What is a Security? A Concept You Must Understand if You're Raising Money

If you are raising money for startup and especially if you are a blockchain startup intending to sell your company’s native tokens to raise money, you must understand what a security is and whether you are selling a security.

If you are selling a security, you must register with the SEC or find an exemption to registration.

What is a Security?

Section 2(a)(1) of the Securities Act of 1933, which defines what a security is, lists a wide range of instruments that are considered securities. This includes notes, stocks, bonds, and “investment contracts,” amongst many others. From reading this list alone, you cannot easily determine what a security is, so its definition has been refined through case law.

How Does the SEC Determine Whether A Blockchain Company is Selling Securities?

The SEC is a regulatory body that provides guidance and brings enforcement actions for violations of securities laws. On July 25, 2017, the SEC applied the Howey test to determine that DAO tokens sold by a German company called slock.it were investment contracts, and thus, securities.

Applying the same framework a few months later, on December 11, 2017, the SEC determined that blockchain tokens sold by a company named, Munchee, were securities. Because the tokens sold by these companies are securities, they were required to either register their securities or find an exemption to registration.

What is the Howey Test?

Under the Howey test, a security exists where the buyer invests money in a common enterprise and reasonably expects profits from the efforts of others. In other words, if someone buys your tokens, expecting you to make them a profit because of your communications to them, then it is likely that your tokens are securities under the Howey test.

When Are Tokens Not Considered Securities?

If we apply this to a real-life example of how tokens work, it can help you understand the Howey test. Imagine you’re at an arcade and you see a game you want to play. In order to play those games, you have to buy tokens. Even if you have money to play, you can’t simply stick your money into that machine and expect it to work. You have to exchange your money for tokens first.

Once you have tokens, you can insert the tokens in the machine and the machine will run, allowing you to play the games you want to play. The tokens act like a key that unlocks the machines within the arcade, allowing you use the machine as intended.

You may be given extra time in the game if you do well and you may even win prizes if you accumulate a certain number of points playing games in the arcade, but you don’t expect to resell the tokens for a profit.

When Would the Same Tokens Be Considered Securities?

The tokens described in the example above would not be considered securities. However, the very same tokens could be considered securities if the context of the sale were different.

For example, if the arcade owner decides that he needs to raise some money and sells you tokens on the promise that he will use the money to build an incredible arcade and create a secondary market where you can resell the tokens to buyers for a profit, then the tokens sold in this scenario would be considered securities even though they are physically the same token and have the same utility--the tokens sold in both cases can unlock the machines and allow you access to the games, but only the latter would be considered a security under the Howey test.

When Are Blockchain Tokens or “Utility Tokens” Securities?

“Utility tokens” are blockchain tokens that can be used to access a particular blockchain company’s goods or services. Like in the arcade example, the only way for you to access that company’s goods and services is to buy and use their utility tokens.

However, the SEC has made clear that merely having utility doesn’t exempt a token from the securities laws. Rather, the facts and circumstances underlying a particular transaction helps determine whether certain blockchain tokens are securities.

A Real Life Example

For example, a company named Munchee sold “utility tokens” that were meant to be used for customers to order food and for restaurants to advertise on the site--it was like a yelp, except Munchee only planned to accept payment in their own native tokens, the MUN tokens.

Although MUN tokens had utility, Munchee had not developed a platform where MUN tokens could be used and they also didn’t sell to customers that would actually use their tokens to purchase their services.

Instead, Munchee marketed their tokens to people who invested in blockchain startups by purchasing their tokens and Munchee also emphasized their efforts in making the MUN tokens more profitable, including building a website, attracting customers to that website to make purchases using MUN tokens, and creating scarcity in the token.

Based on these facts and circumstances, the SEC found that Munchee had violated federal securities laws because they they were offering and selling securities without registration or an exemption to registration.

What Does this Mean for Companies Selling Blockchain Tokens?

Last year, before the SEC published its cease and desist order against Munchee, some blockchain startups believed that securities laws did not apply to utility tokens or that the SEC would not take any enforcement action against blockchain companies raising money by selling utility tokens as long as these companies were not committing fraud.

Before the enforcement action against Munchee, it seemed like the SEC targeted companies that were committing fraud. However, since the Munchee proceeding, we now know that the SEC demands compliance from all companies offering and selling securities within the United States, regardless of whether their offering is fraudulent.

The SEC Enforces All Violations of Securities Laws, Not Only Those Involving Fraud

Munchee did not attempt to defraud their investors and was not advertising in a way that significantly differed from blockchain companies before them that also raised money by selling tokens. In fact, Munchee seemed to have followed a framework used by other blockchain startups raising money.

We now know that the SEC will take enforcement actions against companies selling blockchain tokens in violation of securities laws regardless of whether fraud exists. In addition, enforcement efforts are increasing.

Both Federal and State Enforcement Efforts Are Increasing

The SEC has created a task force to enforce violations of securities laws by blockchain companies and the states through the NASAA (the North American Securities Administrators Association) have coordinated an cryptosweep to go after violations of state securities laws.

Blockchain Startups Planning to Raise Money By Selling Tokens Must Understand What A Security Is and Comply with Securities Laws

Thus, if you are planning to sell blockchain tokens, you must understand whether you are selling securities and if so, comply with securities laws.


This article is also posted on Medium.


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This article is provided for informational purposes only and should not be construed as legal advice. Read our disclaimer here.

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