An initiative of Coinbase, Coin Center, Union Square Ventures, and Consensys
Introduction
A blockchain token is a digital token created on a blockchain as part of a decentralized software protocol.
There are many different types of blockchain tokens, each with varying characteristics and uses. Some blockchain tokens, like Bitcoin, function as a digital currency. Others can represent a right to tangible assets like gold or real estate.
Blockchain tokens can also be used in new protocols and networks to create distributed applications. These tokens are sometimes also referred to as App Coins or Protocol Tokens. These types of tokens represent the next phase of innovation in blockchain technology, and the potential for new types of business models that are decentralized - for example, cloud computing without Amazon, social networks without Facebook, or online marketplaces without eBay.
However, there are a number of difficult legal questions surrounding blockchain tokens. For example, some tokens, depending on their features, may be subject to US federal or state securities laws. This would mean, among other things, that it is illegal to offer them for sale to US residents except by registration or exemption. Similar rules apply in many other countries.
The Framework focuses on US federal securities law because these laws pose the biggest risk for crowdsales of blockchain tokens. In many jurisdictions, there may also be issues under anti-money laundering laws and general consumer protection laws, as well as specific laws depending on what the token actually does.
This document is a general guide for developers and users of tokens.
Part 1 is designed to estimate how likely a particular token is to be a security under US federal securities law.
Part 2 sets out some best practices for crowdsales.
Part 3 is a detailed securities law analysis by Debevoise & Plimpton LLP.
As more fully set forth in the component parts of this document, the document does not constitute legal advice and should not be relied on by any person. Developers and users should consult their own counsel in connection with their initiatives in this area.
You should not rely on this Framework as legal advice. It is designed for general informational purposes only, as a guide to certain of the conceptual considerations associated with the narrow issues it addresses. You should seek advice from your own counsel, who is familiar with the particular facts and circumstances of what you intend and can give you tailored advice. This Framework is provided “as is” with no representations, warranties or obligations to update, although we reserve the right to modify or change this Framework from time to time. No attorney-client relationship or privilege is created, nor is this intended to be attorney advertising in any jurisdiction.
December 7, 2016
This work is licensed under a Creative Commons Attribution-ShareAlike 4.0 International License.
Based on a work at https://www.coinbase.com/legal/securities-law-framework.pdf.
Part 1: How to determine if a token is a security
The Howey Test
The US Supreme Court case of SEC v Howey established the test for whether an arrangement involves an investment contract. An investment contract is a type of security.
In the context of blockchain tokens, the Howey test can be expressed as three independent elements (the third element encompasses both the third and fourth prongs of the traditional Howey test). All three elements must be met in order for a token to be a security.
Using the Framework
Click here to access the framework (google sheet). Save a copy in order to use it, or follow the manual instructions below
Step 1: Access the google sheet or refer to the copy of the framework in the Appendix.
Step 2: Review each characteristic and determine whether or not it applies to the token.
Step 3: For the criteria that apply, add or subtract the corresponding points to get a total for each element.
Step 4: You now have three point scores, one for each element. Your lowest point score represents your overall risk score.
Please remember that this methodology produces nothing more than an estimate. You should seek your own legal advice, tailored to your own specific situation and considerations.
Part 2: Best practices in token sales
The following principles help inform and protect buyers, and increase the chances of a successful token sale, especially for a sale which occurs before there is a live network using the token. They are guidelines and are not designed for any specific situation. Please consult your legal and other advisors.
Most of these best practices do not directly affect whether a token is a security under the Howey Test.
