June 12, 2018
by Larry E. Bergmann

The Problem            

In the Simple Agreement for Future Tokens (“SAFT”) model,[1] investors are sold securities, often “investment contracts”[2] that fund development of a utility (i.e., platform or network), that will be accessible by using “utility tokens,” [3]  i.e., tokens whose only use is to obtain access to the goods or services available on the platform.[4] In return for supplying capital, the investors receive the right to receive utility tokens when the platform and the tokens become fully functional.[5]  At that point, the “SAFT investors’ rights in the SAFT automatically convert into a right to delivery of the tokens.”[6]  SAFT purchasers are typically entitled to the number of units of the token equal to the investors’ purchase amount divided by a discount price (i.e., the investor obtains tokens at a discount to the issuance price of the utility tokens upon launch of the platform).[7]

It is conceded that the SAFT is very likely an investment contract and a security under the Securities Act of 1933.[8]  The SAFT paper contemplates an automatic conversion of the token securities into utility tokens upon the occurrence of an event, i.e., the launch of the platform.[9]

That process can be problematic:

  1. Investors purchase and hold an instrument that is acknowledged to be a security. 
  2. There does not appear to be precedent for an instrument that is a security automatically to become a non-security.
  3. The launch date of the platform could be less than clearly defined, making the point of automatic conversion difficult to determine.[10]

A Proposed Solution

What is needed to address this problem is a mechanism to clearly sever any connection between the capital-supplying “security” and the utility token.  The proposed mechanism is mandatory security redemption:[11]  the capital-raising security would be issued as in the SAFT paradigm, but a mandatory redemption feature would be built into a smart contract to extinguish the securities, as follows:[12]

  1. Capital-raising securities are issued as mandatorily redeemable by the issuer;[13]
  2. Upon declaration of redemption, which cannot occur earlier than launch of platform when tokens are fully functional,[14] securities are redeemed (i.e., deemed sold to issuer);[15]
  3. Redemption is mandatory: all securities are automatically redeemed in exchange for utility tokens (generally at a discounted rate set in the instrument);
  4. Redemption is automatically executed via the smart contract;
  5. Issuer cancels the redeemed securities and issues utility tokens; and
  6. After redemption, only utility tokens are outstanding and additional utility tokens may be sold post-redemption.[16]

Conclusion

By employing a clearly-defined, mandatory mechanism for an issuer to extinguish its outstanding securities that were issued to raise capital to develop a platform, the mandatory redemption of its outstanding securities improves the SAFT process because the redemption results in the issuer having only utility tokens outstanding after the redemption.

 

[1] This article is offered in the spirit of the “SAFT Project” to develop “an emerging standard for how blockchain developers can responsibly innovate” in compliance with the securities laws.  J. Batiz-Benet, J. Clayburgh, M. Santori, “The SAFT project: toward a compliant token sale framework” (October 2, 2017), at 21 (“SAFT Paper”), https://saftproject.com/static/SAFT-Project-Whitepaper.pdf.

[2] The definition of “security” in Section 2(a)(1) of the Securities Act of 1933, 15 USC 77b(a)(1), includes an “investment contract.”  The latter term is not defined in the statute, but the analysis of whether an “investment contract” is a security was formalized in SEC v. W.J. Howey Co., 328 U.S. 293 (1946), and continues to be the test applied by the SEC.  Howey uses four criteria to ascertain security status: (1) an investment of money; (2) in a common enterprise; (3) with a reasonable expectation of profits; (4) to be derived from the entrepreneurial or managerial efforts of others.  See, e.g., Munchee Inc., Securities Act Release No. 10445 (December 11, 2017) (“Munchee”), https://www.sec.gov/litigation/admin/2017/33-10445.pdf.  An “investment contract” also is a security as defined in Section 3(a)(10) of the Securities Exchange Act of 1934, 15 USC 78c(a)(10) (“Exchange Act”).

[3] A “utility token” is “a category of blockchain token … designed to offer intrinsic utility that powers a decentralized, distributed network that delivers to the users of the network a consumptive good or service.”  SAFT Paper at 3; see also id. at 17 (focus on “Step 4” of the SAFT process).

[4] A fundamental assumption of the present analysis is that there can be tokens that are not securities.  See, e.g., Securities and Exchange Commission (“SEC”) Chairman Jay Clayton, “Statement on Cryptocurrencies and Initial Coin Offerings” (December 11, 2017), https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11Some utility tokens may have some associated attributes that are similar to securities, such as a secondary trading market for the tokens, and increases in value of the tokens as the utility platform becomes more successful or as a result of ongoing improvements to the platform by its operators.  Such similarities do not necessarily mean that the tokens are securities.  A complete analysis of the application of Howey to digitized tokens is beyond the scope of this article.  However, the key focus is on the economic realities of the instrument rather than what they are called.  See, e.g., United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 849 (1975).

[5] No utility tokens are issued at the capital-raising stage.  The securities provide investors only with the right to acquire utility tokens at a future date, typically at a discount to the price of the tokens when they are issued.

[6] SAFT Paper at 15-16.

[7] Id. at Exhibit 1, p.2-3.

