Against Tokens: Part II

This is adapted from a Reddit thread (shout out to my homeboys in /r/ethereum). It is a follow-on from an earlier piece, Against Tokens.

Today brings us a paper, written by Coin Center and Debevoise & Plimpton, and sponsored by Coinbase, USV, Coin Center and ConsenSys, which explores the question of whether tokens sold on a blockchain are or are not securities under the test of Howey v SEC.   

Its unsurprising conclusion is:

An appropriately designed Blockchain Token that consists of rights and does not include any investment interests should not be deemed to be a security, subject to the specific facts, circumstances and characteristics of the Blockchain Token itself…. given our analysis in the above, it should be characterized as a simple contract, akin to a franchise or license agreement.

Oh! So tokens are acceptable now, all is forgiven and this is now a valid business model?


The paper arrives at this conclusion because it asks the wrong question. Of course it’s possible to do virtually anything on a blockchain in a legally compliant way, including representing an interest of some kind as a security or not, as any type of data entry you want, whether that be a “token” or otherwise. As one comment on Reddit put it, aptly,

you can make a tree branch into a security if you wrap it in the utterances and ceremonies which make it a tally stick.


How it might look

This view, mind you, is what informed the innovation known as a private blockchain. With private blockchains, no cryptocurrency is involved and the rights and obligations of all the participants are set out neatly in writing somewhere – with the blockchain used as a distributed reconciliation engine for the participants.

But private blockchains aren’t what we’re talking about here. The instant case concerns the idea, per Joel Monegro’s Fat Protocols post, that users of a “public” or “unpermissioned” cryptocurrency/blockchain protocol should

become stakeholders in the protocol itself and [be] financially invested in its success. Then some of these early adopters, perhaps financed in part by the profits of getting in at the start, build products and services around the protocol, recognizing that its success would further increase the value of their tokens.

This process/business model follows a simple four-step plan:

  1. Developers have idea for a coin.
  2. Developers write an application, instantiate their new blockchain and sell tokens on that blockchain to fund development of the half-baked protocol they’ve already released (because, you know, they already sold the tokens). 
  3. Developers and early adopters sell those blockchain tokens on public crypto-exchanges for profit;
  4. Bro down.

How it actually looks

The question the paper does not directly answer, and the question everyone would like to see answered, is whether the method for conducting a token sale as they are actually done on a daily basis – the “Bro Down Model” – is legally compliant.

Given what we are dealing with (selling unregistered investments to unsophisticated investors over the Internet) it is pretty easy for the answer to that question to be “no.” And to reach that conclusion, it doesn’t really matter whether we’re dealing with a security or not.

1A) Scenario A: Bro Down with securities:

Let’s say, for sake of argument, that the tokens issued per the Bro Down Model do turn out to be securities or investment contracts. In this case, their promoters would need to file registration statements and publish prospectuses every time an ICO/protocol offering takes place.

This process is standardised and straightforward, and absolutely required for every offering of investments to the public, yet ICO promoters to date have all chosen not to do this. 

Which is odd – since if these transactions were all above-board, legally kosher investments, as they have been marketed, I can’t see any reason why someone wouldn’t try to make them stand up to the scrutiny of the regulators. Surely an opportunity to legally access public capital markets is an opportunity too good to pass up.

But I digress.

1B) Scenario B: Bro Down without securities:

Of course, these transactions would not pass muster with the regulators. Not even close. Which is why I read Coin Center’s 27 pages’ worth of legal gymnastics earlier today which sought to explain why, in fact, these transactions are not necessarily securities or investment contracts and are in fact some other kind of legal critter.

So let’s give CC the benefit of the doubt and suppose they’re not. This is still not a green-light where we can with confidence say

“OK, so the Bro Down Model is just like selling knitted jumpers from a local store.  Let’s sell tokens willy-nilly. WORD UP.” *fist bump*

To the contrary: we have to explain what, exactly, these non-investment investment tokens actually are.

I find it difficult to think of them as anything other than investments. This is for functional reasons: if the chain is proof-of-work based, tokens’ value in exchange (and the ability for that value to rise and fall in line with electricity costs) is essential for pricing block validation; if proof-of-stake based (and public) the value of that stake is similarly central, but for different reasons. That these tokens are envisioned to have value in market exchange is more or less admitted where the paper issues this recommendation:

(Scheme promoters should d)ecide on the percentage of the total token supply that represents a fair reward for the work of the development team and advisors.

which it then contradicts:

Marketing a token as a speculative investment, or drawing comparisons to existing investment processes, may mislead or confuse potential buyers. It may also increase the likelihood that the token is a security.

You cannot say something you sell to third parties is not an investment if (a) the value of that thing is tied to the performance of the project and (b) you plan to provide that thing to developers in consideration of their work on that project. Even if this isn’t a security within the meaning of Howey, token sales invariably involve a promoter marketing something as an investment. This is simply unavoidable.

