This is adapted from a Reddit thread (shout out to my homeboys in /r/ethereum). It is a follow-on from an earlier piece, Against Tokens.

Warning: this blog post is long.

Today brings us a paper, written by Coin Center and Debevoise & Plimpton, and sponsored by Coinbase, USV, Coin Center and ConsenSys, which explores the question of whether tokens sold on a blockchain are or are not securities under the test of Howey v SEC.

Given what we know of the paper’s sponsors, the paper’s unsurprising conclusion is:

An appropriately designed Blockchain Token that consists of rights and does not include any investment interests should not be deemed to be a security, subject to the specific facts, circumstances and characteristics of the Blockchain Token itself…. given our analysis in the above, it should be characterized as a simple contract, akin to a franchise or license agreement.

Oh! So tokens are acceptable now, all is forgiven and this is now a valid business model?

Wrong.

So I’m going to spend the next 3,000 words taking Coin Center’s proposition apart. The paper arrives at this conclusion because it asks the wrong question. Of course it’s possible to do virtually anything on a blockchain in a legally compliant way, including representing an interest of some kind as a security or not, as any type of data entry you want, whether that be a “token” or otherwise. As one comment on Reddit put it, aptly,

you can make a tree branch into a security if you wrap it in the utterances and ceremonies which make it a tally stick.

This view, mind you, is what informed the innovation known as a private blockchain. With private blockchains, no cryptocurrency is involved and the rights and obligations of all the participants are set out neatly in writing somewhere – with the blockchain used as a distributed reconciliation engine for the participants.

But private blockchains aren’t what we’re talking about here. The instant case concerns the idea, per USV’s Fat Protocols post, that users of a “public” or “unpermissioned” cryptocurrency/blockchain protocol should

become stakeholders in the protocol itself and [be] financially invested in its success. Then some of these early adopters, perhaps financed in part by the profits of getting in at the start, build products and services around the protocol, recognizing that its success would further increase the value of their tokens.

This process/business model follows a simple four-step plan:

Developers have idea for a coin. Developers write an application, instantiate their new blockchain and sell tokens on that blockchain to fund development of the half-baked protocol they’ve already released (because, you know, they already sold the tokens). Developers and early adopters sell those blockchain tokens on public crypto-exchanges for profit; Bro down.

The question the paper does not directly answer, and the question everyone would like to see answered, is whether the method for conducting a token sale as they are actually done on a daily basis – the “Bro Down Model™” – is legally compliant.

Given what we are dealing with (selling unregistered investments to unsophisticated investors over the Internet) it is pretty easy for the answer to that question to be “no.” And to reach that conclusion, it doesn’t really matter whether we’re dealing with a security or not.

Let me break it down for you:

1A) Scenario A: Tokens = Securities

Let’s say, for sake of argument, that the tokens issued per the Bro Down Model do turn out to be securities or investment contracts, which is the only way that the “fat protocol” thesis currently being bandied about in the Valley and elsewhere makes any sense.

If something is sold with the expectation or intention that it’s an investment, irrespective of what function that thing performs, it’s going to be deemed an investment contract by the regulator. Investment contracts, as a matter of law, which are offered to the public may only be so offered through the filing of the appropriate documentation/registration statements, the publication of a prospectus and the sale by broker-dealers or equivalent, licensed service providers.

This would need to be done every single time an ICO/protocol offering takes place.

This process is standardised, straightforward, and legally certain. In the real world the process is absolutely mandatory for every offering of investments to the public. However, ICO promoters to date have all chosen not to follow this remarkably simple, standardized process.

Which is odd – since if these transactions were all above-board, legally kosher investments, as they have been marketed, I can’t see any reason why someone wouldn’t try to make them stand up to the scrutiny of the regulators. Surely an opportunity to legally access public capital markets with a simple coin is an opportunity too good to pass up.

But I digress.

1B) Please note: the argument that tokens are “not an investment” is nonsense

When cryptogeeks talk securities law, Dunning and Kruger are never very far away. A first-year trainee lawyer in a banking seat has the requisite training to see that blockchain token-sale transactions would not pass muster with the regulators. And by “not pass muster,” I mean not even close.

The entire “fat protocol” thesis re: blockchain tokens only makes sense if the tokens are in fact purchased for the purpose of investment and asset price appreciation. Which all ICO promoters, deep down in their hearts, know. But refuse to admit.

