The Securities and Exchange Commission had a busy week this last week on the topic of digital assets.
Unusually expressive on this topic, it released two publications April 3rd, the first its “Framework for ‘Investment Contract’ Analysis of Digital Assets” (Framework), and the second a ‘no-action letter’ in favor of TurnKey Jet, Inc. (No-Action Letter).
Both were hailed as milestones for the SEC in dealing with the vexing difference between security tokens, on the one hand, and mere utility tokens on the other.
Commentators hailed Turnkey as the first no-action letter in relation to an Initial Coin Offering (ICO), and noted this as a unique SEC response in its willingness to step into the hallowed ground of the difference between a securities issuance and mere ‘utility’ tokens ala Chairman Jay Clayton’s “book-of-month-club” participation-interest type tokens.
Some commentators went so far as to say that the no-action letter provides specific guidelines for the ‘public offering’ and promotion of utility tokens, allowing businesses who operate within this framework to adopt utility tokens free of securities law limitations.
However, although useful on their surface, the Framework and No-Action Letter when read together appear contradictory, and may further confuse the distinction between tokens as securities, and tokens as mere utility, ;book-of-the-month’ type tokens.
What’s apparently worse, is that the No-Action letter wholly miss-appreciates the essential role that utility tokens play in token-driven blockchain startups and blockchain enterprise as a whole.
In fact, while Turnkey may have the comfort it sought for its business model, its action in seeking the no-action letter may have shot other blockchain businesses squarely in the foot.
One is left asking whether the SEC wholly misses the importance of utility tokens in driving blockchain innovation, and whether it has gone too far in its narrow interpretation of what can safely not be a security token.
In short, one is left asking, is there any utility left in utility tokens?
In order to understand the basis for this view, some background on the No-Action letter is helpful.
In response to Turnkey’s incoming letter of April 2, 2019 (interestingly just one day prior to the SEC’s response), the SEC essentially vetted as non-securities requiring registration or exemption from registration under the Securities Act Turnkey’s use of blockchain-based “‘tokenized’ jet cards” (Tokens) to facilitate Turnkey member jet travel. It did so subject to the following functional caveats:
Turnkey would not use proceeds from Token sales to develop its platform and the platform must be fully developed and operational by the time any Tokens are sold;
Members must be able to use Tokens to purchase air travel at the time the Tokens are sold;Tokens are prohibited from being held in wallets external to the Turnkey platform;
Tokens to be pegged to a price of US$1 for the whole life of Turnkey’s token program, with each Token representing an obligation to redeem air charter services at US$1 per token;
Turnkey can only itself repurchase Tokens at a discount to is US$1 face value “unless a court within the United States orders TKJ to liquidate the Tokens”; and
Marketing of the Tokens must be limited to emphasizing the functionality of the Token, and not any increase in Token market value.
So, what we have is pure, vanilla ‘book-of-the-month’ type utility tokens. Simple, internal rights of participation, to which in truth, creating them as digital assets, serves no real broader digital industry innovative benefit. Turnkey cites payment efficiencies in casting what are simply traditional jet cards as digital assets. This may be true to their model. But for broader token-driven blockchain interests the narrow confines of the no-action letter plunges the viability of token-driven block chain businesses into further confusion.
Turnkey is not a case of a public offering of tokens or an ICO, as many commentators believe and proffer to the public. The no-action letter is a venture into the realm beyond public securities offerings, and to the very engine of what drives token-driven startups.
The ability to mint a digital asset unique to a startups’ platform is a key driver, and incentive in the use of these platforms, whether as a means of rewarding participation in the platform or reflecting the value of the platform’s utility. Token-driven curated registries are a key example of this, but it extends to any platform that has a viable business model and product for which its tokens are intrinsic to the purchase and sale of goods or services on or through the platform or the promotion of that platform.
Pegging Turnkey’s Token value to a dollar, restricting the flow of tokens to external wallets and similar caveats which the SEC imposed in the No-Action Letter simply may serve to kill innovation. Having a convertible digital asset, or token is an implicit need for the platforms. It shouldn’t, and doesn’t necessarily render these tokens securities. But by expressly excluding conversion in this No-Action Letter, the SEC effectively endorses the use of utility tokens to no more than glorified membership cards, airline miles or other similar stores of vale. It is true book-of-the-month-club type stuff.
While it is understandable to require a mature platform, or immediate use of tokens for utility on the platform or to not promote the tokens for investment purposes, all being key ingredients of securities analysis, conversion shouldn’t be one of them. Certainly to promote this SEC recipe as ‘safe’ guidance for minters of utility tokens, ignores the very fundamentals and rationale for token-driven blockchain businesses.
There is surely a space between regulation of securities offerings, and preservation of blockchain innovation, and the SEC appears to have stepped right stepped right in it.
This becomes evident, if not more confusing when one looks at the Framework, its ‘recipe’ for distinction between tokens as securities and utility. It does so in the Howey ‘investment contract’ context, which is completely understandable and in line with existing wisdom that ICO’s for all intents and purposes are securities offerings where there is an underlying enterprise and where there is a reasonable expectation of profit derived from the efforts of others. The underlying informational balance for these rules, between issuer and buyer of tokens is clear, and this the SEC emphasis.
This is all well and good. But it shouldn’t mean necessarily that just because a token minted by a startup is convertible to the digital currency of the platform on which it is built that it should be classed as a security. And the Framework doesn’t say this. To the contrary, it appears to set forth factors which may render the token sale not a security issuance. For example, the SEC includes as factors which render a token less likely to be a security, the following:
“…
With respect to a digital asset that represents rights to a good or service, it currently can be redeemed within a developed network or platform to acquire or otherwise use those goods or services. Relevant factors may include
There is a correlation between the purchase price of the digital asset and a market price of the particular good or service for which it may be redeemed or exchanged.
The digital asset is available in increments that correlate with a consumptive intent versus an investment or speculative purpose.
An intent to consume the digital asset may also be more evident if the good or service underlying the digital asset can only be acquired, or more efficiently acquired, through the use of the digital asset on the network.
Any 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…” (my emphasis)
So the fact that the SEC, on the same day, includes in its caveats in the No-Action Letter the prohibition on fluctuation of the Turnkey token is, it is submitted, contradictory to its own Framework issued on the same day. Again, it is one thing seeing a token purchased only to be converted and sold on an exchange without any correlation to platform utility. It is totally another to allow free value fluctuations relevant to the value of the goods and services on the platform or the platform’s worth where this incidental to their utility on the platform.
Naturally, both the No-Action Letter and the Framework are non-binding as far as others are concerned. The Framework says as much (“ …It is not a rule, regulation, or statement of the Commission, and the Commission has neither approved nor disapproved its content…”).
However, regardless, they set a dangerous benchmark, and with commentators hailing these publications as pronouncements on ICO’s or frameworks in which businesses can operate without undue concerns for securities violations, this only adds to the misunderstanding and confusion inherent in the security-not-a-security debate, and,perhaps, unintentionally sets a framework for innovation stifling.
Congress needs to act. There are bills in progress. Clarification is sorely needed before innovation is stifled for US token-driven blockchain startups.