This is the third part in my three-part series laying out fact patterns and discussing whether a specific digital asset is a security, a utility, currency, commodity or some other digital asset. In Part 1 of the series, I examined a decentralized token that had been issued without any concurrent capital raise and was able to conclude such token was not a security. Part 1 can be read HERE. In Part 2 I examined a token that was issued with the intent of being a utility token, but as a result of the clear speculative motivation for purchasers, and the lack of decentralization, concluded it was a security. Part 2 can be read HERE.

In this Part 3 of the series, I examine the issuance of the Free Token as a dividend and its cousin the Bounty Token. Unlike the prior blogs in this series, which examined the question of whether a particular token is a security, this blog will analyze the definition of a “sale” under Section 2(a)(3) of the Securities Act of 1933, as amended (the “Securities Act”). As part of this analysis, I will review the SEC action In the Matter of Tomahawk Exploration LLC et al (“Tomahawk Matter”).

The Free Token

Facts

Acme Insurance is building a blockchain-based community for the development of blockchain applications to revolutionize the insurance industry. Acme Insurance intends for the community to ultimately be decentralized and the code to be entirely open-source. Acme Insurance is a regional, top-tier insurance company that hopes to grow in the national marketplace and believes that if it can start and assist in the creation of a community that fosters technological developments in the industry, it will be able to capitalize on those developments to improve its market share. It also fundamentally believes in the improvement and advancement of the industry as a whole, which is defragmented and has a very large incidence of fraud. Prior to launching the Insurance Blockchain, Acme donated 2% of its net profits to educational projects which could benefit the insurance industry and has now committed to donating that 2% to the Insurance Blockchain community.

Acme is launching the Free Token to facilitate its plans. Acme is forming a Foundation to oversee the Insurance Blockchain project. An initial team of international developers is creating the platform. Acme has created 15 million Free Tokens, half of which it will distribute as a dividend to all Acme Insurance shareholders, on a pro rata basis. Acme has 900 shareholders. Acme will not receive any consideration for the issuance. Future Free Tokens will be issued through Proof of Work, and later Proof of Stake, mining efforts and as compensation for website maintenance, code updates, developing and other contributions to the project. All software developments will remain open-source, with no royalty or profit-sharing-type rights.

It is anticipated that the Free Token will trade on cryptocurrency exchanges, and Acme hopes they will increase in value to motivate efforts on the project.

Although Acme believes that ultimately the Free Token would not be considered a security, rather than test its analysis, it intends to sidestep the question and issue the token as a dividend by airdropping the token to all shareholders, without compliance with the registration and exemption requirements of the federal securities laws. Acme has asked me to confirm that it is able to do so.

Legal Analysis

As I’ve written about many times, Section 5 of the Securities Act stipulates that the offering or sale of a security requires registration under the Securities Act and applicable state securities laws, unless it is able to fit within an exemption from registration. Registration under the Securities Act requires the issuer of the security to file a registration statement or offering circular in the case of Regulation A+ offerings, containing specified disclosure about the issuer, its management and business, including financial information. Likewise, the resale of a security by an existing security holder must either be registered or exempt from registration. The registration statement or offering circular is subject to review by the SEC before it can be used for the offer and sale of a security. The process can be both time-consuming and expensive.

Exemptions from registration under both the Securities Act and applicable state securities laws are generally designed for limited offerings of securities to qualified offerees, such as “accredited investors.” Broad-based solicitation without limits on the number or qualifications of offerees, or value of the offering, would make it difficult, if not impossible, to qualify for an exemption.

The registration requirements, or necessity to utilize an exemption, apply to the “offer” or “sale” of a security. Section 2(a)(3) of the Securities Act defines the terms “sale” and “offer” in pertinent part as:

The term “sale” or “sell” shall include every contract of sale or disposition of a security or interest in a security, for value. The term “offer to sell”, “offer for sale”, or “offer” shall include every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value… Any security given or delivered with, or as a bonus on account of, any purchase of securities or any other thing, shall be conclusively presumed to constitute a part of the subject of such purchase and to have been offered and sold for value.

Section 2(a)(3), by its own terms, hinges on the receipt of value. The issuance of a dividend to all shareholders or the issuance of broad-based stock options to all employees has long been viewed as not involving the sale of securities. This theory is often referred to as the “no sale” theory. In a Letter of General Counsel Discussing Question of Whether a Sale of a Security is Involved in the Payment of a Dividend, Securities Act Release No. 33-929, the SEC stated that the distribution of a cash or stock dividend to an issuer’s existing shareholders does not constitute a “sale” under Section 2(3)(a) of the Securities Act, and therefore such distribution does not require a Securities Act registration statement. This guidance was issued in 1936 and has been reiterated on multiple occasions ever since.

Question 103.01 of the SEC Division of Corporation Finance’s Compliance and Disclosure Interpretations, published in November, 2008 confirmed the SEC’s long-standing position. In particular:

Question 103.01

Question: If a company declares a dividend that is payable in either cash or securities at the election of the recipients, does the declaration of the dividend need to be registered under the Securities Act?

