August 15, 2019
by Larry E. Bergmann, Matthew B. Comstock, Macauley B. Venora

The staff of the Securities and Exchange Commission’s (“SEC”) Division of Corporation Finance (the “Staff”) issued a no-action letter to Pocketful of Quarters, Inc. (“PoQ”), a gaming start-up seeking to issue tokens (“Quarters”) to video game users (“gamers”) on a blockchain platform (the “Quarters Platform”) for use across various video games and e-sports tournaments (“Participating Games”).[1] The Staff’s Response Letter permits PoQ to issue Quarters without registration of Quarters as securities under the Securities Act of 1933 or the Securities Exchange Act of 1934.  It is the second no-action letter that the Staff has issued permitting an unregistered token offering and sale for use on a functional platform.[2]     

PoQ’s Incoming Letter: The Quarters Platform and Functionality of Quarters

As described in PoQ’s letter requesting relief,[3] the Quarters Platform is a blockchain-based platform on which the Quarters will be purchased and used.   The platform uses two smart contracts, the “Quarters Smart Contract” and the “Q2 Smart Contract,” and two tokens, the Quarters and the Q2 Token.  In contrast to the Quarters, the Q2 Token is a security issued in compliance with the requirements of the Securities Act to provide funding for the development and creation of the Quarters Platform. 

The Quarters Smart Contract controls the sale of Quarters and imposes restrictions on the functionality and transferability of the Quarter, while also “distribut[ing] 15% of the [Etherum] from the sale of Quarters to the Q2 Smart Contract (to be subsequently distributed ratably to Q2 Token holders as a return on their investment in the Q2 token),” while holding the remaining 85% in the Quarters Smart Contract.[4]  The Q2 Smart Contract will then automatically distribute proceeds upon instruction from the Q2 Token holder.[5]

The Quarter is effectively marketed as a stablecoin,[6] with PoQ fixing the price as the sole seller of the token.  The Quarters Smart Contract additionally imposes various restrictions on the use of the Quarter: the Quarter will be purchased (or earned through participation in e-sports tournaments or during gameplay) by gamers solely for “engaging with Participating Games by transferring Quarters to an Approved Account[7] either to enter e-sports tournaments or make purchases during gameplay;”[8] the Quarters cannot be limited in quantity; and the Quarters can only be transferred to a wallet of an Approved Account, preventing any trading in a secondary market.  The Incoming Letter provided the comparison of the Quarter to an arcade token, such that the arcade token may be used on any game within the arcade, however, the arcade token holds no value outside of the arcade.  The sales documentation will state that Quarters are not investment assets, but that they are being issued solely for consumption by gamers on the Quarters Platform.  Additionally, the documentation will include representations and warranties stating that “[b]y design, Quarters are not redeemable for [Ethereum] from the Quarters Smart Contract by gamers and have no financial value for anyone other than Developers or Influencers with Approved Accounts.”[9]

In requesting no-action relief from the SEC and to avoid any potential claim that Quarters are “investment contracts” under the Howey test, the Incoming Letter focused on the “’expectation of profits’ aspect of the Howey analysis and the consumptive nature of the Quarters token.”[10]  Two noteworthy features of PoQ’s analysis are: (1) because it believed that the terms and manner of sale of Quarters clearly showed that there was “no expectation of profits,” PoQ did not specifically address the other aspects of the Howey analysis; and (2) the analysis relies heavily on United Housing Foundation v. Forman.[11]  The Incoming Letter affirmatively represented that the “Quarters include technologically implemented features that eliminate any potential for speculative or investment purchases by gamers.”[12]   

The Staff’s Response Letter

The Staff stated that it “will not recommend enforcement action to the Commission if, in reliance on your opinion as counsel that the Quarters are not securities, PoQ offers and sells the Quarters without registration under Section 5 of the Securities Act and does not register Quarters as a class of equity securities under Section 12(g) of the Exchange Act.”[13]

The Staff essentially acquiesced in PoQ’s conclusion that Quarters would not be securities, or investment contracts, under either the Securities Act or the Securities Exchange Act based on an application of the Howey test.  The Howey test has long held that whether an asset is a security depends on whether it involves “the investment of money in a common enterprise with profits to come solely from the efforts of others.”[14] 

In granting the no-action relief, the Staff noted that:

  • funds from Quarters sales would not be used to develop the Quarters Platform (as it is already fully functional);
  • Quarters purchasers will be able to use their Quarters immediately in participating games;
  • the Quarters would be held only in Quarters Hot Wallets and would be “technologically prohibited” from transferring Quarters to anywhere but the wallets of Approved Accounts;
  • the Quarters would be sold at a fixed price; and
  • Quarters would be marketed to emphasize its functionality and use in participating games, not for investment purposes or the potential for increase in value.[15] 

The Staff’s response to PoQ seems to confirm the Incoming Letter’s strong emphasis that Quarters should not be deemed an investment contract due to the lack of any reasonable expectation of profit and PoQ’s marketing of Quarters as purely consumptive goods.  Purchasers of Quarters would have no “reasonable expectation of profit” due to the fixed nature of the price, and the sole functionality of Quarters as a means of use in Participating Games on the Quarters Platform. 

