In our last chapter we covered airdrops, the method of providing tokens free of charge. In this chapter we'll cover valueless tokens, meaning tokens that not only are not sold to the public, but have no inherent value, and therefore no expectation of being considered an investment over time.
Most of you know these kinds of tokens in two different forms; the first is airplane miles: you receive a specific reward for your purchases at a specific store (or chain of stores) which may later be used in those stores; or you buy specific money to be used later in that store (or chain of stores) with a set discount. In both cases, there is no expectation that these tokens (or rewards) be deemed later for cash (apart from some cases), and there is no reason for these tokens to increase in cash value over time.
As we learned from the Howey Test, the four foundations of an investment require the investment of money, with a common enterprise, and with an expectation of profit, based on the managerial efforts of others. We'll first discuss airplane miles, or reward programs, to show that they do not fall under the Howey test.
What are reward programs? A reward program is a business method where for each transaction, the member of the program receives an incentive for future use. For example, for each US$100 spent in a grocery store, the store will grant the customer with one "Bubble". A "Bubble" is later used in order to either pay for products sold (at a value of US$1 per Bubble) or to buy specific products sold exclusively for the members of the program. In this case, the "Bubble" requires an investment of money, and maybe could be transferred between members, but it is not considered an investment.
In the case of Lehman Brothers (474 B.R. 139 (2012) In re LEHMAN BROTHERS INC., Debtor.) the court inquired whether "soft dollars", meaning, payments made by an investment banks as rewards to brokers which were deemable only for future services. Soft Dollars were made available to brokers are rewards for their activity in the Lehman Brothers marketing program, and may later be used only to pay for market research and brokerage (sound familiar, right?). When Lehman Brothers went bankrupt, the holders of these soft dollars claimed that these are securities, as they represented debt.
The court ruled that these "soft dollars" are not to be considered securities as they had very limited usage: "These credits have become a means for dealing with a unique problem faced by money managers: accounting for the difference between the commission rate actually paid to a broker-dealer for executing a trade and the rate otherwise payable for best execution of that trade. That spread is accumulated and held as a credit for the benefit of the customer that is available only for the express purposes of paying for brokerage and research service" ... "credits that only may be applied to cover the costs of market research are too remote, indirect and tangential to satisfy the customer definition in SIPA. The Soft Dollar Accounts simply are not sufficiently tied to the investment decisions of a customer".
If we see this in a limited manner, we can conclude that a token that may be used against a specific merchant (or affiliated merchants) and has a specific means and method, may not be a security if it is only provided as a reward for another activity.
Let's take Binance for example. Binance is a cryptocurrency exchange that has an inherent token. This token is to be used to pay brokerage fees, and may be later traded in other platforms. However, it was sold at a pre-sale to customers and has a fluctuating value. If we changed these parameters, and for example set up a cryptocurrency exchange that has an internal currency which is issued as a reward for every transaction, and that may later be used to pay the brokerage fees, and where it has no other value (by its issuer) and may not be deemed later on for cash, it might be considered close enough to be a soft-dollar and therefore not a security.
Think Airplane miles, for example. Lufthansa's "Miles and More" allows you to earn miles for every purchase you make with one of its affiliates, as well as your travels. It also allows you to spend miles at different places. But, what it does not have, is a definition that one mile is one dollar, or euro. It does not allow you to redeem these miles as cash, nor does it provide you with any warranty that the value of these miles today will stay the same tomorrow.
There is another reason to remain in a closed-loop system. If your token is to be utilized only at a closed loop system and acceptable by specific vendors, then it might not be considered an e-money provider by the EU E-Money Directive (the closed loop exemption); the EU E-Money directive states that "This Directive should not apply to monetary value stored on specific pre-paid instruments, designed to address precise needs that can be used only in a limited way, because they allow the electronic money holder to purchase goods or services only in the premises of the electronic money issuer or within a limited network of service providers under direct commercial agreement with a professional issuer, or because they can be used only to acquire a limited range of goods or services".
There are similar justifications in different regulations worldwide. The US CARD ACT, which covers electronic fund transfers (and not securities) also excludes closed loop systems from its regulations: “(D) The terms general-use prepaid card, gift certificate, and store gift card do not include an electronic promise, plastic card, or payment code or device that is— (I) used solely for telephone services; (ii) reloadable and not marketed or labeled as a gift card or gift certificate; (iii) a loyalty, award, or promotional gift card, as defined by the Board; (iv) not marketed to the general public; (v) issued in paper form only (including for tickets and events); or (vi) redeemable solely for admission to events or venues at a particular location or group of affiliated locations, which may also include services or goods obtainable— (I) at the event or venue after admission; or (II) in conjunction with admission to such events or venues, at specific locations affiliated with and in geographic proximity to the event or venue”.
The main conclusion here is that if you plan to issue a token for your internal use, then the best practice would be to first make sure that you may fall under the closed-loop exemption, meaning that you avoid secondary uses of the token. The second is that you do not sell your tokens, but issue them as rewards for consumer activity, and make sure that their redemption has no specific cash-value that is either set or increases over time.
In our next chapter we'll cover Burns, and ask whether burning a token as a proof of its usage may allow us to avoid defining it from being as security.
I'm Jonathan Klinger, I'm a master of law, certified to practice in Israel. I've explored the blockchain, and now I'll be helping you in deciding on whether you should raise funds via a token generating event. I highly recommend you avoid it. Read my blog for more info.
Previous Chapters:
Preface
Chapter One: Other People's Money, an Introduction.
Chapter Two: Scams, or why do we need investor protection?
Chapter Three: The Investors, or who doesn't need protection.
Chapter Four: What is a security, or: the Howey test, simplified.
Chapter Five: Avoiding the Howey Test.