The previous posts in this series (part 1, part 2, part 3, part 4, part 5, and part 6) describe the regulators who have taken an interest in tokens, the applicable legal regimes, the history of those rules, and what provincial securities regulators have said about tokens being securities. Having canvassed this, it's time to look at the American experience, because, under similar legal rules, the federal securities regulator recently issued guidance that surprised many people by saying that a number of types of tokens are permitted.

Clear Guidelines In The US

The Chairman of SEC had this to say about their guidance released two weeks ago (jointly with the CFTC, a commodities regulator that's subsumed within the provincial securities regulators of Canada):

After more than a decade of uncertainty, this interpretation will provide market participants with a clear understanding of how the Commission treats crypto assets under federal securities laws. This is what regulatory agencies are supposed to do: draw clear lines in clear terms.

Page 13 lays out the five categories, of which the first three are said to not be securities (unless combined with an investment scheme, as was the case with Howey/Pacific Coin):

(i) digital commodities

(ii) digital collectibles

(iii) digital tools

(iv) stablecoins

(v) digital securities

Parts 5 and 6 of this blog series explain why the last two are special categories in Canada too. These two categories are not discussed below, as they're less interesting than the broader classes of what sorts of tokens look good from a legal perspective.

Category 1: Digital Commodities

They have in mind send/receive value transfer systems, whether as a native coin of a blockchain or as a token layer above it. Specific examples mentioned: Aptos (APT); Avalanche (AVAX);

Bitcoin (BTC); Bitcoin Cash (BCH); Cardano (ADA); Chainlink (LINK); Dogecoin (DOGE); Ether (ETH); Hedera (HBAR); Litecoin (LTC); Polkadot (DOT); Shiba Inu (SHIB); Solana (SOL); Stellar (XLM); Tezos (XTZ); and XRP (XRP).

The distinction the SEC draws is that these tokens derive their value from a market and relate to a crypto system that is functional. The functionally could be rather slight, such as in the case of SHIB token, or it could be a part of a complex blockchain as a native unit such as SOL, ETH or BTC. It could have technical rights, such as participating in a staking system, governance rights for a crypto system, which could even include voting on treasury expenditures. They also confirm the obvious non-securities use case of being the unit of measurement of computation on the network, as with ETH or SOL, where smart contracts require the native unit for doing things, and the more the program does, the more units are consumed.

There is no digitized version of a security or an investment contract with this category.

Category 1: Tokens For Programs

Without creating a new category, page 16 alludes to the idea of having tokens for computer programs, where a portion of the on-chain activities go to token holders. This is an increasingly popular type of token, exemplified by DEX tokens where some % of fees of the smart contract system are used to increase the value of tokens or to direct payments to token holders.

Users of a functional crypto system use the system’s native digital commodity to interact with the system’s features and functionalities. A functional crypto system incorporates economic mechanisms that reward voluntary cooperation and coordination among the system’s users. Users are encouraged to participate in a functional crypto system based on its economic mechanism design, and developers are incentivized to build crypto applications for functional crypto systems that successfully attract users. A functional crypto system does not have a central party54 that oversees participation or distributes rewards to users. As a result, the value of a digital commodity is intrinsically linked to the programmatic functioning of the associated functional crypto system. Therefore, given that a digital commodity is associated with a functional crypto system, a purchaser would not reasonably expect to profit based on the essential managerial efforts of others.

Category 2: Digital Collectibles

This category includes NFTs but also fungible tokens like Fan Tokens (explicitly mentioned as being not a security.) A digital collectible is a crypto asset that is designed to be collected and/or used and may represent or convey rights to artwork, music, videos, trading cards, in-game items, or digital representations or references to internet memes, characters, current events, or trends, among other things.

They also explicitly endorse $WIF, a meme-based token. This may be one of the least professional citations I've ever seen in regulatory guidance. But it's there for a reason: the more pointless the thing, the less likely to be considered a security. So-called meme coins are explicitly endorsed on page 18 as non-securities (and previously endorsed separately last year).

But tokens don't have to be pointless. The SEC points out that an image token could be associated with licensing rights (I've helped to set up such a system for NFTs - there is a market for this). Or they could be stylizing items in a video game, which although outwardly pointless, has meaning to the players of the game. People are social creatures, who love style, design, brands, and imagery, and these can themselves become a market. Unquestionably there is a massive market for digital collectibles, and the SEC is endorsing the idea that just because it has a blockchain incarnation doesn't mean it's any different from non-blockchain collectibles, virtually all of which have never come under scrutiny for being securities.

The SEC has no problem with a token that starts off as being pointless (they don't use that term) but later transforms into being useful with a crypto system (page 18):

a crypto asset may be offered and sold initially as a meme coin that has no functionality within an associated functional crypto system (and no related representations or promises to create such functionality or crypto system) and that derives its value from the asset’s artistic, entertainment, social, or cultural significance, but later become a digital commodity because it becomes functional within an associated functional crypto system.

