Security or Utility? This is the question.

*** This article was written by Andrey Shirben and was originally published at the AFR. This is the longer and unedited version of it ****

In my humble opinion, it’s a rhetorical question. Before we get into it, let’s have a bit more context. In the previous article, I discussed the broad ICO topic and how it’s disrupting the traditional angel and VC investors, most of whom got caught by surprise by the perfect crypto storm.

In today’s world, ventures can raise funds via alternative methods, such as ICO (Initial Coin Offering), SAFT (Simple Agreement for Future Tokens) etc.
In its current form, most of these methods don’t require the companies to issue shares to the investors. Instead, they are either issuing them tokens or promising to issue them tokens in the future.
Given that most of the angels & VC’s still want to hold shares in a company, rather than tokens in some foundation, most of the money that is flowing into this space is either coming from “Gen-Crypto” (Gen-Z) or from average punters.

The punters heard about this trend from a friend or read an article in the news and bought into the “get rich fast” idea.  They are often driven by greed and/or FOMO (Fear of Missing Out). Neither understand/care much about shares vs tokens issue; therefore, they have no problem throwing money on these projects, without understanding what rights are attached to these tokens, voting mechanism and so on. The crypto-preneurs and their creative lawyers came up with a new concept, the “utility token”, to circumvent the existing security laws and regulations that exist in most of the developed countries.

These laws and regulations require the entities raising funds through issue of securities to issue a prospectus which provides: adequate information to the investor, proper risk disclosures and notice of compliance with a whole bunch of rules. Plenty of law firms, all over the globe, were happy to sign legal opinions stating a particular token is classified as utility, well, at least until recently… They were arguing that if a token is used in a game or to get access to a platform or service, it’s definitely a utility. In a nutshell, if a token is classified as utility and not security, the entity selling these tokens can get around most of the restrictions, skip many disclosures and do it in a “quick & dirty” way to raise lots of money.

In 2017 alone, the successful ICO’s netted US$5.6B. In the first quarter of 2018, the ICO’s raised astonishing US$6.8B (including Telegram’s US$1.7B ICO). Well, this is where the regulator is supposed to intervene and make sure these “investors” are protected and not scammed. It was naïve to assume that the crypto “Wild, Wild West” would continue uninterrupted for a very long time, especially, given the sheer volumes of money flowing into it. Indeed, the SEC (Security & Exchange Commission, the US regulator, equivalent to the Australian ASIC) has been publishing its position on this matter continuously and quite consistently since the in-depth analysis of the DAO project. Digging a bit into the history, the US Supreme court set a precedent ruling back in 1946  The SEC won a case against W. J. Howey Co., creating the famous “Howey Test”, which outcome determines whether an instrument qualifies as an “investment contract” for the purposes of the Securities Act.

The Howey Test has a slightly varying interpretation, but the test generally determines whether an arrangement constitutes (1) an investment, (2) in a common enterprise, (3) with a reasonable expectation of profits, and (4) to be derived from the entrepreneurial or managerial efforts of others. If all four of those elements are true, then the arrangement is an investment contract or a security.

Let’s have a look at a typical crypto project that sells tokens (be it in a private or public sale) and particularly, try to analyse the drivers and the expectations of the token acquirers. Despite the fact most of the ICO’s are structured as a foundation (or in other words – a not for profit organisation), it can still be labelled as a “common enterprise”. As such, it’ll be pretty safe to assume that these buyers are not intending to donate their money to a good cause but are investing their money with an expectation to make a profit.

The last point is easy to assess as well, given most of the token holders don’t participate in the project themselves, but rather counting on the founding team, entrepreneurs & managers, to create something from nothing. As a result of this effort, the tokens appreciate. Case closed! Or in other words, if there is any token sale – it’s clearly a security.

But wait, “What about the utility. My answer to this: There’s no such thing as utility; it’s all security, with a few exceptions such as Bitcoin, Litecoin and funnily enough DOGE coin, which can be classified as commodities. It might be easier to determine whether a particular token is a security or not, based on the “intention of usage” test (it’s effectively the investment test, Howey’s #1).

For example, if you’re buying $20 worth of gaming tokens and intend to spend these tokens on playing the game and buying some fancy virtual goods or skip waiting time – it’s all good. If you’re buying $1M worth of these tokens and you probably don’t even know how to play this game and all you want is for the price to go up and then flip it – it’s clearly an investment contract or a security. The thing is, a token cannot be sometimes a utility and sometimes a security, so even if only one out of a thousand people bought it as a security – all the tokens are a security now, bringing us back to regulations and the need to comply with the security laws.

So, are all ICO’s doomed to be banned eventually? In my view, not at all, but this one is probably worthy of a separate discussion.