Where this gets tricky is that that there may not, in fact, be a real, legally constituted investment opportunity backing it up.

This means a promoter could find himself in a world of pain, depending on

  • whether promoting investments is a regulated activity,
  • what the promoter said to third party investors in order to induce people to buy the tokens,
  • how much money these buyers subsequently lose, 
  • whether the regulator, and which regulator, takes notice of the activity; and
  • whether any of the promoter’s statements were untrue and misleading, or whether the promoter failed to disclose material information.

A range of potential civil and criminal sanctions are therefore available depending on the fact pattern. They range from the relatively benign such as

  • innocent misrepresentation entitling the buyer/investor to rescind;

to the more serious such as

  • undertaking a regulated activity without authorisation (or equivalent in whatever jurisdiction you’re operating in);

to show-stoppingly, life-endingly, extremely serious e.g.

  • theft or fraud by false representation. 

This is to say nothing of the tax consequences of operating such a scheme, liability for which (absent a legal entity) would arise personally against each of the scheme’s promoters, likely through the lens of a Partnership Act 1890 general partnership or local equivalent. 

As I said. World of pain. 

In terms of what statements we typically see made out in the field, cryptocoin promoters are not known for sober restraint and are usually not *that* careful with the representations they make. 

Screen Shot 2016-12-09 at 18.00.07.png

Exhibit A

Usually the promoter will describe some trivial functionality that the token performs and marry it up to some sociology technobabble like “futarchy” or “code is law.” Promises will be made that the token will have some value in exchange and be listed on exchanges such as Poloniex or GDAX. The promoter will add that there is the possibility of wildly outsize returns if the token takes off, usually followed by the swift disclaimer that despite this possibility the token is not an investment.

In some cases the promoter might even be right about the returns in the short-term. 

Just because a scheme can make some people very rich doesn’t change what the scheme is in the eyes of the law.

And the law wasn’t born yesterday. Saying a token is “purely functional” and “not an investment” is language we’ve seen before – the Federal Trade Commission observes that fraudulent investment schemes (of the non-cryptocurrency variety) often promise “consumers or investors large profits based primarily on recruiting others to join their program, not based on profits from any real investment or real sale of goods to the public. Some schemes may purport to sell a product, but they often simply use the product to hide their pyramid structure.”

For this reason,

  • legitimate investments don’t try to walk the line – they try to be two miles away from the line, and on the right side of it; and
  • long has it struck me, and just about every other lawyer I know who is not enamoured with cryptocurrency and its myths, that given these facts there is almost no lawful excuse for conducting an ICO as we encounter one in the wild. This is because, legally speaking, actual ICOs are closer to Ponzi schemes than they are to securities issuances. This should be distinguished from notional ICOs the paper considers, which characterises token-holders as being akin to licensees or franchisees.

2) If the tokens are designed to have intrinsic value, like Bitcoin, you’re doing it wrong

Assuming that “rights” exist at all presupposes the existence of a licensor/franchisor, i.e. someone against whom the “right” can be enforced. Tokens that follow the mold of Bitcoin or the “fat protocols” idea espoused by USV, on the other hand, are designed to have standalone value which is intrinsic to the token and does not depend on a third party to redeem or honour it. These two approaches are mutually exclusive.

As anyone who knows how a crypto-token ICO works, public blockchain systems with exchange-listed tokens follow the latter approach. Where there’s no licensor/franchisor, there is only

  • the protocol,
  • its tokens, and
  • what those tokens are worth.

Because of this, it’s impossible for there to be legally binding licences or franchise agreements, because contracts require counterparties. The suggestion from Debevoise that we could characterise blockchain tokens created through a token sale as being licenses or franchises is therefore not accepted. Legally, what we’re dealing with is

  • an automatic, distributed software system, that
  • a promoter set up with money from unsophisticated “investors,”
  • which confers those unsophisticated “investors” no legal rights, and
  • which uses game theory to hold itself together – game theory backed by the money of new investors combined with the promise of astronomical returns made by the original promoters.

This is not something I could recommend as a prudent structure for a transaction. 

3) What if I don’t sell any tokens and just hold back a pre-mine?

Different set of issues, but still real potential for a crap sandwich.  World of pain etc. etc.

4) Shenanigans 

To be perfectly frank, trying to get around public offering rules strikes me as a bit of a minefield and not worth the risk. It would be easier to just do things correctly, constitute your token as a security on a private chain and publish an offering circular. As Patrick Byrne’s T0 is planning to do (no relation).

But saying we should listen to Sherriff McLawdog all the time stifles innovation! I hear you cry.