The SEC then specifically endorses the idea that speculative intent is not what determines the nature of the token, noting the analogy to art markets:

Like a physical collectible, a digital collectible’s value is not based on the expectation of profits from any essential managerial efforts of its creator following creation but rather on supply and demand, which in many cases depends on the subject matter, popularity, or scarcity of the digital collectible, as is the case with physical collectibles. For example, buying a digital collectible with the hope that its subject matter, popularity, or scarcity will increase its price is like buying a piece of art with the hope that market forces will create demand for the art and increase its price.

Lawyers and government regulators have wrongly considered speculation and intent to make a profit as a relevant freestanding factor, but it is only so in conjunction with other factors that are actually relevant to the determination of a security. The SEC's explanation goes on to note that of course the creator of the art might impact the value of it at a later date, but the inquiry is about whether or not they undertake essential managerial efforts from which a purchaser would reasonably expect to derive profits.

Category 3: Digital Tools

This is an interesting way to categorize tokens that lawyers haven't commonly done in the past. The SEC's category is digital asset that are like a a membership, ticket, credential, title instrument, or identity badge. Examples include NFT-based tickets or ENS domain names (which make it easier to send to an address on Ethereum by providing a DNS-like system to resolve names to addresses).

Page 21 has a great analogy. The SEC compares these tokens to membership of a museum. Yes, the buyer of the ticket has an ongoing reliance on the museum, and the museum services are delivered later (and are subject to change) but the key is that there's no way to realize a profit from the efforts of the museum operator. They go on to say that resale value improvements aren't relevant. What's relevant is the promises made at the beginning, with respect to profits:

The price at which the digital tool may be resold, if it may be resold at all, is based upon its functional utility rather than any expectation of profits from any essential managerial efforts of its developer. While the value of a digital tool may be impacted directly or indirectly by the activities of the developer, the creator of a digital tool typically does not make representations or promises to undertake any essential managerial efforts from which a purchaser would reasonably expect to derive profits.

Categories 4 and 5

Categories 4 and 5 in the SEC's ontology aren't helpful for the Canadian discussion because there's a different legal regime for stablecoins and because tokens that are intentionally securities are not the focus of this blog series. But for anyone who wants to learn about these, and how they differ from the other categories, can read from pages 21-24.

Wrapped Tokens

Although not a part of the categorization scheme, page 54 of the guidance explains why wrapped tokens (i.e. a token bridged to another network by depositing them and wrapping that in another token that can be moved onto the other network) are not securities either. The logic isn't as well spelled out for this one, but basically it's that the wrapped tokens are just receipts for the underlying tokens, and since the underlying tokens aren't security, the receipts aren't either as they are held on a 1:1 basis.

The Harder Questions: Investment Contract Or Not?

If it was easy to say what's an investment contract, the highest courts of Canada and the US wouldn't have ended up struggling with it. The SEC tackles this issue at page 24. Key factors:

1. How does the creator/promoter/issuer/maker market the token? Profit expectations depend on marketing/representations, not on subjective belief. The reasonable expectation part of the Howey test is with respect to what is said to buyers (whether directly, or perhaps through secretly authorized third parties, as they mention on page 26). And this is more than just 1:1 chats with other buyers that weren't known to the specific buyer, when determining what someone's reasonable expectation was/is.

2. Explanations of how the investment of money leads to a return. Explaining the people, funding, timelines, resources, and details of how the buyer will profit from all of this in the end? That would probably fulfill this leg of the Howey test. In contrast, representations or promises that are vague or contain no semblance of an actionable business plan, such as those lacking milestones, funding, or other plans for needed resources, likely would not create reasonable expectations of profit.

3. Page 28 explicitly repudiates a past view that the SEC has put forward, which is that the investment contract doesn't go with the token, unless there's some reason for that to be the case. In other words: there's a difference between primary and secondary sales, with respect to the promises/representations made by the token project. They suggest one trigger point could be delivery of the token to the buyer, after which the investment contract doesn't move with the token. Another possibility is that the promises are fulfilled or abandoned (pages 29-33).

4. Crypto mining and what I call technical staking (including liquid staking) are given as examples of non-securities activities, whether done on their own or with others as part of a mining pool. Receipt tokens for liquid staking systems are also not securities because although they are receipts, they are not receipts for securities, since the underlying staking activity isn't a security either (page 53). There is a potentially important caveat in footnote 131 about this, but the general idea is endorsed strongly.

Promoting America

Page 65 explains that one reason for the SEC to address the confusion (that they created) is to encourage more crypto asset market activity in America that would otherwise go offshore. This is a very sensible idea, but Canadian regulators generally don't explicitly mention points like this as their reasons for doing things. Essentially the SEC is walking back some of their previous positions, partly due to a change in administration, partly due to a maturation of the market, and partly due to losing in court on some points. Regulators don't exist to merely push an aggressive view of the law, they take stock of how court cases have gone and they modify their positions accordingly. That's a correct way to approach the law, and regulators in Canada share this philosophy (even if they don't always do it). Courts usually have the ultimate say about what the law is.