This chapter will provide a high-level overview of the potential applicability of distributed ledger technology ("DLT") to the transfer of assets represented by "tokens" or other digital assets1 (which, for the purposes of this chapter, we will call "Transfer Tokens"), and the regulatory environment developing around such tokens. Using a token as a means of representing an underlying asset (colloquially referred to as the "tokenization" of that asset) in order to facilitate transfers of that asset is a relatively new idea, but has its roots in a very old and well understood principle: some things that have value are not easily transferred. Whether because of practical difficulties, regulatory hurdles or imperfect or outdated trading infrastructures, sometimes the easiest way to transfer an asset – whether it be title, an ownership interest, an entitlement, or a beneficial interest in that asset – is by transferring something that represents the asset.2
Tokenization has potentially wide applicability to traditional markets. The trading of securities in the United States, for example, is beset with inefficiencies related to existing trading infrastructures. For example, repurchase transactions ("repos," whereby one party agrees to sell securities to another party and then buy them back at a later time) traditionally involve transfers of ownership that are recorded on the books of a clearing bank or the Fedwire Securities Service. Recording these transfers takes time and relies on a central intermediary, placing operational bounds on a traditional repo's minimum duration. Using Tokens to represent the underlying securities can potentially streamline this process, as parties could instead transfer (and have such transfer be reflected in a distributed ledger) Transfer Tokens that represent an interest in the securities, rather than the securities themselves.
Of course, tokenization in this manner faces a number of regulatory hurdles – some inherent to the concept itself, and some particular to each specific implementation. For example, as a general matter, it is of particular import that parties not run afoul of the broad reach of the U.S. securities laws: 3 if the purpose of a Transfer Token is to facilitate trading of underlying assets, it is important to establish whether the creation and use of such a token actually creates any of its own barriers – namely, whether the Transfer Tokens could potentially be characterized as "securities," and whether the entity creating such Transfer Tokens could be considered an "issuer" subject to the securities laws. If Transfer Tokens were to be treated as securities, the very purpose of their creation and existence (i.e., to facilitate otherwise cumbersome transactions) is challenged. A further challenge is the essential dependence of many securities law analyses on the particular facts and circumstances of each case, precluding a "one-size-fits-all" approach to compliance. Additionally, applying a layer of tokenization to traditional transactions, such as repos, for which the applicable legal regimes are well-established regarding legal certainty, security interest, and enforceability in bankruptcy, raises the question of whether tokenized transactions that resemble traditional transactions in all substantive respects should necessarily benefit from the same legal treatment as traditional transactions.
Section I of this chapter will provide a basic overview of DLT and how it can be used to create Transfer Tokens that represent underlying assets. Second, we will describe a "generic" implementation of a Transfer Token, and discuss how we believe such a token should be characterized for the purposes of U.S. securities laws. Third, we will provide a number of examples of the potential uses of Transfer Tokens, along with an overview of certain legal issues germane to each implementation.
While a full overview of DLT is outside the scope of this chapter, DLT (commonly implemented in the form of "blockchain" technology) generally refers to a "decentralized peer-to-peer network that maintains a ledger of transactions that utilizes cryptographic tools to maintain the integrity of transactions and some method of protocol-wide consensus to maintain the integrity of the ledger itself." 4 While early implementations of DLT, such as Bitcoin, were limited in scope and intended primarily to facilitate peer-to-peer transfers of value, other implementations of DLT incorporate the ability for parties to "structure and update data on a ledger through robust computer code, known as smart contracts." 5 This allows "any asset or thing [to] be modeled on a ledger," and "parties to run computer functions to interact with the data structures on the ledger." 6
One potential application of DLT in this context is the ability to "tokenize" a broad range of traditional assets, which, at least theoretically, can encompass nearly anything. In this way, transfers of the asset "can be tracked automatically on a blockchain platform in the same manner as a cryptocurrency such as Bitcoin is tracked using the same technology." 7 By tokenizing an asset and allowing it to be digitally represented on a blockchain or other form of distributed ledger, the process of recording and transferring ownership of the asset can be significantly streamlined. The question of whether such digital assets are "securities" is therefore critical, as the application of the securities laws to the issuance and transfer of digital assets such as the Transfer Tokens would impose onerous, and potentially irrational, requirements on the "issuers" of the Transfer Tokens and hamper the ability of secondary market participants to trade Transfer Tokens amongst each other.
Characterization of tokens under securities laws
Background of treatment of digital assets
Beginning in 2017, the SEC has, through various avenues, articulated its general stance toward the regulatory classification and treatment of digital assets. In April 2019, the SEC issued its Framework for "Investment Contract" Analysis of Digital Assets (the "SEC Framework"). As described in the SEC Framework, any person "engaging in the offer, sale, or distribution of a digital asset" must "consider whether the U.S. federal securities laws apply," and a threshold issue is "whether the digital asset is a 'security' under those laws." 8 While the framework is new, its essential underpinning is not: central to the SEC's analysis has been, and continues to be, the well-worn three-prong test articulated by the Supreme Court in SEC v. W.J. Howey Co., 328 U.S. 293 (1946) ("Howey"). The Howey test "applies to any contract, scheme, or transaction, regardless of whether it has any of the characteristics of typical securities," and is meant to determine whether a particular asset or arrangement is an "investment contract" (and therefore a security). Under the test established in Howey, an "investment contract" exists if there is (i) an investment of money, (ii) in a common enterprise, (iii) with a reasonable expectation of profits derived predominantly from the efforts of others.