Let’s revisit the “fat protocol” blogpost quoted above, only this time, let’s put some text in bold:

become stakeholders in the protocol itself and [be] financially invested in its success. Then some of these early adopters, perhaps financed in part by the profits of getting in at the start, build products and services around the protocol, recognizing that its success would further increase the value of their tokens. (emp

That these tokens are envisioned to have value in market exchange is more or less admitted by Coin Center where the paper issues this recommendation:

(Scheme promoters should decide on) the percentage of the total token supply that represents a fair reward for the work of the development team and advisors.

yet the USV-sponsored Coin Center paper goes on to contradict itself by saying:

Marketing a token as a speculative investment, or drawing comparisons to existing investment processes, may mislead or confuse potential buyers. It may also increase the likelihood that the token is a security.

These ideas are, from a securities law perspective, not reconcilable. One cannot say something one sells to third parties is not an investment if (a) the value of that thing is tied to the performance of the project and (b) you plan to provide that thing to developers in consideration of their work on that project, with the expectation that they can cash out.

1C) Scenario B: Tokens ! Securities. Are we in the clear now?

No.

Coin Center’s 27 pages’ worth of legal gymnastics earlier today struggled desperately to explain why ICO transactions are not necessarily securities or investment contracts and are in fact some other kind of legal critter. So let’s be charitable and give Coin Center & friends the benefit of the doubt – and suppose they’re right.

This is still not a green-light where we can with confidence say

“OK, so the Bro Down Model is just like selling knitted jumpers from a local store. Let’s sell tokens willy-nilly. WORD UP.” *fist bump*

To the contrary: we have to explain what, exactly, these non-investment investment tokens actually are.

Even if token sales aren’t investment contracts, there’s unquestionably a contract somewhere in here to sell them. Where promoters plead “decentralization” to try to disclaim that any contract exists, there are still unquestionably inducements and representations made by promoters – marketing – to buy into these schemes, otherwise we would not know they exist.

Misbehaving in any way in relation to the promotion of a token scheme can still attract extremely serious criminal penalties of various kinds, depending on:

what the promoter said to third party investors in order to induce people to buy the tokens,

whether any of the promoter’s statements were untrue and misleading, or whether the promoter failed to disclose material information;

whether the sale is considered an unfair trade practice under applicable local statutes (as these things often are);

whether the promotion activity requires a licence;

how much money these buyers subsequently lose,

whether the regulator, and which regulator, takes notice of the activity.

A range of potential civil and criminal sanctions are therefore available depending on the fact pattern. They range from the relatively benign such as

innocent misrepresentation entitling the buyer/investor to rescind;

to the more serious such as

undertaking a regulated activity without authorisation (or equivalent in whatever jurisdiction you’re operating in);

to show-stoppingly, life-endingly, extremely serious e.g.

theft or fraud by false representation, or

a finding that the promoter engaged in unfair trade practices .

This is to say nothing of the tax consequences of operating such a scheme, liability for which (absent a legal entity) would arise personally against each of the scheme’s promoters, likely through the lens of a Partnership Act 1890 general partnership or local equivalent.

When enforcement comes, false or exaggerated statements are what is most likely to get scheme promoters into trouble. In terms of what statements we typically see made out in the field, cryptocoin promoters are not known for sober restraint and are usually not *that* careful with the representations they make.

2) If the tokens are designed to have intrinsic value, like Bitcoin, you’re doing it wrong

Assuming that “rights” exist at all – as the Coin Center paper does – presupposes the existence of a licensor/franchisor, i.e. someone against whom the “right” can be enforced. Tokens that follow the mold of Bitcoin or the “fat protocols” idea espoused by USV, on the other hand, are designed to have standalone value which is intrinsic to the token and does not depend on a third party to redeem or honour it.

These two approaches are mutually exclusive.

As anyone who knows how a crypto-token ICO works, “public blockchain” systems with exchange-listed tokens follow the latter approach (coins, intrinsic value, not redeemable). Where there’s no licensor/franchisor, there is only

the “fat” protocol,

its tokens, and

what those tokens are worth.

Because of this, it’s impossible for there to be legally binding licences or franchise agreements, because contracts require counterparties. The suggestion from Debevoise that we could characterise blockchain tokens created through a token sale as being licenses or franchises is therefore not accepted. Legally, what we’re dealing with is

an automatic, distributed software system, that

a promoter set up with money from unsophisticated “investors,”

which confers those unsophisticated “investors” no legal rights, and

which uses game theory to hold itself together – game theory backed by the money of new investors combined with the promise of astronomical returns made by the original promoters.

Here, as with many ICOs, there are no rights and obligations conferred – just tokens which serve no practical function and which value depends on whether people will buy them, and little else.

It is not therefore something I could recommend as a prudent structure for a transaction.

3) What if I don’t sell any tokens and just hold back a pre-mine?

Different set of issues, but still real potential for a crap sandwich. Including AML/KYC issues and money transmission issues. World of pain, etc.

4) Shenanigans

Trying to get around public offering rules strikes me as a bit of a minefield and not worth the risk.

