Security Token vs Utility Token
A crucial question that often arises in conversations with our clients is whether a digital asset that is being offered or planned to be launched soon will trigger compliance with security laws. The answer to the question typically is based on the analysis as to whether the client will issue a security token or a utility token.
A security token brings the business activities of the issuer under the purview of the Securities Exchange Commission (SEC). US Federal Courts and the SEC still rely on the Supreme Court’s Howey test to deem a token a security when there is an “investment contract”. The breakdown of the latter is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others
1 – An investment of money: any type of consideration will be sufficient to satisfy this first element;
2 – In a common enterprise: this exists when investments are pooled;
3 – Reasonable expectation of profits: this requirement is met when an investor is funding a project in exchange of a token with the goal to obtain a capital appreciation (not solely driven by macroeconomic factors) or participation in future earnings. Also, when a token is broadly offered and can be traded on a secondary market is an indication that the issuer is targeting investors that have a reasonable expectation of profits.
4 – Effort of others: this component is in place when a sponsor/promoter is in charge of the development, operation and promotion of the project for which the funds are collected in exchange of tokens. Therefore, when a digital asset is truly decentralized (such as Bitcoin), it shall not be considered a “security”.
In applying the Howey test, US Federal Courts carved out which tokens should not be treated as securities but as utilities. The decisive factor is whether the token purchased by the investors can be utilized immediately in the network developed by the issuing company. Some of the clues showing actual and existing utility of the token are: the value of the token is correlated to the amount invested and not expected to grow significantly; the token can be used to make payments or to receive goods or services; the marketing of the token by the issuer is focused on its functionality; trading on a secondary market is either not allowed or restricted to users of the network.
The distinction between security token and utility token is not merely cosmetic. Issuers of security tokens are required to comply with exacting federal and state securities laws, including either registering with the SEC, or satisfy an exemption at the time of the issuance of the tokens. The registration with the SEC is a very burdensome, expensive, and time-consuming procedure that would stifle the great majority of new projects in the industry. To avoid and limit unintended damaging consequences, at Cea Legal we provide assistance with analyzing the proposed token to be offered, drafting opinion letters regarding the nature of the token offered (security vs utility token), and taking steps to satisfy the SEC exemptions from registration, if necessary.