Principle 1: Publish a detailed white paper | |
How? |
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Why? |
A white paper defines the network and its use cases. It is critical for buyers to be able to understand the characteristics and functionality of the token they are buying, the challenges and risks of development, and the benefits of using the network. |
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Principle 2: For a presale, commit to a development roadmap | |
How? |
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Why? |
A clear development roadmap gives buyers confidence that the proceeds of the sale will be properly used for the project and that the network will be launched, meaning that they will be able to use the tokens as intended. Setting aside funding for each stage of the project helps establish structure and allows buyers to assess the likelihood of success. Using blockchain features to restrict the development team’s access to funding can deliver more transparency. Members of the development team and advisors should be paid full and fair value for their services, through a combination of money and tokens. Quantifying the value of contributions, especially early contributions (pre-crowdsale) provides transparency. Identifying the development team and advisors helps potential buyers assess the credibility of the project and its potential for success. It reduces the likelihood of fraud. Note: Many aspects of Principle 2 only apply to token sales which occur before there is a live network using the token |
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Principle 3: Use an open, public blockchain and publish all code | |
How? |
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Why? |
Building with open source software and using an open, public blockchain provides transparency, enables real participation from token holders and independent developers, allows for auditing, and helps prevents fraud. Enabling real and meaningful participation in the network from a diverse set of independent parties may also strengthen the arguments against the second and third criteria of the Howey test, because participants are less reliant on the initial developers. |
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Principle 4: Use clear, logical and fair pricing in the token sale | |
How? |
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Why? |
The total proceeds from a crowdsale should not exceed the estimated costs of development. A crowdsale should be capped at the number and price of tokens required to raise this amount. Pricing mechanisms which increase over time can encourage irrational behavior (e.g. FOMO) and do not treat buyers equally. Setting the price in a single currency reduces the potential for confusion and arbitrage. |
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Principle 5: Determine the percentage of tokens set aside for the development team | |
How? |
Decide on the percentage of the total token supply that represents a fair reward for the work of the development team and advisors. Release those tokens to the development team incrementally over time (contingent on their continued work on the project). |
Why? |
Concentrating too many tokens in the hands of the development team and other contributors increases the risk of centralization of control of the network. On the other hand, setting aside too few tokens does not align the interests of the development team with the interests of other token holders. Releasing tokens to the development team over time aligns their interests with other users over a longer period. Releasing tokens to the development team over time also reduces the risk of affecting the market - it prevents large numbers of tokens from flooding the market at one time. |
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Principle 6: Avoid marketing the token as an investment | |
How? |
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Why? |
Marketing a token as a speculative investment, or drawing comparisons to existing investment processes, may mislead or confuse potential buyers. It may also increase the likelihood that the token is a security. Using a short, relevant disclaimer which accurately describes the risks of the tokens, protocols and network is useful. Long, legalistic disclaimers about the risks of investment are not helpful to buyers and may provide the impression that the token is an investment. |
Part 3: Detailed Securities Law Analysis
December 5, 2016
Securities Law Analysis of Blockchain Tokens
You should not rely on this Memorandum as legal advice. It is designed for general informational purposes only, as a guide to certain of the conceptual considerations associated with the narrow issues it addresses. You should seek advice from your own counsel, who is familiar with the particular facts and circumstances of what you intend and can give you tailored advice. This Memorandum is provided “as is” with no representations, warranties or obligations to update, although we reserve the right to modify or change this Memorandum from time to time. No attorney-client relationship or privilege is created, nor is this intended to be attorney advertising in any jurisdiction.
This outline sets forth our analysis as to whether cryptographic blockchain tokens (known as “Blockchain Tokens”) with certain features (in our parlance, “rights” versus “investment interests”) would be considered a “security” for purposes of Section 2(a)(1) of the Securities Act of 1933 (“Securities Act”) and Section 3(a)(10) of the Securities Exchange Act of 1934 (“Exchange Act”).
