At the PLI’s “SEC Speaks in 2018” conference, staff from the SEC’s Division of Corporation Finance acknowledged that token sales presented difficult issues under the federal securities laws, especially for tokens that could be used on the issuer’s platform. Those tokens could be considered utility tokens, not securities, the staff said. Additionally, the staff said, some tokens could have hybrid qualities, containing characteristics of a utility token and a security.
While the SEC might be at the early stages of ICO regulation, some state legislators are moving full steam ahead to perhaps be at the forefront of token regulation and incentivize the growth of tokens in their states through clear-cut regulation. In particular, Arizona and Wyoming have proposed legislation to provide definitive—or at least more definitive than at the federal level—guidance as to when ICOs would not be considered securities offerings.
Arizona’s proposed legislation would create a legal category called a “virtual coin offering.” A virtual coin offering would be defined as an offer for sale of a virtual coin that meets the definition of a security and that the issuer elects to treat as a security by complying with state law governing exempt transactions. Issuers could conduct virtual coin offerings on an intrastate basis in Arizona by complying with provisions governing the conduct of the offering, the size of the offering, and the eligible purchasers in the offering.
Arizona’s proposed legislation also would create an exception to the definition of a virtual coin offering. Under this exception, an offer for sale of a virtual coin would not be a virtual coin offering if it has not been marketed by the issuer as an investment and it grants to the purchaser, within 90 days after the purchaser’s receipt of the virtual coin, the right to use, contribute to the development of, or license the use of a platform using blockchain technology. In other words, Arizona apparently is providing a safe harbor for tokens that purchasers can use within 90 days. As we understand the proposed legislation, even if tokens issued in an offering could meet the definition of a security under applicable law, the tokens would be excluded from securities regulation so long as they could be used on the issuer’s platform within 90 days. The proposed legislation would thus recognize what effectively would be a utility token provided it was issued in compliance with the safe harbor requirements.
Wyoming introduced a bill that proposes a more policy-based approach to token offerings. The bill would provide an exemption from securities regulation for “open blockchain tokens.” The definition of open blockchain tokens would broadly include most, if not all, tokens. To qualify for the exemption, the token would have to meet the following requirements:
- the developer or seller of the token files a notice of intent with Wyoming;
- the purpose of the token is for a consumptive purpose, which may only be exchanged for, or provided for the receipt of, goods, services, or content, including rights of access to goods, services, or content; and
- the developer or seller of the token did not sell the token to the initial buyer as a financial investment.
Wyoming would define when a token is not sold as a financial investment, requiring that the developer or seller not market the token as a financial investment and at least one of the following criteria be true:
- the developer or seller of the token reasonably believed that it sold the token to the initial buyer for a consumptive purpose;
- the token has a consumptive purpose that is available at the time of sale and can be used at or near the time of sale for a consumptive purpose;
- if the token does not have a consumptive purpose available at the time of sale, the initial buyer of the token is prevented from reselling the token until the token is available for use for a consumptive purpose; or
- the developer or seller takes other reasonable precautions to prevent buyers from purchasing the token as a financial instrument.
Unlike Arizona’s proposed legislation, Wyoming’s bill would raise interpretive, line-drawing issues, albeit with more definitive guidance than what the SEC has given thus far. For example, the second condition would focus on whether the token is provided for the purposes of receiving goods or services, which could require courts to conduct Howey tests and to determine whether profit is a predominant motive for a purchaser’s investment. Nevertheless, Wyoming's final bill should provide a clearer definition of when a token is a security as compared to a previous version of the bill. The timing element incorporated into the third condition would result in an approach to ICO regulation slightly more akin to Arizona's safe harbor, although with less clear guidance on what is considered "at or near the time of sale."
Arizona and Wyoming’s efforts illustrate the difficulties of attempting to distinguish via legislation a utility token from a security. Arizona’s proposed legislation benefits from a bright-line 90-day rule. But one could imagine a token that would fit within the 90-day safe harbor yet still have characteristics of a security. Wyoming’s approach is more policy-driven and, arguably, flexible. But it suffers from a similar lack of clarity as federal regulation. These two approaches reflect the trade-off between fostering capital raising and protecting investors. We will continue to monitor and help our clients shape how states regulate ICOs as they compete to be seen as regulatory leaders.
 The text of Arizona’s proposed legislation can be found at: https://legiscan.com/AZ/text/HB2601/id/1718697. The legislation passed Arizona’s House and is currently being considered by Arizona’s Senate.