SEC expands the circumstances where it deems a digital asset to not be a security

July 29, 2019

Esports Alert

Author(s): Daniel McAvoy

In its most significant no-action letter regarding digital assets yet, on July 25, 2019, the Securities Exchange Commission found that a proposed payment solution token to use on a platform for esports and online gaming would not be a security and could be sold without registration under federal securities laws.

On July 25, 2019, the Securities Exchange Commission (SEC) issued a no-action letter in response to an incoming letter from Pocketful of Quarters, Inc. (PoQ) regarding certain digital assets (the PoQ Incoming Letter). According to PoQ, the platform for the digital asset (the Platform) will utilize blockchain technology to provide gamers the ability to use in-game tokens (Quarters) across participating online video games, and enter PoQ hosted esports tournaments (each, a Participating Game). Quarters and the Platform are meant to address the issue of multiple in-game currencies that currently are not transferrable between different games. PoQ expects that the Platform would be “fully functional” at launch, which includes being able to use Quarters in twelve online games (including classic games such as Space Invaders and Galaga) and to use the Platform to participate in PoQ hosted esports tournaments in at least twenty games (including Fortnite, Minecraft, Counterstrike GO, Apex, Call of Duty, and Area Q). Quarters will be made available in unlimited quantities and at a fixed price set by PoQ. Additionally, the transfer of Quarters is limited, though not completely prohibited.

Use and transfer of Quarters by gamers, developers, and influencers

PoQ expects to offer and sell Quarters to three groups: (1) gamers, (2) approved video game developers, and (3) social media influencers and other marketers of the Platform. The use of Quarters by gamers will be restricted to making in-game purchases in Participating Games and spending Quarters to enter into PoQ hosted esports tournaments. Gamers can receive Quarters by either purchasing Quarters with Ethereum (ETH) at a fixed price set by PoQ or by earning them from Participating Games. Developers can receive Quarters from gamers that play the games they develop and can only use Quarters to transfer them to gamers as in-game rewards or exchange them for ETH at a pre-determined exchange rate. Influencers can receive Quarters as compensation from PoQ for promoting Participating games and can only use Quarters in exchange for ETH at a pre-determined exchange rate. Developers and influencers are the only ones who can exchange Quarters for ETH and can only be approved by meeting specific criteria set by PoQ and will be subject to KYC / AML checks at account initiation and on an ongoing basis. The Quarters would be solely for use by gamers, and gamers cannot exchange the Quarters back for other currencies.

All exchanges of ETH and Quarters are done by transferring the ETH or Quarters to a smart contract, a pre-programmed coded function that allows for self-execution at specific times or based on the occurrence or non-occurrence of an action or event, and receiving Quarters or ETH in return (the Quarters Smart Contract).

Use of proceeds and manner of sale

PoQ represented that the proceeds from the sale of Quarters will not be used to develop the Platform or any of its components and that it issued a separate security token for these purposes. PoQ will market and sell Quarters to gamers solely for “consumptive use as a means of accessing and interacting with the range of Participating Games” and, with respect to the gamers, the Quarters will have no value outside of their use in Participating Games. Documentation for the offer and sale of Quarters will include disclosures that the sale of Quarters is not an investment opportunity or a sale of securities, and purchase should not expect Quarters to increase in value. Additionally, purchasers of Quarters will represent, via agreement to a click-through terms of service, that they are not acquiring Quarters for any investment purpose or to benefit from any appreciation in the price of Quarters.

Howey Test and Framework for “Investment Contract” Analysis of Digital Assets

The U.S. Supreme Court’s decision in SEC v. W.J. Howey Co., 328 U.S. 293 (1946), continues to be the seminal case that forms the basis of the test used to determine whether a financial instrument or transaction should be deemed a security and, therefore, subject to securities regulation. Under Howey, “an investment contract for purposes of the Securities Act of 1933 (the Securities Act) means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party….” The Howey test generally requires a security to include the following elements: (1) an investment of money (2) in a common enterprise (3) with an expectation of profits from the efforts of others.

The SEC released a Framework for “Investment Contract” Analysis of Digital Assets (the Framework) on April 3, 2019, to address specifically treatment of digital assets as securities. The Framework glosses over the first two prongs of the Howey test and primarily focuses on providing guidance on whether a holder would have an expectation of profits from the efforts of others. The Framework notes that one must analyze whether the purchaser is relying on the efforts of others for a reasonable expectation of profits, and whether the digital assets are offered and sold for use or consumption by purchasers which, while not a traditional prong of the Howey test, has been looked at in the past to determine when certain assets, such as timeshares, might be securities in the hands of one holder and not in the hands of another. Additionally, the Framework identifies certain characteristics of digital assets that would not be “determinative, [but] the stronger their presence, the less likely the Howey test is met,” which includes whether the platform on which the digital assets will be used will be “fully developed and operational.”