While the Staff’s response is another welcome step forward on the heels of the relief granted in the TurnKey Jet Letter, it again fails to address whether and under what circumstances a consumptive/utility token sold for use on a functional platform could be traded on a secondary market.  The Division indicates that the technological restriction of secondary market trading played a significant role in its granting of relief to the issuance of tokens like Quarters.  The letter “particularly note[d] that:

  • PoQ will implement technological and contractual provisions governing the Quarters and the Quarters Platform that restrict the transfer of Quarters to PoQ or to wallets on the Quarters Platform; [and]
  • gamers will only be able to transfer Quarters from their Quarters Hot Wallets for gameplay to addresses of Developers with Approved Accounts or to PoQ in connection with participation in e-sports tournaments.”[16]

However, the continued development of the utility token ecosystem requires guidance on if, and subject to what criteria, secondary market trading of utility tokens would be permissible from the SEC’s point of view.

 

[1] Response of the Division of Corporate Finance to Pocketful of Quarters, Inc. (July 25, 2019), available at https://www.sec.gov/corpfin/pocketful-quarters-inc-072519-2a1 (“Staff’s Response Letter”).

[2] The first no-action letter was  “Response of the Division of Corporate Finance to TurnKey Jet, Inc.” (April 3, 2019), available at https://www.sec.gov/divisions/corpfin/cf-noaction/2019/turnkey-jet-040219-2a1.htm (“TurnKey Jet Letter”).

[3] Pocketful of Quarters, Inc. Incoming Letter (July 25, 2019), available at https://www.sec.gov/divisions/corpfin/cf-noaction/2019/pocketful-of-quarters-inc-072519-2a1-incoming.pdf (“Incoming Letter”).

[4] Id. at 5.

[5] The proceeds from the sale of Quarters “will not be used to develop the Quarters Platform or any of its components, as this has already been financed and fully developed using proceeds from the sale of the Q2 Tokens and other financial resources.” Id.

[6] A stablecoin is a price stabilized virtual currency.

[7] Approved video game developers (“Developers”) and video game marketers with established audiences (“Influencers” and together with the Developers the “Approved Accounts”) will be capable of exchanging Quarters for Ethereum at pre-determined exchange rates by transferring their Quarters to the Quarters Smart Contract; however, to create an Approved Account, Developers and Influencers will be subject to KYC / AML checks at account initiation as well as on an ongoing basis.  Incoming Letter at 9.  There is no secondary market potential for Developers or Influencers as their capability for transfer is solely limited to the transfer of Quarters to the Quarters Smart Contract.  Id. at 7.  Additionally, neither the Incoming Letter nor the Staff’s response addresses the applicability of the Financial Crimes Enforcement Network’s (FinCEN) rules and regulations regarding registration under the Bank Secrecy Act.  See id.at 9 n.20.

[8] Id. at 7.

[9] Id. at 5; Quarters purchasers must accept these representations and warranties as part of the purchase process.

[10] Id. at 11 (citing SEC v. W.J. Howey Co., 328 U.S. 293, 298 (1946)).

[11] 421 U.S. 837 (1975). “As in Forman, the reasonable expectation of a purchaser is that Quarters will provide an opportunity to use and consume the item purchased, not an opportunity for profit.”  Incoming Letter at 15.  PoQ’s analysis also notes that “The Quarters and the Quarters Platform exhibit many characteristics indicative of use or consumption consistent with the factors in Section II.C.3 of the recent Framework guidance from the Strategic Hub for Innovation and Financial Technology … of the Commission.”  Incoming Letter at 11 n.23.

[12] Incoming Letter at 12.

[13] Staff’s Response Letter, supra note 1.

[14] Howey, 328 U.S. at 301.

[15] The Staff based its response in the TurnKey Jet Letter on similar factors, including the technologically implemented restrictions on transferability and the functionality-based marketing.

[16] Staff’s Response Letter, supra note 1.