What are Security Tokens?

In crypto, a “token” simply represents something from a particular ecosystem, like actual value (cash equivalent), stake, voting rights, anything the ecosystem chooses it to be. Therefore, a token can have multiple roles in its native ecosystem, which makes it truly unique in today’s digital world of finance.

Think back to the first time you went to Dave & Busters, Game Works, Chuck-E-Cheeses (RIP), or any other arcade. Remember how you were given a loadable game card to play on the machines? Same concept here.

Distinguishing ‘Crypto Coins’ from ‘Tokens’

Now, let’s not get ahead of ourselves. The term “token” differs from a “cryptocurrency coin”. A cryptocurrency coin--Bitcoin, Bitcoin Cash, Ethereum, the list goes on--is capable of being independent of the ecosystem. In other words, you can do “things” with it outside their native environment.

Tokens, however, are those game cards that can only be used in that particular environment. They are simply a representation of an asset or utility that a company has, often given away during an ICO or AirDrop.

Defining a ‘Security Token:’ The Howey Test

If you are looking to enter the cryptocurrency space (or already part of it), you cannot move forward until you know about the U.S. Supreme Court (landmark) case of the SEC v. Howey, the foundation for determining whether a transaction is considered to be an “investment contract” (securities offering) or a “commodity”.

As of 2020, you will learn that companies and their officers still fail to understand (or willfully ignore) Howey, which gets them in some serious legal trouble, often resulting in imprisonment.

The Howey Case

Since 1946, the U.S. Supreme Court case, SEC v. W.J. Howey Co., continues to remain the leading standard in U.S. securities law for determining whether or not a transaction is considered to be an “investment contract” (securities offering), or a “commodity” under the U.S. Securities Act.

The Facts

The U.S. Supreme Court has previously held that “investment contracts” include, but are not limited to—interests in orange groves, animal breeding programs, railroads, airplanes, mobile phones, and enterprises existing only on the Internet.

The Rule

An investment contract implies that the transaction is a type of security.

In the world of blockchain technology and digital currencies, the Howey Test comprises of three elements to determine whether a transaction is an investment contract:

  1. Was there an investment of money?
  2. Was there a common enterprise?
  3. Was there an expectation of profits predominantly from the efforts of others?

For a token or coin to be considered a “security” under Howey, all three elements must be met.

Expectation of Profits Predominantly from the Efforts of Others

The Court has previously looked to a company’s press releases and FAQs — persuasive authority, to help expand on its analysis. For example, if the company holds its coins out to be some kind of “investment”, there’s really no way to argue against that.

A great case applying the Howey elements is the Balestra v. ATBCoin case out of New York, filed back in March 2019.

SEC v. Telegram

On October 11, 2019, the SEC filed a complaint against the messaging app, Telegram, alleging that the company raised capital to finance its business by selling 2.9 billion tokens, which it calls ‘Grams’ to over 170 investors across the world.

When the SEC first was made aware of this potentially unregistered token sale, it sought to preliminary enjoin Telegram from delivering the Grams it sold, believing the tokens to be “securities” under the U.S. Securities Act and Howey.

Six months later, after written arguments were presented from both parties, and one hearing in the U.S. Southern District Court of New York, Judge Kevin Castel supported the findings.

On March 24, 2020, the U.S. District Court for the Southern District of New York issued a preliminary injunction preventing the further delivery of the Grams, finding that the SEC had made sufficient arguments that Telegram’s sales were most likely a violation of federal securities law.

Back in June 2020, the SEC ruled that Telegram Group, Inc. and its wholly owned subsidiary, TON Issuer, Inc. to return the $1.2 billion it collected from its unregistered token sale to investors, and to pay an additional $18.5 million civil penalty. Telegram is further required, for the next three years, to give notice to the SEC staff before participating in the issuance of any digital assets.

For more information on the case, please click here.

SEC v. KIK INTERACTIVE, INC [19-cv-5244]

In June 2019, the SEC sued the messaging app, Kik Interactive, Inc, for allegedly conducting an illegal $100 million securities offering of digital tokens back in 2017, which it called “Kin”, without registering their offer and sale pursuant to federal securities laws.

In its complaint, the SEC alleged that because Kik had been losing money for year on its online messaging application, the company’s sole product, that the company would run out of money in 2017, as predicted by internal management.

In response, KIK sought to find a way around this by financing one trillion digital Kin tokens through a sale, raising more than $55 million from U.S. investors.

The complaint alleges that Kin tokens were traded at about half of the value that public investors paid in the offering.

On September 30, 2020, the U.S. District Court for the Southern District of New York held, in a 19-page ruling, that Kik’s token sale violated federal securities law, having satisfied all three elements of Howey.

For more information on this case, please click here.

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