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Aaron Wright @awrigh01
, 48 tweets, 19 min read Read on Twitter
Late last week Bill Hinman from the SEC gave a speech that outlined a handful factors that lawyers and projects should use “in assessing whether a digital asset is offered as an investment contract and is thus a security.”… (towards the end)
These factors indicate that many of the tokens sold via an “ICO” run the risk of being deemed a security.
They also shed some light on previous statements from the SEC and highlight risks that I and others at @TheBKP_Official previously flagged. A more detailed analysis follows below.
@TheBKP_Official The first thing to note is that Hinman framed these factors as assessing “whether a digital asset is offered as an investment contract.”
@TheBKP_Official It is noteworthy that Hinman describes the inquiry as whether the digital asset is sold *as* -- not through -- an investment contract.
@TheBKP_Official This seemingly indicates that the staff may not agree with the argument made by some commentators that …
@TheBKP_Official … a token whose intrinsic factors are consumptive in nature -- i.e., a “consumer” or “utility” token -- is always, from a securities law perspective, distinct and separable from an “investment contract” through which it may have been sold.
@TheBKP_Official It seems that selling a token through an investment contract, such as a pre-sale agreements SAFT, will still create securities law risks for the token itself.
@TheBKP_Official As described by Hinman, the primary factor in determining whether a token will be deemed a security is “whether a third party – be it a person, entity or coordinated group of actors – drives the expectation of a return.”
@TheBKP_Official To make such a determination, Hinman articulated six factors.
@TheBKP_Official The first factor is: “Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value?”
@TheBKP_Official This factor is hardly surprising. And, in many token sales, this first factor weighs in favor of finding a token a security.
@TheBKP_Official Even after a token is launched, many of these projects anticipate maintaining the core code base of the project and making ongoing improvements to the blockchain-based application or protocol.
@TheBKP_Official If the project does so, it runs the risk of the token being deemed a security (at least initially).
@TheBKP_Official Factor two: “Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? …
@TheBKP_Official “... Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?”
@TheBKP_Official As with the first factor, most token sales currently contemplate that a person or group of persons will retain some portion of the generated tokens, thus weighing in favor of characterizing a token as a security.
@TheBKP_Official This second factor appears to serve as a rough proxy for determining whether the party or group initially creating the token will be motivated to support the ongoing development of the platform and thus be motivated to increase the value of the token.
@TheBKP_Official Query whether this means that projects will no longer retain a significant portion of the generated tokens to avoid securities law concerns. Query further what this means for projects where ownership is highly concentrated (e.g., Ripple/EOS)
@TheBKP_Official Factor three: “Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise?”
@TheBKP_Official This factor seems to use the total amount raised as another proxy for determining whether the original person or group generating the token (i) are creating a valuable enterprise of the type normally subject to federal securities laws, or ...
@TheBKP_Official … (ii) are incentivized to support the token and increase its value in a manner similar to an enterprise supporting the value of its security.
@TheBKP_Official In other words, if it reasonably costs $5 million to develop the underlying blockchain-based software protocol, why is a project raising $200 million--except to support or enhance the value of the token?
@TheBKP_Official Frankly, this factor strikes me as a bit odd. Even before “ICOs,” the #1 Kickstarted project raised $168 million, in excess of what was necessary to develop the project. That wouldn’t necessarily indicate that the sold good is a security.
@TheBKP_Official The fourth factor: “Are purchasers ‘investing,’ that is seeking a return?...”
@TheBKP_Official “… In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?”
@TheBKP_Official The fourth factor squarely goes to the manner of sale, and strikes at one of the core problems with the SAFT and other pre-sale instruments flagged above.
@TheBKP_Official Most of these instruments and agreements confirmed that purchasers were “investing” and purchasing tokens to generate a passive profit.

Many tokens also were not sold to potential users of the network. Thus, these agreements may result in tokens being deemed securities.
@TheBKP_Official The fifth factor: “Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? …”
@TheBKP_Official “… Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?”
@TheBKP_Official In other words, do the creators or developers of the platform know more than investors thus creating a need for public disclosure? If so, this may support a securities law violation.
@TheBKP_Official In practice, as @angela_walch and others have noted, I don’t see how information asymmetries won’t exist for most blockchain-based protocols.

The developers and ardent users/supports understand these systems better than the public. There always will be a gap.
@TheBKP_Official @angela_walch It also seems that information asymmetries will equally exist if the token is sold to “accredited investors.”
@TheBKP_Official @angela_walch As others have recognized, many accredited investors are not all that sophisticated, especially given the complexity surrounding blockchains. If a token is sold to investors, the need for ongoing disclosures would appear to be higher.
@TheBKP_Official @angela_walch The last and sixth factor is: “[d]o persons or entities other than the promoter exercise governance rights or meaningful influence?”
@TheBKP_Official @angela_walch This factor goes to whether there is a common group or individual that regulators can turn to in order to impose disclosure obligations.
@TheBKP_Official @angela_walch It also goes to questions of “decentralization,” a standard which is murky under existing law and will require more thought and discussion.
@TheBKP_Official @angela_walch Taking these six factors as a whole, we see why the SEC has indicated that most token sales may involve the sale of a security.
@TheBKP_Official @angela_walch Many token projects to date were: (i) created by centralized companies or identifiable groups of individuals; (ii) these projects retained material portions of the generated tokens; (iii) many raised more capital than they needed to launch the project; ...
@TheBKP_Official @angela_walch (iv) the tokens were directly sold and marketed to investors and not consumers; (v) information asymmetries exist as to the development of these projects; ...
@TheBKP_Official @angela_walch .. and (vi) even after these projects are launched it is not anticipated that anyone else beyond the initial promoter will provide meaningful governance rights or influence.
@TheBKP_Official @angela_walch If the above is correct, that means that most tokens sold in 2017 run the risk of being deemed securities unless and until they can established the underlying blockchain-based network is “decentralized.”
@TheBKP_Official @angela_walch The “decentralized” exception may apply to some projects, but likely not many.
@TheBKP_Official @angela_walch For example, this exception may only apply to open source protocols that distribute the tasks for operation and governance to multiple different parties on the network. That doesn’t cover many current “ICO” projects.
@TheBKP_Official @angela_walch Importantly, it doesn’t seem as if it will apply once a project satisfies its initial promises as articulated in a white paper.
@TheBKP_Official @angela_walch It also likely will not apply just simply because a network is “functional” or operational, as some have argued.
@TheBKP_Official @angela_walch As a result, many tokens will need to be treated as securities on an ongoing basis (i.e., limitations on transfer). This will limit a token’s ability to be traded and accessed by everyday consumers.
@TheBKP_Official @angela_walch That’s why, again, it may make sense to raise funding through traditional ways and then distribute tokens to users if and when a project is ready. Hinman articulated some features of what that sale could look like. I’ll unpack those in another thread.
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