In order to analyze Blockchain Tokens under the federal securities laws, we start with the broad definition of “security” contained in Section 2(a)(1) of the Securities Act: “any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement ... investment contract ... or, in general, any interest or instrument commonly known as a ‘security’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing” (emphasis added).1
Based on that definition and our reading of relevant case law, as well as on our understanding of the facts and our review of the materials you provided on the structure of Blockchain Tokens, we conclude that appropriately designed Blockchain Tokens would not be deemed to meet the definition of security and, accordingly, that the federal securities laws would not apply to the initial distribution and subsequent trading of such Blockchain Tokens.2
We stress that this conclusion is dependent on the particular features of the relevant Blockchain Token. Accordingly, this outline first lists various rights that a Blockchain Token might have that we believe support the conclusion that it is not a security, as well as various investment interests a Blockchain Token might have that we believe would make such an instrument more likely to be considered a security. We then summarize the relevant legal principles for determining what constitutes a security, and why we conclude, based on those principles, that properly designed Blockchain Tokens are better considered something other than a security. Finally, we analogize these types of Blockchain Tokens to the rights of a franchisee or licensee, who would not be treated as a security-holder.
I. Nomenclature
II. A Preliminary List of Rights and Investment Interests
III. Analysis under the Howey Test
Expectation of Profits. Under this element, profit refers to the type of return or income an investor seeks on their investment (rather than the profits that the system or issuer might earn).4 Thus, for purposes of Blockchain Tokens, this could refer to any type of return or income earned as a result of being a Blockchain Token holder, which would be narrowed to the extent it is derived passively, i.e., from the efforts of others. Since courts consider this factor through the lens of the “efforts of others” factor, we analyze this prong along with the fourth factor below. In other words, just because there is a return or profit, does not mean that the investment contract is a security. It is the essentially passive nature of the return, as determined by the “efforts of others” analysis, that results in an “investment contract” and security as opposed to a simple contract instrument.
Solely from the Efforts of Others. Typically, courts have been flexible with the word “solely,” such that, in addition to the literal meaning, it also will include significant or essential managerial or other efforts necessary to the success of the investment. See e.g., SEC v. Glenn W. Turner Enters., 474 F.2d 476, 482-83 (9th Cir. 1973); SEC v. Koscot Interplanetary, Inc., 497 F.2d 473 (5th Cir. 1974) (holding that where promoters retain immediate control over the essential managerial conduct of an enterprise, rather than remote control similar to a franchise arrangement, this element is met); but see Hirsch v. Dupont, 396 F. Supp. 1214, 1218-20 (S.D.N.Y. 1975), aff’d, 553 F.2d 750 (2d Cir. 1977) (indicating that solely should have literal application).
We analyze the “expectation of profits” and “solely from the efforts of others” factors below:
The expectation of profits resulting from the purchase of a Blockchain Token would primarily relate to whether the holder receives (i) rights and/or (ii) investment interests. While non-security Blockchain Token holders may receive money or other forms of financial incentives by virtue of holding the token, we believe that any such incentives are derived through their own efforts, rather than through a passive investment (as would be the case with a Blockchain Token security).
Essentially, each of the rights allows the non-security Blockchain Token holder to utilize, contribute to or license the use of the system in various ways, none of which would be considered a passive investment. Rather, we see the non-security Blockchain Token holders as active participants, like franchisees or licensees.
Furthermore, although an issuer may have some managerial oversight over the system and the distribution of the Blockchain Tokens, if the holders retain voting rights related to changes to the protocol and other legal rights enforced through technical permissions, this would seem to strengthen the view that token holders have no reliance on the efforts of others. That said, security holders often have voting rights, so we do not view this point as being definitive.
We note that appreciation in the value of a non-security Blockchain Token after issuance, due to secondary trading, does not change our view that it is not an investment contract. For example, the value of license or franchise right can increase over time due to the secondary market. Such increases in value derive both of the efforts of the holder and from the system itself, so we do not view such changes as decisive.
We note that the manner in which the sale of a Blockchain Token occurs, particularly the promotion and marketing, may also affect the “expectation of profits” analysis. For example, if the language used to promote the Blockchain Token includes words like “investment,” “returns” or “profits,” the purchasers of the Blockchain Token may be more likely to expect profits from the efforts of others than if the Blockchain Token is promoted on the basis of the usefulness of the rights attaching to it.
