Can a Future Network’s Token Be “Presold” and Not Qualify as an Investment Contract?

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On June 14, 2018, the Director of the SEC’s Division of Corporation Finance, William Hinman, suggested “a digital asset offered as a security [could], over time, become something other than a security.”[2] This coincided with Director Hinman’s remarks that, based on his understanding of the present state of Ether, “current offers and sales of Ether are not securities transactions.”[3] This boon to Ethereum was tempered, however, by Director Hinman qualifying that he was “putting aside the fundraising that accompanied the creation of Ether.”[4] This appears to leave open the question: can a digital cryptocurrency, crypto asset or other digital asset (“token”) that is intended to be used or consumed in the future on a network, platform or other system (“network”) be “presold” today and not constitute an investment contract (and, thus, not constitute a security)?

The answer appears to be yes, but only in very narrow cases.[5] This article focuses on one of those narrow cases, but others may exist. Now, imagine receiving a token from a video game developer when you preorder an upcoming video game, which would allow you to download the developer’s game as soon as it releases and/or for a discount. This “preorder token” could not be transferred to anyone nor used for anything else. It would never get listed on third-party exchanges, and no person preordering the game would expect the value of their preorder token to appreciate. Just like when you preorder a game today, you assume at some point in the future you will get a video game from the developer to whom you gave your funds. A developer of a network should be able to presell tokens to users under similar facts and circumstances.

Like Director Hinman explained, when Gary (Plastic)[6] met Howey[7] it became clear that an instrument could be exempt under (or excluded from) federal securities laws, but sold in such a manner that it becomes part of an investment scheme—constituting an investment contract and, thus, a security under federal securities laws. In Gary (Plastic), the Second Circuit found the certificates of deposit that Merrill Lynch offered and sold to the plaintiff did in fact constitute “investment contracts” within the meaning of the federal securities laws because, as Director Hinman said, they were sold to the plaintiff as “part of a program organized by a broker . . . offer[ing] retail investors promises of liquidity and the potential to profit from changes in interest rates,”[8] despite the fact that certificates of deposit are typically exempt under federal securities laws.[9]

Director Hinman indicated that the “digital asset itself,” which is “simply code,” is the analogous instrument exempt under (or excluded from) federal securities laws, but the method by which the tokens are sold (i.e., “as part of an investment; to non-users; by promoters to develop the enterprise”) is what makes the non-security instrument an investment contract.[10] This is the moment Gary (Plastic) met Howey—the case in which the Supreme Court established the test for determining whether an instrument constitutes an “investment contract” under the Securities Act of 1933 (“Securities Act”).[11] In Howey, the owner of a citrus grove sold acreage in the grove through a contract that required W.J. Howey Co. (a subsidiary of the owner) to market, harvest and cultivate the citrus grove. The Supreme Court determined that the contract constituted an “investment contract” under the Securities Act because it involved “[1] a contract, transaction or scheme whereby a person invests his money [2] in a common enterprise and [3] is led to expect profits [4] solely from the efforts of the promoter or a third party.”[12]

Since the summer of 2017, the SEC has consistently used the Howeytest in analyzing whether the sale of a token is the sale of a security under federal securities laws; in each instance, the SEC found that the tokens at issue were sold as investment contracts.[13] There has been no indication that the SEC will stop using Howeyin determining whether tokens constitute investment contracts. So how can a token be presold by a network developer and not constitute an investment contract under Howey and Gary (Plastic)? If the reasoning of those cases is to be applied to tokens, then a token—that otherwise would not constitute a security under federal securities laws—could nevertheless be deemed a security if sold pursuant to, for example, an investment scheme, through which the value of presold tokens might appreciate.[14]

Luckily, Director Hinman provided some helpful cues for how to offer and presell tokens to users without those sales of tokens being deemed an “investment scheme” under the federal securities laws. In his remarks, Director Hinman called upon token developers to ask certain questions in developing and selling their tokens. In answering Director Hinman’s questions using the example of preorder tokens, the video game developer offering preorder tokens should, among other things, be able to answer each question as follows:

Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?

The amount of preorder tokens sold should approximate market demand for the video game under development. The developer should expect each purchaser of a preorder token to buy the token in order to ultimately use the video game once released. If the aggregate amount of preorder tokens mirror market demand for the video game, then it is less likely that purchasers of the preorder token are buying it as a speculative investment.

Are independent actors setting the price or is the promoter supporting the secondary market for the token or otherwise influencing trading?

The price of a preorder token should near what a purchaser would expect to pay for the video game under development. For example, the video game developer could set the price of a preorder token at a 20% discount to the market rate of $59.99 for a new game. If the developer limits (or outright prohibits) the transferability of a preorder token and does not list preorder tokens on any third-party exchanges, then the developer, in turn, limits (or eliminates) the risk that a secondary market will pop up for preorder tokens.