Poppycock. If you want to get investment from someone, there are ready categories – VC, equity crowdfunding, bank debt, convertible debt – which a young blockchain entrepreneur can and should avail him/herself of in order to obtain working capital for his or her business. These legal classifications involve the entrepreneur obtaining that capital, usually from a sophisticated investor, after setting out a detailed business case and setting out in writing, the legal rights which his or her investor will obtain in the business in exchange for their money. 

When someone is selling a coin, on the other hand, this means that someone is trying to get money very quickly from unfussy, unsophisticated investors who are grateful for the chance to get in on the ground floor of the “next big thing.”

Because they’re unsophisticated, in consideration they do not insist upon, and therefore do not receive,  any rights in the business which those funds build in return (e.g. equity, interest, or a share in the profits).

I repeat: someone selling you a coin is bootstrapping their business with your money, and may very well be giving you jack squat – no stake – in their business in return. 

Experience shows that unsophisticated investors are not particularly aware of how badly they’re treated by promoters of these ICOs or similar schemes.

5) Ignoring the law doesn’t mean it doesn’t exist

This, of course, is questionable from a legal perspective. Its questionableness would be more obvious if the coin-sellers were to promise a security and give you nothing in return; you could take your fake share certificate or fake secured loan to a lawyer, who could undertake some inquiries, and tell you whether the document were genuine/enforceable or not.

Turn a fake “share” into a “coin,” however, and suddenly all bets are off? I don’t think so – and I don’t think regulators such as the UK FCA or the Securities and Exchange Commission think so either although, for reasons known only to God, they have so far failed to drop the flaming hammer of justice on these schemes.

So, when we see a project not choosing a legal framework up front and saying “the software rules all,” it means, more often than not, that someone promoting a ICO has a compelling interest in not following the formalities because they’re out to screw you.

Doing things on a purely P2P basis has been shown to frustrate enforcement enough that, at least in the short term, scheme promoters are able to get away with it. But ignoring the law doesn’t mean it doesn’t exist. 

Blockchains and cryptocurrencies are not a new paradigm in personal property or the law of obligations. When enforcement occurs – as it surely will – courts will look at the arrangements and take the initiative in classifying them themselves. That’s generally not a good thing – making an affirmative choice to be this thing or that (e.g. a LLC or a Limited Company) comes with significant tax, liability, or ease-of-doing-business benefits which you will very likely lose if you let a court make that decision for you (and, say, calls your blockchain critter a general partnership or a mere misrepresentation).

5) Not buying it

The question then turns to why this subject is coming up again today, given how much the tech has moved on since the altcoins’ heyday (and collapse) three years ago.

I have no idea why any honest new business would want to run an ICO unless they were supremely poorly advised. Entrepreneurs owe their users better treatment, it’s commercial suicide from a VC or new business development standpoint, and creates a huge contingent risk of future enforcement action.

One theory I have is that some companies in the “blockchain” space got into Bitcoin or some other coin – hard – and possess such an intractably deep-seated loss aversion bias that they’re held in thrall to the Almighty Coins, unable to cast off their original thesis, and incapable of seeing what the space has become. Chiefly:

  • Bitcoin and internet funny money tokens are on the way out, and
  • good old-fashioned applied cryptography, business process/workflow automation and enterprise networking are on the way back in.

Because the only other plausible explanation for so many people thinking that crypto-tokens are appropriate investment products is that they’re all on drugs.

I’m going to give them the benefit of the doubt and assume they’re talking their own books.

The 2017 interpretation of the tech is not just legally correct, but it’s morally correct as well – and in keeping with the ethos of open-source software development. There’s nothing “free and open” about a FOSS protocol that costs money to use and causes a direct pecuniary benefit to accrue to early adopters – that’s called a rent, and imposing it runs contrary to the idea that the “free” in “FOSS” should mean both free as in beer and free as in speech.

A point which, over the course of 2017, I shall enjoy pointing out whenever it is prudent to do so.



  1. […] Polychain Capital will have to carefully assess which projects to invest in. Some argue that ICOs are outright illegal. Preston J. Byrne, Lawyer and Counsel for Monax Industries, said: […]


  2. But in order to Decentralized you tube Facebook etc, you need open sourced ledger. Now you can fund it with VC and aspire to be listed on Nasdaq, the traditional way, or allow your contributors to take part in the success through crowdfunding and alignment of interests. The challenge remains, and is bit delayed by infrastructure development, how to make airbnb, YouTube work on Blockchain. So Blockchain crowdsales are good concept in general, allowing inclusion in funding innovation. If Nasdaq/SEC/gs get left behind its not the blockchain fault, the opposite.


    1. If you’re buying tokens in it, it isn’t going to be the next Facebook.


      1. On the other hand next facebook will share its revenues with more than the handful Facebook shared with coming to their IPO, and Nasdaq will not even be the facilitator in that case, #thankstoblockchain


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