Answer: No, as there is no sale of the dividend shares under the Securities Act. [Nov. 26, 2008]

The analysis is based in part on the lack of investment decision by the recipient of the dividend. If the recipient is not bargaining for the dividend and is not giving up anything of value, there is no risk, and therefore no sale of securities has occurred.

Accordingly, without more, even if the Free Token is a security, Acme Insurance can issue it as a dividend without compliance with the registration or exemption requirements under the federal securities laws.

The Bounty Token

Facts

To increase distribution of the Free Token, Acme will create a bounty program whereby initial users receive Free Tokens for (i) signing up to the Insurance Blockchain project; (ii) sharing certain white papers and other information documents on the project; or (iii) writing and creating educational and informational documents on the project.

Bounty programs are also often referred to as airdrop programs, though an airdrop can be used for a dividend release as well. An airdrop involves a controlled and periodic release of “free” tokens to people that meet a specific set of requirements, such as user ranking or activity. Generally the goal of an airdrop is to promote the new cryptocurrency. Bounty programs are essentially incentivized reward mechanisms offered by companies to individuals in exchange for performing certain tasks. Bounty programs are a means of advertising and have gained in popularity in ICO campaigns. During a bounty program, an issuer provides compensation for designated tasks such as registering at a website, reading and sharing materials, or marketing and making improvements to aspects of the cryptocurrency framework. In an airdrop, however, the issuer does not assign any tasks to the recipients; they need only meet some effortless requirements. In a bounty program, however, individuals must execute assigned tasks before receiving the tokens.

Legal Analysis

Tokens issued in a bounty program generally involve the sale of securities that must either be registered or exempt from registration. The concept behind a bounty token program is not new. In the Internet bubble of the ’90s, companies were issuing free stock to gain website traffic and the SEC took notice. In a series of no-action letters, the SEC shut down the practice.

In Vanderkam & Sanders (January 27, 1999), an unnamed operator of an Internet-based auto referral service proposed to issue free stock to anyone who registered at the company’s website or who referred others to it. Visitors would complete a simple registration form and would not be required to provide cash, property or services for their shares. The SEC ruled that “the issuance of securities in consideration of a person’s registration on or visit to an issuer’s Internet site would be an event of sale” and would be unlawful unless “the subject of a registration statement or a valid exemption from registration.”

In Simplystocks.com (February 4, 1999), a web-based provider of financial information proposed to distribute free stock from a pool of entrants who logged in to the company’s website and provided their name, address, Social Security number, phone number and email address and then chose a log-in name and password. Visitors would receive one entry in the stock pool for each day they logged in to the website. After 180 days, the stock would be randomly allocated among the entrants in the stock pool. The SEC stated that the Simplystocks.com stock giveaway would be unlawful unless registered or exempt from registration.

In Andrew Jones (June 8, 1999), the promoter proposed to issue free stock to the first one million people who signed up or referred others to sign up. Shares would be claimed either by sending a self-addressed stamped envelope to the company along with the person’s name, address and email address, or by visiting the company’s website and providing the same information. The company said the information provided by shareholders would be used solely for corporate purposes and would not be sold or given to others or used for advertising purposes. The SEC ruled that “the issuance of securities in consideration of a person’s registration with the issuer, whether or not through the issuer’s Internet site, would be an event of sale” and would be unlawful unless registered or exempt from registration.

In the Matter of Tomahawk Exploration LLC et al (“Tomahawk Matter”)

On August 14, 2018 the SEC obtained a judgment against Tomahawk Exploration LLC and its principal for engaging in a fraudulent ICO. According to the SEC, Tomahawk attempted to complete an ICO using fraudulent and misleading sales materials. However, the ICO failed to raise any money and so Tomahawk “gave away” its tokens as part of a bounty program involving online promotional services.

The bounty program, like the ICO sales materials, were misleading on their face and clearly an effort to promote the token. Tomahawk featured the program prominently on its ICO website, offering between 10 and 4,000 tokens for activities such as making requests to list TOM on token trading platforms, promoting tokens on blogs and other online forums, and creating professional picture file designs, YouTube videos or other promotional materials.

The SEC Order found that Tomahawk’s issuance of tokens under the Bounty Program constituted an offer and sale of securities because the company provided tokens to investors in exchange for services designed to advance Tomahawk’s economic interests and foster a trading market for its securities. In other words, the services required in the bounty program were a valid consideration. It has long been established that value for securities can be in the form of services, cash, property, or anything that a board of directors reasonably determines as valuable. Tomahawk received value in the form of online marketing and promotion, and by the creation of a secondary public trading market for its token. In the case of SEC vs. Sierra Brokerage Servs, Inc., the court specifically found that “where a ‘gift’ disperses corporate ownership and thereby helps to create a public trading market it is treated as a sale.”

Although the Insurance Blockchain bounty program does not require outright promotional activity, at this point, I would still recommend that the bounty program be discontinued or comply with the registration or exemption requirements of the federal securities laws.