Courts have also analyzed the existence of voting rights through this Howey factor. Whether voting rights are determinative of a security will be based on the facts at hand. For example, where (i) the holder is provided with rights that provide it with significant managerial control— i.e., the ability to participate in decisions that will affect the success of the enterprise; (ii) the holder has the resources and expertise to make a meaningful contribution; and (iii) the holder does, in fact, participate in management decisions, the instrument is less likely to be considered a security.5
Thus, in our view, similar to our analysis above, the existence of voting rights itself should not result in a Blockchain Token being deemed a security. Rather, whether a determination would need to be made as to whether the holder would be viewed as passive or reliant on the efforts of others. Given that holders of non-security Blockchain Tokens play a more active role by using, contributing to or licensing the use of the system, it is less likely that the voting rights in this regard would be viewed as a security.
IV. Other Analytical Frameworks
System License. Another potential framework by which to consider non- security Blockchain Tokens is by using the analogy of a software license, where the rights associated with the Blockchain Tokens could be considered in line with the contractual contours of such a license.
Software licenses typically are governed by contract law, and one way in which to categorize software may be through focusing on the legal rights of the licensor and what rights may be granted to the licensor. For example, the licensor’s rights would include the ability to grant or distribute all, some or none of the rights attached to the use of the software code (originally the licensor’s intellectual property), as well as the right to exclude certain parties from using any of those rights. Thus, the licensee would receive either all of these rights, or a portion of these rights, depending on what the licensor grants.
For the purposes of Blockchain Tokens, this structure would be applicable in the following manner: (i) the issuer acts as the licensor of the system, which includes the underlying protocol, as well as the associated rights; (ii) the token holder acts as the licensee, who receives those rights (or a portion of those rights) in order to use the underlying protocol and the overall system; and (iii) any associated rights provided to each token holder are accomplished through the initial issuance of the tokens (akin to negotiating a software licensing contract between two parties).
Franchise Law. Although we do not suggest that Blockchain Tokens fall under federal or state franchise law requirements, in thinking about the rights that might be included in a non-security Blockchain Token, we drew an analogy to franchise law.
Under the franchise structure, a franchisor operates as the overarching organization that owns the intellectual property of the franchise (and business plan) and has the authority to sell the franchise right to a potential franchisee. The franchisee is the person to whom these rights are granted.
In receiving these rights, the franchisee pays money to the franchisor, which can be an initial fee, an ongoing royalty or both.
Typically, state and federal laws governing franchises require franchisors to provide to prospective franchisees detailed information about the franchise. The disclosure obligations under the various federal and state franchise laws are primarily to mitigate the risk of loss to franchisees that make a capital contribution to the franchise.
The Federal Trade Commission (“FTC”) rules require a franchisor to provide a prospective franchisee with disclosures related to the trademark being used, the total investment needed to begin operations, the provisions of the franchise agreement and other related disclosure items related to receiving the franchise rights. 16 C.F.R. pt. 436.
New York franchise law has detailed disclosure requirements for the prospectus that the franchisor must provide to the prospective franchisee. N.Y. Gen. Bus. Law § 683, et seq.
California state law requires that a franchise agreement include certain protective rights for the franchisee should the franchisor terminate the franchise prior to its expiration date. The purpose of these provisions is to mitigate the loss of investment in the case of unlawful termination by a franchisor. Cal. Bus. & Prof. Code § 20020-22.
In a franchise, the franchisee puts forth the effort and work directly to build up the business in his/her location and the control or management of the franchisor is more remote. Thus, courts have held that a franchise interest should not be considered an investment security. See Koscot Interplanetary, 497 F.2d at 485; Lino v. City Investing, 487 F.2d 689 (3d. Cir. 1973).
We view the holder of a non-security Blockchain Token as being similar to a franchisee in that the rights granted by the Blockchain Token allow the holder to contribute to a system in a manner remote from the issuer of the Blockchain Tokens. In essence, the issuer provides the Blockchain Token holder with rights in the system by virtue of the associated Blockchain Token, rather than through a passive investment interest.