Is it clear that the primary motivation for purchasing the token is for personal 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?

By restricting the transferability of preorder tokens, it becomes unlikely a purchaser could use a preorder token for anything other than downloading the video game in the future (i.e., for personal use and not investment purposes). The video game developer might, in a preorder token’s terms of sale, ask the purchaser to represent that they plan to use a preorder token to obtain the video game under development and are not purchasing the preorder token for investment purposes. Since the developer will release preorder tokenscommensurate with market demand for the upcoming video game, the tokens are only being made available in increments that correlate with a consumptive intent.

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?

Similarly, each purchaser of a preorder token should only be able to purchase an amount of preorder tokens that seems reasonable to meet their needs (for example, it seems unlikely any given purchaser of a video game really needs more than a handful of preorder tokens). To address this, the video game developer could place a commercially reasonable limit on the amount of preorder tokens any one person can purchase.[15] To encourage purchasers to use their preorder token when the game has launched, developers could create a sunset window for expiration of the preorder token or, to the extent technologically feasible, ensure that the preorder token automatically triggers the download of the video game on the purchaser’s respective gaming account and/or device. This would incentivize purchasers to use the preorder token for its intended purpose, i.e., downloading the developer’s video game.

Is the token marketed and distributed to potential users or the general public?

One would expect the video game developer would advertise preorder tokens in the same method they would advertise any other preorder option for an upcoming video game. If the developer typically uses certain channels to advertise preordering its games, then preorder tokens should be similarly advertised. If the developer starts marketing preorder tokens through unusual channels (e.g., running advertisements for preorder tokens on the soap opera TV channel), then it is imaginable that the SEC would be less likely to find that the developer marketed preorder tokens to potential users.

Are the tokens dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?

A purchaser of a preorder token would have the ability to download a video game once launched, but would not have the ability to exert influence over the developer or the developer’s video game (besides, of course, complaining that the game’s Easter eggs were ultimately lackluster).

Is the application fully functioning or in early stages of development?

While the video game might not be fully functional at the time the developer sells the preorder tokens, the developer itself will be at a particular stage of development. If the video game developer is Nintendo, for example, then there is little risk that a preorder token issued by Nintendo would be purchased as a speculative instrument. Purchasers of preorder tokens for the next Mario Party game assume Nintendo will be able to, in the future, release the next Mario Party game. In comparison, if an indie developer has never released a video game yet, then purchasers of preorder tokens from that indie developer are taking on more speculative risk and may, depending on the facts and circumstances, appear to be investing in the indie developer itself as opposed to purchasing a preorder token in order to use that indie developer’s video game once released.

As with the preorder token example, token developers interested in preselling their tokens should answer each of these questions. These questions, just as in Gary (Plastic), drive at the difference between tokens (like certificates of deposit) and the investment scheme used to sell tokens. If a video game developer were to offer and presell a preorder token in the manner described above, it would appear reasonable for the developer to take the position that neither the preorder tokens nor the manner in which they were sold constitute an investment contract under federal securities laws and, thus, application of federal securities laws to preorder tokens would be unnecessary.A similar analysis may hold with respect to other token presales, but every case would have specific facts and circumstances relevant to that determination. For one thing, the video game example above may be far simpler than many token presales because there is a product or service that is ultimately provided by the centralized issuer exclusively rather than by a decentralized network of unaffiliated participants. If the issuer of a token is also the only service provider on a network, then it might be easy for them to limit future uses of their tokens once delivered—the issuer would accept one token for one copy of the game and that’s the end of it. If purchasers anticipate a decentralized network, then there almost invariably will be speculation about future uses or transferability of tokens that may be out of the issuer’s control by design—a token may be redeemable for certain goods or services with price, quantity and quality dependent on the number of persons who join the network as suppliers and on how those unaffiliated persons ultimately behave. In these cases, it is far more likely that a presale of a token will be a sale of a security.

Additionally, token issuers that presell tokens in this manner should remember that their presales of non-security tokens will still need to comply with other federal laws outside of securities laws. For example, even if a token issuer’s presale tokens do not constitute securities, the token issuer will still be subject to truth-in-advertising laws enforced by the Federal Trade Commission, so their advertisements about the tokens and any associated network will need to be truthful, not misleading and potentially even backed by scientific evidence. In this sense, purchasers of tokens that are presold in the manner described above will still have federal protection against fraud and misrepresentation.[16]

While token presales, structured like the sales of preorder tokens described above, represent one of the most likely manners by which token issuers can presell non-security tokens to potential users of future networks, there are other avenues for token presales that may exist (including, for example, a determination by Congress or the SEC that certain types of tokens, such as stablecoins, are exempt under (or excluded from) federal securities laws). This preorder token structure, however, should be a useful starting point for those developers seeking to presell tokens—that are intended to be used or consumed on a future network—in a manner so that their presold tokens do not constitute investment contracts under Gary (Plastic) and Howey.