In analyzing whether something is a security, "form should be disregarded for substance." 9 The SEC has primarily applied the Howey test to digital assets because such assets do not otherwise fall into any of the enumerated categories of the definition of "security." Accordingly, the Howey test focuses not only on the form and terms of the asset or arrangement itself, "but also on the circumstances surrounding the digital asset and the manner in which it is offered, sold, or resold (which includes secondary market sales)." 10 As a result, the question of whether a hypothetical Transfer Token is a "security" is one that resists blanket classification, and that instead depends on both the form and function of the Transfer Token as well as the particular facts and circumstances surrounding the issuance, offering, and secondary market transfers of the Transfer Token.
While "[no] one factor is necessarily dispositive as to whether or not an investment contract exists," 11 the SEC Framework articulates a wide range of factors that would be indicative of the presence of an "investment contract," mapping these factors to each prong of the Howey test. These factors include, among others:
- An investment of money:
Investors purchase or otherwise acquire the digital asset in exchange for value, whether that value takes the form of fiat currency, another digital asset, or another type of consideration.
- A common enterprise:
While the SEC Framework notes that the SEC does not view the "common enterprise" requirement as a distinct element of the Howey test, the SEC noted that investments in digital assets have generally constituted investments in a common enterprise "because the fortunes of digital asset purchasers have been linked to each other or to the success of the promoter's efforts." 12
- Reasonable expectation of profits
derived from efforts of others:
An investor has a reasonable expectation of profits derived from the efforts of others if a promoter, sponsor, or other third party (each, an "Active Participant" or "AP") provides essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts. While no one factor is determinative, the SEC Framework lists the following factors as indicative of whether this prong is met:
- the purchaser reasonably expects to rely on the efforts of an AP;
- the managerial efforts are significant and affect the failure or success of the enterprise, as opposed to efforts that are ministerial in nature;
- an AP is responsible for the development, improvement, operation, or promotion of the network;
- where the network or digital asset is still in development or not yet fully functional, investors would reasonably expect an AP to further develop the functionality of the network and/or digital asset;
- there are essential tasks or responsibilities performed and expected to be performed by an AP;
- an AP creates or supports a market for, or the price of, the digital asset;
- an AP has a lead or central role in the direction of the ongoing development or management of the network or the digital asset;
- investors would reasonably expect the AP to undertake efforts to promote its own interests and enhance the value of the network or digital asset, such as where the AP has the ability to realize capital appreciation from the value of the digital asset, the AP distributes the digital asset as compensation to management, or the AP monetizes the value of the digital asset;
- the digital asset gives the holder rights to share in the enterprise's income or profits or to realize gain from capital appreciation of the digital asset;
- the digital asset is transferable or traded on a secondary market or platform;
- purchasers reasonably would expect the AP's efforts to result in capital appreciation of the digital asset;
- the digital asset is offered broadly to potential purchasers or in quantities indicative of investment intent;
- the AP is able to benefit from its efforts as a result of holding the same class of digital assets as those being distributed to the public;
- the potential profitability of the operations of the network or the potential appreciation in the value of the digital asset is emphasized in marketing or other promotional materials; and
- the availability of a market for the trading of the digital asset.
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1. It should be noted that the use of the term "digital assets" is somewhat of a misnomer, as assets are typically understood as things which have value. Ideally, the Transfer Token should be conceptualized as akin to a book-entry that has no value in and of itself, but merely represents an underlying asset. Even the use of the word "token" is problematic, as it can both imply value and carry negative connotations associated with the raft of tokens issued pursuant to "initial coin offerings" in recent years. Here, we use the word token to mean that it is symbolic.
2. One archetypal example of this concept drawn from traditional markets, of course, is the framework that has developed around the indirect ownership of securities under the Uniform Commercial Code ("UCC"). In response to a "paperwork crisis" on Wall Street during the 1960s and 1970s, when the burden of reconciling trades using the traditional certificate-based system overwhelmed brokerage firms and transfer agents, the Depository Trust Company ("DTC") was created to act as a central securities depository and hold immobilized share certificates on behalf of its participants. The regulatory scheme that governs transfers of interests in the securities held by DTC is Article 8 of the UCC, which provides that persons holding securities through brokers or custodians hold "security entitlements," rather than direct ownership of the underlying securities. Article 8 describes the package of rights held by the holder of a security entitlement (the "entitlement holder"), and provides that an entitlement holder may issue an "entitlement order" in respect of a financial asset that directs an intermediary to transfer or redeem the financial asset to which the entitlement holder has a security entitlement.
3. The use of "securities laws" in this chapter generally refers to the Securities Act of 1933 (the "Securities Act") together with the Securities Exchange Act of 1934 ("Exchange Act") and the regulations and interpretations issued thereunder.
4. See Blockchain and Distributed Ledger Technology: An Analysis of its Impact on the Syndicated Loan Market, Part One: Generation Considerations and Blockchain Primer, LSTA (2018).
7. See Blockchain and Distributed Ledger Technology: An Analysis of its Impact on the Syndicated Loan Market, Part Three: Application of Blockchain Technology to the Loan Market, LSTA (2018).
8. SEC Framework, Section I.
9. Tcherepnin v. Knight, 389 U.S. 332, 336 (1967).
11. SEC Framework, footnote 4.
12. SEC Framework, footnote 11.
Originally Published by Global Legal Insights
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