokens : Throwing The Baby Out With The (Securities Regulation) Bathwater?
The digital asset road show continued this last week with The July 30th Senate Banking, Housing and Urban Affairs Committee hearing on virtual currencies and online market places, convened to hear “…how Congress should regulate digital currencies and blockchain technologies in the online financial market…”.
Just a few days earlier, on July 25th, the Securities and Exchange Commission’s (SEC) Division of Corporate Finance issued a ‘no-recommendation of enforcement’ letter’ (No-Action Letter) in favor of a Pocket Full of Quarters, Inc (PoQ), a blockchain powered gaming ecosystem built to create ‘…a universal gaming token…[and]… “ wallet for all of your games…”’ and eliminate “siloed video game economies” and their non-exchangeable inter-game currencies which leave an ever-increasing supply of unused gaming currencies on the table for gamers who cant take them to other platforms.
This No-Action Letter followed on from the SEC’s previous one for TurnKey Jet, Inc., dated April 3, 2019. In an earlier piece, “Is There Any Utility Left in Utility Tokens? The SEC Speaks”, we wrote about TurnKey and its token, essentially blockchain based jet cards allowing jet service ‘Consumers’, Brokers’ or ‘Carriers’ to redeem TKJ Tokens for jet travel services .
At or about the same time as TurnKey, the SEC issued guidance on the distinction between security token and utility tokens in its “Framework for ‘Investment Contract’ Analysis of Digital Assets” (Framework), giving a list of non-exhaustive factors in analyzing the distinction, representing the views of the SEC Strategic Hub for Innovation and Financial Technology rather than, formally, the SEC itself.
While Congress continues to debate digital asset regulation, with Facebook’s Libra being the poster child of these hearings, the United States blockchain token economy has been left to deal with a patchwork of decades old laws on securities, money transmission and other corners of the blockchain regulatory landscape.
Token driven blockchain startups, like PoQ, TokenJet and so many others are left trying to apply the existing regulatory framework, and, at times, inconsistent, statements, guidelines and no-action letters issued by the SEC and other regulators. Added to this is the maze of State regulation dealing, in particular, with securities and money transmission compliance.
While Congress debates, blockchain startups have the unenviable choice of innovating at risk of regulatory action or spending considerable sums seeking no-action letter. Some, as Congress is keen to point out, have left for more progressed digital asset locations, but doing so to cater to markets outside of the US regulatory domain is not generally a tenable alternative, unless the US market can happily be ignored.
Each No-Action Letter is tailored to its particular facts and clearly gives no certainty otherwise. But emerging from the haze of regulatory confusion and Congressional delay, there appears to be an outline of what may, in the current regulatory framework, be acceptable carve-outs from securities regulation of ‘consumptive’ or ‘utility’ blockchain tokens. An outline, though, which, sadly, may serve at best to stifle, at worst kill US blockchain innovation, essentially limiting blockchain tokens not requiring securities registration (or falling within an existing exemption from registration) to a definition certainly more conservative in scope than Wyoming’s consumptive or ‘open blockchain’ token concept and relegating these tokens to mere ‘arcade’ type credits . All this while Congress fiddles, caught in the regulate-or-not-regulate headlights of the tech giants’ assault on its monetary preserve.
So how is this outline taking shape? Extracting common themes from the PoQ and TokenJet No-Action Letters, gives us an idea, and key take-aways include the following:
- No Investment Intent: tokens must not be marketed, offered or sold for investment. The axis of the securities analysis ala Howey;
- No ‘Equity’ Participation: tokens can’t have dividend, distribution or other ‘equity’ type rights;
- Developed Platforms: use of tokens must be strictly consumptive, i.e. used to buy goods or services on, or access the platform. No pre-platform release, or funds in sale of tokens used to build the infrastructure. From the TokenJet No-Action Letter: “… Platform, Network, or App…[:]…each of these will be fully developed and operational at the time any Tokens are sold…”;
- Immediately Usable Tokens: no delay in token usability on the platforms;
- No Outside Transfer: all on-and off ramps for token usage to be limited solely to Platform wallets: no transfers to external wallets. Another key limitation on secondary market potential;
- Value Pegging: token price fixed to service value. Platform to sell tokens always at fixed price consumed or redeemed for that fixed value in services. Naturally, platform vendors can adjust the cost of their services or goods, requiring more or less tokens to purchase, but each token remains pegged at the $ value it was sold at. Another mechanism to prevent profit or appreciation ala Howey. Pegged tokens supplied by Platform administrators have little or no investment value: why buy on a secondary market where continuing fixed-price supply at source?;
- Correlation to Goods or Services Value: as per the PoQ No-Action Letter: “…there will be a correlation between the purchase price of Quarters and the market price of accessing and interacting with Participating Games…”. The scope or extent of this is not immediately apparent. PoQ acknowledges in its Incoming Letter, that although the $ price of the Quarters (tokens) would be fixed, game Developers could adjust the cost of the game by increasing the number of tokens needed to play.
- No Redemption at a Premium: another speculation-avoidance mechanism. No prospect for price appreciation on Platform redemption.
And the PoQ No Action Letter seems to have gone further.
While Turnkey Jet’s incoming letter to the SEC appears to indicate that the Token Jet Consumers would be able to transfer their tokens to other Consumers on the platform and that Token Jets may redeem TKJ tokens within its discretion, PoQ’s specifically limited gamers’ token transfers to consumptive use in game playing, putting the kibosh on inter-gamer transfers, and apparently excluding redemption directly from gamers.
What’s more, from the PoQ incoming letter to the SEC, (game) Developers and Influencers (game promoters), the other two other cornerstones of the PoQ platform, would only be able to transfer their PoQ tokens by way of redemption from the Platform for ETH at “…at pre-determined exchange rates by transferring their Quarters to the Quarters Smart Contract…”.
