Performing a Howey Test analysis on your ICO - or, why your token, even your utility token, is almost always a security
Virtual currency clients are used to pushing the envelope. They're on the cutting edge of the next great species of digital innovation. Blockchain technology is already the revolution in finance and society we dreamed about as children.
For this reason, blockchain innovators sometimes act like they're beyond the rules. So many of my clients come when they're at the eleventh hour in response to a terrifying action from the Securities and Exchange Commission, or a complaint from a state regulator, or a nasty demand letter from an investor or lender demanding to know why they're underwriting an enterprise they didn't know was illegally trading securities.
The most shocking thing about it from a legal perspective is that the cost of complying with the applicable securities regulation is trivial compared to the consequences of ignoring, defying, or trying to dodge them.
The problem that many innovators share is that they often just don't know what they don't know. Many ICOs are launched by courageous young entrepreneurs who aren't even aware of the vast spectrum of securities regulation. Or maybe they've gotten bad advice - maybe they've been told that just because they call it a "utility token" and sell it as a component of technology rather than as an asset issued by a company means that they're in the clear.
They're not. I'll walk you through the Howey Test, but the long and short of it is that your new token, even if you call it a "utility token," is almost certainly subject to securities registration requirements.
The test is named for the first lawsuit that explicitly stated the components of the test, which stated as questions, are:
- Is the alleged security offered for an investment of money?
- Is there an expectation of profits from the alleged security?
- Is the money invested into a "common enterprise?"
- Do the profits come from the efforts of a promoter or third party?
Prongs one and two of the test are simple. Do you want to make money off of what you're selling? Then yes, step 1 is met. Further caselaw elaborates that step 1 is extremely broad. Investment of equipment or other assets with a readily-ascertainable free market value (for example, other virtual currencies) still counts. And hopefully the answer to step 2 is yes.
Step 3 requires a little bit of definition. A "common enterprise" does NOT mean that you have to be an active participant in the enterprise. It does NOT mean that the enterprise in question must be open to the entire world, nor does it mean that it must be closed to a select few. It means only that multiple people must be acting in concert, usually by also making investments for money.
Step 4 should always be yes. If your company is working to improve the value of the coin it is issuing in any way, then yes, congratulations!(?) You have "passed" the Howey Test, and now get to go shopping for a securities lawyer. (Feel free to see my article here for how to do that).
Misconceptions abound in the virtual currency community. Many a client will protest: but mine is a "utility" token! It isn't just a mislabeled piece of stock, it actually does something!
Unfortunately, the original case that created the Howey Test addressed this potential dodge directly: "it is immaterial whether the enterprise is speculative or non-speculative or whether there is a sale of property with or without intrinsic value" (emphasis added). Whether or not your token represents access to underlying technology is immaterial. Whether or not your actual product is a software suite or other service or product that has almost nothing to do with your token, and whether or not your token will ever have any appreciable valuable, are completely irrelevant to the Howey Test.
Looking at the test as a securities lawyer it is hard to see how any ICO could be made that does not fall within the broad parameters of the Howey Test. This is why it is so surprising to me that ICO issuers so rarely seem to get themselves good securities advice. Your coin almost certainly "passes" the Howey Test. Whether you choose to be proactive and undergo the very simple, almost routine SEC and state-level compliance this requires of you, or wait for a suit, a demand letter, fines, and possibly jail time, is your call. Make it wisely!