By Reuben Bramanathan, Blockchains, cryptocurrency & law. Helping crypto teams solve hard problems. Previously product & legal@coinbase
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2020 saw the rise of personal, social and community tokens — tokens that are connected with an individual, an artist or creator, or a group, rather than a protocol or application.
The most interesting aspect of these tokens is that typically, there is no existing structure for the relationships they seek to define. They are a nebulous collection of promises and intentions that can be molded to fit the different dynamics of each community.
When used effectively, these tokens have the potential to help communities coordinate around their shared purpose and objectives.
This post examines the US federal securities law treatment of social and community tokens. It is intended to help issuers of tokens think through some of the different pathways to non-security status, and to give some practical examples of things that could affect that status. Nothing in this post should be taken as legal advice. There can be no guarantee that a token will not be a security even if all of the positive characteristics in this document apply.
Practically speaking, there are five broad factors which can affect the analysis:
- Financial Returns
- Control & Contribution
Based on the SEC’s digital asset framework, here are three potential pathways which may result in social and community tokens not being classified as securities, along with the factors which are relevant to the pathway. There may also be other pathways.
- First, if there is no ‘investment of money’ (Distribution)
- Second, if the project is community owned and sufficiently decentralized so as to not rely predominantly on the efforts of the creator or core team. This is likely only achievable by genuine communities, rather than creator or fan tokens which have a person, group or team at the center of the project. It will be very difficult for personal tokens to achieve this. (Distribution, Vesting, Control & Contribution).
- Third, if token holders genuinely do not expect to profit from the tokens, and they hold them for other reasons. This is unlikely to be achievable if the tokens are transferable or there is any market for the tokens. (Distribution, Financial Returns, Usefulness)
If a token performs strongly on at least one of the pathways, it is less likely to be a security. In addition, tokens which have more of the positive characteristics across all five factors are less likely to be securities.
- The less money raised from selling tokens, the better. It is much better if the tokens are never sold, and are only ever given away.
- The smaller proportion of the total supply that is allocated to the creator and project team, the better.
[Best] Recipients get tokens for free with no strings attached, or for work they previously did without any expectation of being rewarded
- Free distribution to community members, volunteers, historical supporters & contributors (e.g. a retroactive distribution). Retroactive distributions reward those whose contributions were intrinsically motivated.
- Tokens are available only to members of the existing community, and are not available to investors or speculators (may require restrictions on transfer)
[Good] Recipients get tokens retroactively for doing things they would have done anyway
- Tokens are occasionally given as a bonus to people who have used the product (but not so regularly or predictably that users start to use the product with the expectation that they will receive tokens)
- Tokens are given as rewards to people who make contributions to the project — where the rewards are not promised in advance
- Community members organically propose changes, make improvements and new projects — with the the best initiatives being rewarded with tokens
[OK] Recipients can earn tokens as a reward for doing specific tasks
- Grants and bounties for delivering specific projects
- Ongoing rewards to incentivize use of the product
- Prizes for challenges or competitions where some amount of work is required
- Tokens given away as an additional bonus when users buy something else (e.g. an NFT), as long as obtaining the tokens is not a significant motivation for the purchase
[Bad] Recipients directly or indirectly exchange financial value for the token
- Public token sale
- Private/insider token sale
- OTC Sale
- Yield Farming (Stake the token or other assets to earn tokens)
- Liquidity Mining (Stake LP shares to earn tokens)
- Selling other items (e.g. NFTs) where a significant motivation for the purchase of the item is to obtain the tokens that come with it
- The longer the vesting for the creator & team, the better. The shorter the vesting for community members, the better.
- The more provable the vesting schedule, the better. On-chain restrictions are better than binding legal agreements, which are better than a ‘social’ or soft commitment.
3. Financial returns
A token which delivers, promises or implies the possibility of any financial return is much more likely to be a security
[Bad] Direct or indirect revenue is paid or promised to token holders
[Bad] A ‘buy and burn’ or similar model which redirects revenue or profits to increase the value of the token
[Bad] Liquidity mining which is designed to increase liquidity of the token.
[Bad] Yield farming which is designed to prop up the value of the token by incentivizing the reduction of circulating supply
[Bad] Holders of the token earn a return for simply holding the token e.g. token holders automatically earn a passive return denominated in stablecoins or other tokens
[OK] Holders of the token have access to benefits which are primarily non-financial in nature, even if those benefits are capable of having financial value e.g. token holders get free access to members-only content or events.
- If and when a project becomes ‘sufficiently decentralized’ it may be possible to direct revenue to token holders without significantly increasing the securities law risk.
- Note that this is a very uncertain area of law and there is no case law or guidance about when a community token will be sufficiently decentralized.
- As a rough guide, a project may be considered sufficiently decentralized, if at that moment, the token creator & team were to permanently abandon the project, the project would still be carried forward by other token holders, and would still be likely to succeed without the core team.
- In general, a useful token is less likely to be a security, provided that people genuinely want the token for its usefulness, rather than its financial upside. But there’s a saturation point: cramming extra functionality into a token doesn’t help (‘utility theater’)
- If a token promises financial returns, adding usefulness is unlikely to help
[Good] Token holders automatically get exclusive and free access to content, chats, community groups, events or other perks that are primarily of non-financial value (e.g, anything that is of artistic, cultural, entertainment, or fan value)
[Good] Token holders get direct access to the creator or team’s time
[Good] Tokens can be redeemed for any of the above.
[Good] Token holders perform operational decision making within the project: e.g. curation (note: this is a positive factor for Control too)
[OK] Token holders get discounts on or early access to products, content etc
[Bad] The token has no use or benefits
[Bad] The token’s main purpose is to provide a financial return to the holder
[Bad] The token has trivial or contrived functionality e.g. The creator says that the token is required in order to access exclusive content, but in reality they give that content away for free anyway
5. Control & Contribution
- The greater the voice, influence & contributions of token holders, the better.
- The less control by the creator, team and insiders, the better
- A fully decentralized community token is less likely to be a security e.g. a community that operates as a member-owned cooperative
[Good] Token holder voting is required for major strategic and financial decisions about the project. The creator or team cannot unilaterally make these decisions
[Good] Community members contribute value directly to the project e.g. generating new content, collaborating to create new works or products, and these contributions are at least as significant as those of the creator or core team
[Good] Token holder voting is used to determine token rewards and benefits for the community
[OK] Token holders can signal their intent about project direction and decisions
[Bad] Token holders do not have any input, or only have input on insignificant decisions (‘governance theater’)
Again, nothing in this post is legal advice. You should definitely seek legal advice before launching a social or community token.