We believe that, despite the more decentralized framework of Blockchain Tokens, the franchise analogy is still useful based on how the initial issuer grants its intellectual property—i.e., the system and its underlying protocol—to each individual token holder. Under the franchise model, a franchisor grants its intellectual property (which may also include a business plan) to a franchisor. While a franchise results in a more uniform application of the intellectual property or business plan by each franchisee, in the Blockchain Token context, analogously, the token holder is granted access to a system, which is the baseline framework by which the token holder operates.
Further, we think it is useful to consider whether the use of disclosures—both to inform token holders of their rights (e.g., voting rights and other systems rights) and to demonstrate the nature of the Blockchain Token—may be useful to incorporate at the time of the issuance of the tokens.
V. Conclusion
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We hope this outline has been helpful. Please feel free to contact us with any further questions.
Foot notes:
1 |
We note that the Supreme Court has stated that the definitions of “security” under the Securities Act and the Exchange Act are treated as being the same, despite some technical differences. SEC v. Edwards, 540 U.S. 398 (2004) (citing Reves v. Ernst & Young, 494 U.S. 56, 61 n.1 (1990)). |
2 |
Our analysis is based on our discussions with you, the materials you provided and the law as it exists as of the date hereof. We have not considered any state or non-US law analysis, including that of federal preemption related to state blue sky laws, and this outline relates solely to the definition of security under the federal securities laws. We do not express any view on any other body of law or legal construct, including without limitation the franchise laws of any state. We are unaware of any court cases, SEC rules or releases that directly address the question discussed in this memorandum as to whether Bitcoin Tokens should be characterized as a securities for purposes of Section 2(a)(1) of the Securities Act. As such, the SEC or a court could reach an alternative conclusion different from those provided in this memorandum. |
3 |
However, in Teamsters, the court found, in the pension benefits context, that providing labor in return for possible benefits appeared to be more akin to obtaining a livelihood rather than making an investment. Teamsters, 439 U.S. at 560. Analogously, if Blockchain Token users are granted the right to mine in order to earn the eventual rights or rewards to a token, it might be reasonable to conclude that no investment of money had occurred. |
4 |
More specifically, profits may include all manner of returns, such as dividends, other periodic payments or the increased value of the investment—whether it is a variable or fixed return. See e.g., Edwards, 540 U.S. at 390. |
5 |
See, e.g., Williamson v. Tucker, 645 F.2d 404 (5th Cir.), cert. denied, 454 U.S. 897 (1981); Odom v. Slavik, 703 F.2d 212, 215 (6th Cir. 1983) (noting that “[t]he managerial powers vested in general partners and the express right of inspection of documents gives them the kind of leverage and ability to protect themselves that takes them outside the intended scope of the ‘34 Act”); see also Klaers v. St. Peter, 942 F.2d 535 (8th Cir. 1991) (finding no security where non-managing partners collectively had 80% voting power on “any items of partnership business which will substantially affect” the partners); Stewart v. Ragland, 934 F.2d 1033 (9th Cir. 1991) (finding no security even though each well was managed by an independent contractor after an examination of the “intricacies of the operating agreement” that laid out significant managerial powers retained by the non-operators, who were sophisticated investors). |
6 |
Edwards, 540 U.S. at 390 (noting that Reves applies to the term “note” as opposed to “investment contract”). |
7 |
Under Reves, if the purpose is, for example, to “facilitate the purchase and sale of a minor asset or consumer good, to correct for the seller’s cash flow difficulties, or to advance some other commercial or consumer purpose,” it is unlikely to be deemed a security. See Reves, 494 U.S. at 66. |
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Last updated December 7, 2016
Creative Commons License
This work is licensed under a Creative Commons Attribution-ShareAlike 4.0 International License.
Based on a work at https://www.coinbase.com/legal/securities-law-framework.pdf.