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[1] Julie Krosnicki is an associate in the Fintech, Blockchain & Cryptocurrency Group at Wilson Sonsini Goodrich & Rosati (“WSGR”). This article expresses the views of the author and does not necessarily represent the views of WSGR, the author’s colleagues at WSGR or clients of WSGR. This article is for informational purposes only and is not intended to create an attorney-client relationship or constitute professional advice as to any particular situation.

[2] Director William Hinman, Division of Corporation Finance,Digital Asset Transactions: When Howey Met Gary (Plastic), Remarks at Yahoo Finance All Markets Summit: Crypto (June 14, 2018) (“Director Hinman Remarks”).

[3] Director Hinman Remarks, note 2. See alsoDave Michaels, Ether Shouldn’t Be Subject to SEC Regulation, Official Says, W.S.J. (June 14, 2018).

[4] Director Hinman Remarks, note 2.

[5] This could, of course, change as facts and circumstances and/or applicable laws, rules and regulations change.

[6]Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 756 F.2d 230, 239–41 (2d Cir. 1985),cert. denied, 498 U.S. 1025 (1991).

[7]SEC v. W.J. Howey Co., 328 U.S. 293 (1946).

[8]Gary Plastic, 756 F.2d at 230 (finding plaintiff invested “in reliance upon the efforts, knowledge and skill of Merrill Lynch”). Director Hinman Remarks, note 2.

[9] Section 3(a)(2) of the Securities Act (15 U.S.C. § 77c(a)(2)) (exempting certificates of deposit issued or guaranteed by the U.S. federal or state government).

[10] Director Hinman Remarks, note 2.

[11] The owner of a citrus grove sold acreage in the grove through a contract that required W.J. Howey Co. (a subsidiary of the owner) to market, harvest and cultivate the citrus grove. The Supreme Court determined that the contract constituted an “investment contract” under the Securities Act. SEC v. W.J. Howey Co., 328 U.S. 293 (1946).

[12]Howey, 328 U.S. at 301. In 1973, the Ninth Circuit expanded the phase “solely from the efforts of the promoter” to include “efforts made by those other than the investors are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.” SEC v. Glenn Turner, 474 F.2d 476, 482 (9th Cir. 1973);United Housing Found., Inc. v. Forman, 421 U.S. 849, 852 n.16 (1975) (expressing no view on the findings inGlenn Turner).

[13] In each case, the SEC focused on the current status of the tokens, not their future promise. See SEC v. Sohrab Sharma & Robert Farkas, Complaint at 5, 1:18-cv-02909 (S.D.N.Y. Apr. 2, 2018) (“Each of the investments offered in the Centra ICO . . . is an investment contract and, therefore, a ‘security’”); Munchee, Inc., SEC Order Instituting Cease-and-Desist Proceedings Pursuant to Section 8A of the Securities Act of 1933 (Dec. 11, 2017) (“Munchee Order”) (stating MUN tokens were “investment contracts” underHowey); SEC, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Rel. No. 81207 (July 25, 2017) (“DAO Report”) (finding investments in DAO Tokens created an investment contract underHowey). See also The SEC Has an Opportunity You Won’t Want to Miss: Act Now!, SEC Press Release (May 16, 2018) (announcing the SEC’s introduction of a mock “HoweyCoins.com” website intended to educate investors about fraudulent securities offerings in the form of initial coin offerings).

[14]Gary Plastic, 498 U.S. at 241.

[15] In theory, a purchaser of a preorder token should also be able to gift it to their friends and family without triggering application of the federal securities laws, but the ability to gift the preorder token would have to be closely monitored by the game developer so that a secondary market for preorder tokens did not pop up abusing this limited transferability. Because the developer would ultimately be liable for any abuse of this transfer right, it is safer to limit transferability entirely until there is greater clarity from regulators on non-security token presales.

[16] InGary (Plastic), the Second Circuit specifically noted the application of federal law to the certificates of deposit protected investors and applied federal securities law to the activities from which investors were not protected. Gary Plastic, 498 U.S. at 241 (“The banking laws protect investors from the abuses and misrepresentations of [the issuer of the certificates of deposit, the deposit bank]. The securities acts regulate [Merrill Lynch as the market maker, the investment bank].”). An alphabet of regulators (including the SEC, the CFTC, FinCEN, the IRS, the DOJ, the Treasury Department, the FTC, FINRA and various state agencies) may be able to, depending on the facts and circumstances, assert jurisdiction, potentially concurrently, over tokens and entities involved in or activities associated with token presales. See CFTC v. McDonnell, 287 F. Supp. 3d 213, 222 (E.D.N.Y. Mar. 6, 2018) (“The SEC, IRS, DOJ, Treasury Department, and state agencies have increased their regulatory action in the field of virtual currencies without displacing CFTC’s concurrent authority.”).