[8] SAFT Paper at 1, 15, 17.  The securities may be issued in uncertificated, digitized form, using distributed ledger technology, i.e., blockchain.  See, e.g., id. at 16.  The SAFT Paper contemplates that developers would sell the securities to accredited investors relying on an exemption from security registration.  Id.  The approach discussed in this article could be employed in connection with security sales in private or public offerings, such as Regulation A under the Securities Act, 17 CFR 230.251-257.

[9] SAFT Paper at 15-16.

[10] Cf. SAFT Paper at 17.

[11] If the issuer has a class of equity securities registered under Section 12 of the Exchange Act, 15 USC 78l, or is required to file periodic reports pursuant to Exchange Act Section 15(d), 15 USC 78o(d), there might be a concern that the issuer’s acquisition of its equity securities would be viewed as an issuer tender offer subject to Exchange Act Rule 13e-4, 17 CFR 240.13e-4.  However, that rule does not apply to “calls or redemptions of any security in accordance with the terms and conditions of its governing instruments.”  Rule 13e-4(h).  The potential application of Exchange Act Rule 13e-3, 17 CFR 240.13e-3, also should be considered, as it applies to the purchase of any equity security by the issuer (or by an affiliate) that would have certain effects described in Rule 13e-3(a)(3).  Similar to Rule 13e-4, however, the rule does not apply to “redemptions, calls or similar purchases of an equity security by an issuer pursuant  to specific provisions set forth in the instrument(s) creating or governing that class of equity securities,” Rule 13e-3(g)(4).  In addition, one could analyze whether an investment contract is an equity security in this context.  Compare Exchange Act Section 3(a)(10) [which includes investment contract in the definition of “security”] with Exchange Act Section 3(a)(11) [which does not include investment contract in the definition of “equity security”] and Exchange Act Rule 3a11-1, 17 CFR 240.3a-11-1 [defining “equity security” for purposes of Exchange Act Sections 12(g) and 16, and which also does not include investment contract].

[12] According to the Chamber of Digital Commerce: “Smart Contracts are computer code programmed to execute transactions based on pre-defined conditions.”  https://digitalchamber.org/policy-positions/smart-contracts/. See also Laster, J., and Rosner, M., “Distributed stock ledgers and Delaware law,” 73 Bus. Law. 319, 331 (Spring 2018).

[13] “Mandatorily redeemable shares are shares owned by an individual or entity which are required to be redeemed for cash or another such property at a stated time or following a specific event. Essentially, they are shares with a built-in ‘call’ option that will be exercised by the issuer of the shares at a pre-determined point in the future.” Source: Investopedia, https://www.investopedia.com/terms/m/manditorily-redeemable-shares.asp.  FASB FAS 150 describes such instruments to include “A financial instrument issued in the form of shares that is mandatorily redeemable—that embodies an unconditional obligation requiring the issuer to redeem it by transferring its assets at a specified or determinable date (or dates) or upon an event that is certain to occur.”

 A full discussion of issues related to mandatorily-redeemable securities is beyond the scope of this article.  For example, on the issue of the need to clearly define a “redemption,” see Willett, S., “Searching for redemption,” 72 Bus. Law. 699 (Summer 2017), https://www.americanbar.org/content/aba/tools/digitalassetabstract.html/content/dam/aba/publications/business_lawyer/2017/72_3/article-redemption-201707.pdf. See also SEC, Division of Corporation Finance, “Current Accounting and Disclosure Issues” (June 30, 2000), “Commission releases and staff accounting bulletins (Rule 5-02 of Regulation S-X, Financial Reporting Codification Section 211, SAB 3C, and SAB 6B(1)) describe the accounting and reporting that is applicable to mandatorily redeemable preferred stock and all similar equity securities,” https://www.sec.gov/divisions/corpfin/acctdisc_old.htm; Bragg, S., “Redeemable preferred stock,” (November 1, 2017), https://www.accountingtools.com/articles/2017/5/13/redeemable-preferred-stock.

Mandatorily redeemable preferred stock can have debt and equity characteristics:  “This study examines whether mandatorily redeemable preferred stock (MRPS) is priced more like debt or equity by (1) investigating its debt and equity characteristics and (2) specifying conditions under which one characteristic would dominate the other. Based on a sample of 113 nonconvertible MRPS issued during 1970 to 1990, our results are consistent with the view that MRPS has both debt and equity characteristics. The debt (equity) feature is more pronounced among nonutility (utility) issues. Within the utility group, we find high (low) rated MRPS issues to be more debt (equity) like. Our results appear to support current MRPS disclosure rules. Copyright 1997 by Kluwer Academic Publishers. “Debt and Equity Characteristics of Mandatorily Redeemable Preferred Stock,” available at https://www.researchgate.net/publication/5157863_Debt_and_Equity_Characteristics_of_Mandatorily_Redeemable_Preferred_Stock  [accessed April 17, 2018].

 [14] To avoid any ambiguity about the point when the platform becomes fully functional, the smart contract would specify the conditions that must be satisfied to “launch,” perhaps including third party verification or certification of the requisite event(s).

[15] Mandatory redemption pursuant to the terms of the security also avoids any potential registration issue that could be associated with an offer by the issuer to buy back the securities.  Cf. Munchee at 7 n.2.

[16] Subsequent sales of the utility tokens would be undertaken in a manner to avoid the characteristics of securities offerings subject to the Securities Act.  See, e.g., Munchee at 4-6 (promotional and marketing activities); SAFT Paper at 9-10 (discussion of “already-functional tokens”).