Why treating all tokens as securities would harm innovation
For decentralized networks, compliance would be impossible, and it would amount to a ban on trading
At least one member of Congress has suggested that crypto tokens, including cryptocurrencies like Bitcoin, should be treated as securities if the public invests in them. This is a wrongheaded approach, but it raises the question, what would be so wrong with treating all tokens as securities? After all, if we did, developers would just have to register their new tokens with the SEC, and exchanges would simply register as national securities exchanges or ATSs. Moreover, merely being classified as a security isn't an inherent burden; trillions of dollars of value are invested is securities. So, why is it such a bad idea?
There are two cases in which we believe securities treatment is reasonable, (1) promises to deliver a future token to investors and (2) tokens that represent specific contracted-for rights to profits from a developer’s efforts. (We will be posting more about this tomorrow.) In these situations, classifying the token agreement as a security is not overly burdensome and, indeed, is a sensible way to achieve investor protections through issuer disclosure and regulation of exchanges.
However, in the case of a token that is free of any contractual promises or associated agreements between issuers and holders, classification as a security is nonsensical and certain to harm innovation. Tokens that lack these contractual promises or associated agreements are without discernible issuers. Rather, their value stems from a large number of unaffiliated persons working in the same general industry, often as competitors.
The value of gold stems from innumerable persons digging it out of the earth, buying and selling it on open markets, and employing it in scientific, industrial or artistic pursuits. Similar to this, a token free of any contractual promises or associated agreements between issuers and holders has value (if it has any value at all) because innumerable persons are buying and selling it on open markets, while others are running the protocol software and maintaining the blockchain (e.g. mining), and still others are developing that protocol software through contributions to open source repositories, or developing software and applications that would utilize the underlying blockchain to accomplish valuable work.
It may be tempting to search for and then identify some particularly active software developer of the protocol, or some particularly successful miner of the blockchain, as an issuer for purposes of securities regulation, but this would be folly. For one, this is not the only person upon whom purchasers are relying. It would be sham compliance to take whatever disclosures can be squeezed from this one person as the full list of disclosures relevant to a purchaser with questions about the token’s value generally. Again, this would be akin to suggesting that the prospectus of one palladium mining corporation is a complete description of the risks and benefits inherent in investing in palladium. Such a sham disclosure is more likely to misdirect investors than it is to protect them. Individual miners may have some limited expertise but may nonetheless fail to turn a profit; individual software developers may have intimate knowledge of one aspect of the protocol but be ignorant about other salient details of the network; longstanding contributors may lose interest in the project and newcomers may join. Irrespective of any of these person’s specific efforts, the token’s value will continue to shift on open markets as buyers and sellers continue to refine their expectations of the token’s long term value and utility.
Additionally, the person we choose to identify as an issuer will never have deliberately obligated themselves to any so-called investors. (If they have, then there is likely a contract and securities treatment is sensible). Most developers of truly decentralized token projects choose to contribute code to core software libraries because they believe in the broad technological goal of the project (e.g. building a peer-to-peer cash system for the Internet), not because they are a paid employee of some company whose stated objectives and fiduciary duty is to maximize shareholder value. Similarly, miners choose to provide the network with computing resources because they want to earn the mining reward, not because they have promised investors that they will continue to power the network and make it a lucrative endeavor.
To summarize, in the case of a token that is free of any contractual promises or associated agreements between issuers and holders, any attempt to identify an issuer would both (a) fail to generate accurate disclosures and (b) place unfair and un-bargained-for obligations upon an arbitrary party within a large ecosystem of collaborative actors.
Conversely, if it can be shown that a particular token developer or promoter has, whether explicitly or implicitly, made promises of profits to persons investing in the token, then it may be reasonable to identify that person as an issuer.
This same analysis applies to any token that was developed initially through funds raised in a pre-sale or SAFT agreement. During the pre-sale there is a developer who has deliberately obligated themselves to investors by promising a future decentralized token in return for consideration. Similarly, it is the efforts of this developer upon whom the investors solely rely (should they fail, no promised tokens will be delivered). This developer is, therefore, capable of providing a comprehensive set of risk and benefit disclosures, and it may be reasonable to classify the pre-sale agreement as a security, and treat the developer as an issuer.
Once the developer delivers that promised token, however, that investment contract has, in effect, been liquidated. The resultant token is separate from the investment contract that led to its formation, and a separate inquiry regarding the classification of that token should then be undertaken. The relevant question at that point is whether the developers have, implicitly or explicitly, accepted new consideration in return for a new promise to undertake further profit-generating efforts upon which token-holders rely.
If the following three conditions are present, it seems likely that no further promises (implicit or explicit) have been made:
- The developers have made no further explicit promises to undertake future efforts and have accepted no further consideration for said promises.
- The developers have released the protocol software gratis and open source to the world (such that anyone can now continue to refine and develop the protocol), and
- The protocol software allows multiple unaffiliated participants to power the network by contributing computing resources (such that the resultant blockchain and any functionality associated with the token can be truly derived from an open set of unaffiliated participants).
So long as these three conditions hold, the delivered token is indistinguishable from any other decentralized token for which we cannot discern an issuer upon whom it would be reasonable to place registration and disclosure obligations. Indeed, it is the stated objective of several projects to release a token and useful network service over which they will ultimately have no meaningful control. The developer of a decentralized cloud storage network protocol does not want to be the lynchpin of that network; otherwise, they’d be no different than the incumbent centralized cloud storage providers (e.g. Amazon or Dropbox) that they hope to disrupt. The inquiry regarding securities laws should focus on validating that aspiration: has meaningful decentralization emerged or are token-users still relying fundamentally on as-of-yet unfulfilled promises of the issuer. If promises remain then the token is a security and the developer remains a reasonable person upon whom disclosure obligations can be placed. If no promises remain and the network functions free of the developer’s specific efforts, then the token has no issuer and is not a security.
If we accept that some tokens will not have discernable issuers, and if we also accept that creating, through legal fiction, an identifiable issuer is undesirable, can we, nonetheless, classify the token as a security? No. Securities laws mandate that securities must only be traded on National Securities Exchanges or ATSs and only securities that are registered by their issuers with relevant state and/or federal securities regulators are permitted to be traded on these exchanges. A token without an issuer, by definition, is unregistered. So if it is deemed a security, it can no longer be traded on non-securities marketplaces, nor can it be traded on securities exchanges. In short, it simply cannot be traded on any organized platform whatsoever. Such action would effectively ban organized trading in that token and do immense damage to American competitiveness with respect to emerging decentralized token technologies.