The law wasn’t born yesterday. Saying a token is “purely functional” or a “software product”, so therefore “not an investment” is language we’ve seen before – the Federal Trade Commission observes that fraudulent investment schemes (of the non-cryptocurrency variety) often promise “consumers or investors large profits based primarily on recruiting others to join their program, not based on profits from any real investment or real sale of goods to the public. Some schemes may purport to sell a product, but they often simply use the product to hide their pyramid structure.”

For this reason, legitimate investments don’t try to walk the line – they try to be two miles away from the line, and on the right side of it.

It would be easier to just do things correctly, constitute your token as a security on a private chain and publish an offering circular. As Patrick Byrne’s T0 is planning to do.

But saying we should listen to Sherriff McLawdog all the time stifles innovation! I hear you cry.

Poppycock. If you want to get investment from someone, there are ready categories – VC, equity crowdfunding, bank debt, convertible debt – which a young blockchain entrepreneur can and should avail him/herself of in order to obtain working capital for his or her business. These legal classifications involve the entrepreneur obtaining that capital, usually from a sophisticated investor, after setting out a detailed business case and setting out in writing, the legal rights which his or her investor will obtain in the business in exchange for their money.

When someone is selling a coin, on the other hand, this means that someone is trying to get money very quickly from unfussy, unsophisticated investors who are grateful for the chance to get in on the ground floor of the “next big thing.”

Because they’re unsophisticated, in consideration they do not insist upon, and therefore do not receive, any rights in the business which those funds build in return (e.g. equity, interest, or a share in the profits).

I repeat: someone selling you a coin is bootstrapping their business with your money, and may very well be giving you jack squat – no stake – in their business in return.

Experience shows that unsophisticated investors are not particularly aware of how badly they’re treated by promoters of these ICOs or similar schemes.

5) Ignoring the law doesn’t mean it doesn’t exist

This, of course, is questionable from a legal perspective. Its questionableness would be more obvious if the coin-sellers were to promise a security and give you nothing in return; you could take your fake share certificate or fake secured loan to a lawyer, who could undertake some inquiries, and tell you whether the document were genuine/enforceable or not.

Turn a fake “share” into a “coin,” however, and suddenly all bets are off? I don’t think so – and I don’t think regulators such as the UK FCA or the Securities and Exchange Commission think so either although, for reasons known only to God, they have so far failed to drop the flaming hammer of justice on these schemes.

So, when we see a project not choosing a legal framework up front and saying “the software rules all,” it means, more often than not, that someone promoting a ICO has a compelling interest in not following the formalities because they’re out to screw you.

Doing things on a purely P2P basis has been shown to frustrate enforcement enough that, at least in the short term, scheme promoters are able to get away with it. But ignoring the law doesn’t mean it doesn’t exist.

Blockchains and cryptocurrencies are not a new paradigm in personal property or the law of obligations. When enforcement occurs – as it surely will – courts will look at the arrangements and take the initiative in classifying them themselves. That’s generally not a good thing – making an affirmative choice to be this thing or that (e.g. a LLC or a Limited Company) comes with significant tax, liability, or ease-of-doing-business benefits which you will very likely lose if you let a court make that decision for you (and, say, calls your blockchain critter a general partnership or a mere misrepresentation).

6) Conclusion: don’t buy it

The question then turns to why this subject is coming up again today, given how much the tech has moved on since the altcoins’ heyday (and collapse) three years ago.

I have no idea why any honest new business would want to run an ICO unless they were supremely poorly advised. Entrepreneurs owe their users better treatment, it’s commercial suicide from a VC or new business development standpoint, and creates a huge contingent risk of future enforcement action.

One theory I have is that some companies in the “blockchain” space got into Bitcoin or some other coin – hard – and possess such an intractably deep-seated loss aversion bias that they’re held in thrall to the Almighty Coins, unable to cast off their original thesis, and incapable of seeing what the space has become. Chiefly:

Bitcoin and internet funny money tokens are on the way out, and

good old-fashioned applied cryptography, business process/workflow automation and enterprise networking are on the way back in.

Because the only other plausible explanation for so many people thinking that crypto-tokens are appropriate investment products is that they’re all on drugs.

I’m going to give them the benefit of the doubt and assume they’re talking their own books.

The 2017 interpretation of the tech is not just legally correct, but it’s morally correct as well – and in keeping with the ethos of open-source software development. There’s nothing “free and open” about a FOSS protocol that costs money to use and causes a direct pecuniary benefit to accrue to early adopters – that’s called a rent, and imposing it runs contrary to the idea that the “free” in “FOSS” should mean both free as in beer and free as in speech.

A point which, over the course of 2017, I shall enjoy pointing out whenever it is prudent to do so.

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