The SAFT Is a Symptom of Regulatory Uncertainty

Let’s put to rest a common misconception.

During a recent fintech conference at Georgetown Law, Brian Quintenz, a commissioner of the Commodity Futures Trading Commission, said that crypto-tokens offered in a pre-sale “can transform.” He added, “They may start their life as a security from a capital-raising perspective but then at some point – maybe possibly quickly or even immediately – turn into a commodity.”

This is how many understand the “simple agreement for future tokens” (or SAFT) concept – that the tokens start as securities and later become commodities. It’s wonderful to see that Quintenz is open to novel legal and policy arguments, but that’s not exactly how the SAFT model of token distribution is meant to work.

The impetus behind the SAFT structure is the fact that there is no bright line rule that determines which types of tokens are securities and which are not. Instead, what qualifies as a security can only be determined by an application of the flexible Howey test to the facts and circumstances of particular tokens. So, in the face of this uncertainty, someone who would like to pre-sell a token that they believe will be a commodity when it is delivered in the future can, in the present, issue a security that promises investors delivery of tokens once a functioning network or application has been developed and tokens can be used on it (i.e. a SAFT).

Once the tokens are delivered, and initial investors seek to sell their tokens on secondary markets to persons who may want to use the network or application, or perhaps to persons who wish to speculate on the future demand for the tokens, then it’s appropriate to apply the Howey test to the tokens to determine whether they are securities or not.

The bet that issuers and investors of a SAFT are making is that the U.S. Securities and Exchange Commission (SEC) or the courts, applying the Howey test at this point, will determine that the tokens are not securities.

So there is no “transformation” of a token from a security to a commodity. What we have instead are two separate things: a SAFT instrument that is and will always be a security, and a token that never was and won’t ever be a security. This is more than an academic distinction. Transformation is unheard of, while a two-step approach is novel, but not inconceivable.

No guarantees

There are two things to note about this arrangement. First is that this structuring is not guaranteed to work.

I and many others believe that when these tokens are delivered, there will be a good argument to be made that the tokens should not qualify as securities under the Howey test. But it’s just that – an argument – and the SEC and courts may not accept it.

Second, the argument depends on the facts and circumstances and the economic reality surrounding a particular token. In particular, the argument hinges on the value of the token not depending on the continued efforts of the original issuer, and that market demand for the token is driven by the token’s commercial or consumptive use in addition to speculation.

Again, there is no bright line test for which tokens are securities, and a token’s putative utility alone does not shield it from classification as a security.

Mission over minutiae

The SAFT approach is very clever, but cleverness is often the hallmark of poor legal reasoning. In this case, however, there’s reason to believe that the SEC should want to look kindly on this clever argument.

We have to remember that the SEC’s mission is not to robotically apply securities law, whatever the outcome. If it were, we wouldn’t have such a flexible case-by-case test for securities. Instead, the SEC’s mission is “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” Its application of the securities laws is in service of that mission.

With that in mind, put yourself in the shoes of an SEC commissioner. What state of the world would you want? One in which token presales are always offered to the public – including unsophisticated moms and pops – and hopefully they will buy them for their use rather than as a speculative investment? Or a world where developers, using a security instrument that you understand, limit pre-sales to accredited investors and only once the network or applications is functioning, and the tokens can actually be used, are they made available to the wider public?

It seems to me that a policy goal of protecting mom and pop investors and facilitating capital formation argues in favor of allowing a SAFT approach – even if it’s a novel and clever structure that pushes the bounds of current law.

Long-term aspirations

An even better policy might be for the SEC to issue guidance articulating clearly how it plans to apply the Howey test to token sales, or for Congress to write a new law creating a bright line test that excludes tokens with certain criteria from securities regulation.

And Congress should certainly consider creating a safe harbor for exchanges that list tokens that seem useful and don’t seem to be securities using some specific criteria, like GDAX’s new Digital Asset Framework.

But given political realities, the probability that the SEC or Congress will do this in the next few years is probably pretty low.

While it’s certainly worthwhile to advocate for these potentially better approaches, I don’t think anyone can expect entrepreneurs to sit on the sidelines waiting for Congress or the SEC to act rather than taking a SAFT route, avoiding U.S. buyers, or avoiding a pre-sale altogether for token distribution.

A piece of the action

Finally, a SAFT approach has the unfortunate effect of potentially excluding the general public from participation (although perhaps not if a SAFT relies on the SEC’s crowdfunding rules).

But this is not a problem specific to token sales; it’s an issue of how our government has chosen to protect mom and pop investors – by creating incentives that limit many investment opportunities to the wealthy.

It might be time to do away with those limitations, but that’s a policy issue that’s about much more than token sales. And it’s great to see Blockchain Caucus co-chair Rep. David Schweikert working to do just that though bipartisan legislation – which recently passed the House – that would expand the universe of persons who can become accredited investors.

The lesson in all this? Don’t let the perfect be the enemy of the good.