Pocketful of Quarters incoming letter

PoQ’s legal analysis in the PoQ Incoming Letter focuses on the third prong of the Howey test, specifically that purchasers will not have a reasonable expectation of profits from purchasing Quarters and Quarters are offered and sold for use or consumption. These arguments included:

  • purchasers having no rights to distributions from the issuer;
  • limitations on the transferability of the Quarters outside of the Platform;
  • characteristics of Quarters that should result in price stability, including the ability for there to be an unlimited number of tokens and that they would be sold at a fixed price;
  • the marketing and manner of sale of Quarters, including clear disclosures that the offering and sale of the Quarters is not an offer or sale of securities and that there would be no ability to profit from the Quarters, along with click-throughs by users representing that they are not purchasing the Quarters with a view towards redistribution or profit; and
  • that the Platform is already fully functional and thus there already could be consumptive use of the Quarters for goods and services.

SEC no-action letter findings

The SEC stated that, on the basis that the Quarters are not securities, it would not recommend an enforcement action if PoQ were to offer and sell Quarters without registration under Section 5 of the Securities Act or Section 12(g) of the Securities Exchange Act. The SEC relied on the following as characteristics of Quarters in coming to this conclusion:

  • PoQ will not use any funds from Quarters sales to build the Platform, which has been fully developed and will be fully functional and operational immediately upon its launch and before any of the Quarters are sold;
  • the Quarters will be immediately usable for their intended purpose (gaming) at the time they are sold;
  • PoQ will implement technological and contractual provisions governing the Quarters and the Platform that restrict the transfer of Quarters to PoQ or to wallets on the Platform;
  • gamers will only be able to transfer Quarters for gameplay to addresses of developers with Approved Accounts or to PoQ in connection with participation in esports tournaments;
  • only developers and influencers with Approved Accounts will be capable of exchanging Quarters for ETH at pre-determined exchange rates by transferring their Quarters to the Quarters Smart Contract;
  • 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;
  • Quarters will be made continuously available to gamers in unlimited quantities at a fixed price;
  • there will be a correlation between the purchase price of Quarters and the market price of accessing and interacting with Participating Games; and
  • PoQ will market and sell Quarters to gamers solely for consumptive use as a means of accessing and interacting with Participating Games.

While this no-action letter still has limited utility for many issuers of digital assets that may or may not be securities, it does expand upon the only prior no-action letter relating to digital assets that was issued to TurnKey Jet at the same time the SEC released the somewhat cryptic Framework. For instance, the purchase price of Quarters is pegged to a virtual asset that has been the subject of speculation rather than to a more stable fiat currency. Thus, while gamers may not profit in the traditional sense, the value of the Quarters relative to local fiat currencies such as U.S. dollars or euros may increase or decrease, effectively making in-game extras and the ability to participate in esports competitions more or less expensive depending on the trading price of a cryptocurrency. Generally, the cost of tournament participation or in-game extras in the U.S. would be payable in either Quarters or dollars, and thus gamers would be more likely to use quarters at a time when the value of a dollar is weak relative to the pegged currency of the Quarters and more likely to pay in dollars and save the quarters when the value of the Quarters is strong. While developers can set their own prices and increase or decrease the number of quarters required to make in-game purchases based on their value, they are not required to do so and, because developers and influencers can convert their Quarters back into ETH at pre-determined exchange rates, they may even be incentivized not to do so if they are willing to hodl. That said, this quality is not particularly different from cryptocurrency arbitrage, in which case the currency would be deemed a commodity rather than a security. Furthermore, unlike TKJ tokens, the Quarters are transferrable rather than solely being a payment solution, even if they are only transferable on a very limited basis. Additionally, because each developer gets to set its own in-game prices that are not required to be linked to fiat, the value of Quarters may actually differ as between different games, whereas TKJ tokens would have the same value for all participants and services on the platform.

Even as such, the Quarters and TKJ tokens share certain characteristics that would make it difficult for startups that are not more traditionally funded to utilize these no-action letters. For instance, in both cases, no transfers of the tokens are permitted outside of the actual platform. Further, in both instances, the issuer represented that the platform was fully functional, although it is unclear how much additional functionality might be developed after the issuance. Further, in both instances, an unlimited number of tokens could be issued, which would limit the ability for companies to sell reserves as a means of capital raising if a platform has been fully built for consumption and the digital assets cease to be securities.

This comes on the heels of a flurry of activity from the SEC. First, the SEC qualified its first tokens under Regulation A+—Blockstack’s Stack Tokens, which will be used for the development of decentralized applications, and YouNow’s Props Tokens, which will be used for accessing premium content in consumer-facing digital media apps, such as YouNow’s live streaming app. Notably, neither of these tokens have some of the typical indicia of a security, such as the right to receive distributions or the right to vote. In addition, on July 8, the SEC and FINRA issued a Joint Staff Statement regarding the custody of digital asset securities by broker-dealers. These actions may indicate that the SEC is about to break through the logjam of hundreds of issuers seeking to qualify or register their token offerings and dozens of broker-dealers that are seeking to register with FINRA in order to facilitate the resale and trading of securities tokens

Nixon Peabody will continue to review developments in this always changing space and work with our clients to ensure compliance with the securities laws.

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.

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