On PoQ, Developers and Influencers’ redemption of tokens for ETH would be in accordance with a prescribed formula which would“…take into account the number of Quarters being exchanged as well as the amount of ETH available in the Quarters Smart Contract at that time. Generally, the more Quarters a Developer or Influencer is exchanging, the greater the percentage of the available ETH they will receive…”. The amount of ETH available for redemption, having originally been paid in by gamers to buy PoQ tokens, would be reduced by a 15% return on investment payable to the holders of a separate, investment class of token holders, the Q2 Token Holders “… (to be subsequently distributed ratably to Q2 Token holders as a return on their investment in the Q2 Tokens), while … [the platform continues to hold…] 85% of the ETH from such sale at an address controlled by the Quarters Smart Contract…”.
In short, the PoQ No Action Letter seems to go further than Token Jet to constrict the ‘consumptive’ or ‘utility’ restrictions on utility tokens. Was this simply reflective of the further constraints PoQ placed on itself to ensure that it steered clear of SEC action?
And one may ask what use is restricting utility tokens to mere pre-paid credits? Why go to the extent and effort of building a distributed ledger ecosystem where all in essence you are doing is digitizing corporate jet cards or tokens to play games. Granted, particularly in the latter, there is more confidence and transparency where the objective is to create “a common in-game currency” in a gaming ecosystem to end or limit gaming token wastage and allow cross-game pollination, but the question we ask is whether this is achievable where gamers cannot transfer or redeem tokens for fiat or virual currency?
And why shouldn’t utility token holders be entitled to benefit from value appreciation, reflective of the robustness and success of the platform? Isn’t there, in any event, some degree of speculation potential in the PoQ tokens already, where tokens are tied to a pre-determined ETH price, perhaps a sort of future on ETH appreciation?
Not saying here that the tokens should be entitled to any dividend or distribution, or any ‘equity’ type rights in the platform, but the Framework’s statement that there is more likely an inference of expectation of profit (and hence classification as a security under Howey) where there is an “… appreciation in the value of the digital asset that comes, at least in part, from the operation, promotion, improvement, or other positive developments in the network, particularly if there is a secondary trading market that enables digital asset holders to resell their digital assets and realize gains…” seems to us to strip a material part of the innovation opportunity in blockchain. After all, it is blockchain’s solving of the “Double Spend” problem and the ability for platforms to incentivize its participants through the creation of digital assets which is a primary innovation.
And, nevertheless, the Framework, arguably, with some contradiction, does anticipate at least some token value appreciation, noting that “…[a]ny economic benefit that may be derived from appreciation in the value of the digital asset is incidental to obtaining the right to use it for its intended functionality…”.
We are not saying, by any means, that securities compliance is not required or important. To the contrary. However, for innovation to flourish here in the US there needs to be a middle ground. If not legislatively addressed, applying existing principles, and, continuing on a piece-meal basis, based on facts and circumstances presented by startups to meet their specific requirements in the moment, may result in a body of ‘practice’ which serves even more, through a series of No Action Letters, to further whittle away the scope for innovation, not to mention the prohibitive costs of seeking individualized non-enforcement comforts.
The fact that there is potentially a middle ground, is reflected in Wyoming SF0125’s definition of “digital consumer asset” meaning “…a digital asset that is used or bought primarily for consumptive, personal or household purposes and includes…” (emphasis added). The Wyoming system does not exclude value appreciation in the token, but emphasizes its consumptive primary purpose, coupled with requirements for notification (to the Wyoming Secretary of State) and ‘non-investment’ sale or marketing (HB0070).
While debates and hearings are good, it seems that Congressional digital asset reform efforts continue to quagmire in confusion, fear-of-Facebook, and, fundamentally, an apparent mismatched equation of the pressing need for innovation inspiring reform in enterprise blockchain with the Pandora’s box fear of undermining US monetary sovereignty or tech giant alleged disregard for regulation.
The July 30th Senate Committee hearings were no different. Sen. Sherrod Brown’s (D-OH) questioning why we need new rules and regulations to address this technology where apparently there aren’t any new ‘products’, tends to leave one a little pessimistic for the prospects for quick reform. The witness answering his questions seemed to suggest that while clarity was important, blockchain technology fits into existing regulatory buckets. The devil in the detail here didn’t seem to get across, at all.
This doesn’t need to be the case. Congressional hearings seem to spend a lot of time focusing on the potential for losing opportunity to Switzerland and other foreign blockchain ‘havens’. But these jurisdictions are not the wild-west. They, for the most part, have simply recognized that there is a mid-way between traditional securities regulation and blockchain innovation.
This nuance in the fleeting opportunity for US innovation by token driven blockchain startups in revolutionizing every-day practical applications, from secure identity repositories, to document authentication, to gaming, to the way we buy and sell, or own things, from fine art to real estate, needs to be recognized, and quickly.
The US has taken steps in this direction with the Token Taxonomy Act (TTA) and the Blockchain Regulatory Certainty Act making their (slow way) through Congress. But these, it is submitted, are not enough. The TTA, as currently crafted, appears to leave this line in the sand open to uncertainty.
There needs to be this statement of definition clearly delineating utility from security, without at the same time stripping utility tokens of value appreciation, or more colorfully put, throwing the baby out with the bath water.
All eyes are on Congress.
**Competent, specific legal advice from a suitable, licensed attorney, should always first be obtained before taking any action, and the information in this article should not be relied upon independently of that advice. Sam Miller is Founder: theFineArtLedger.com, the blockchain powered fine art title and authentication platform, art collector, and Rimon P.C. corporate finance attorney