What classifies a token as an investment contract.

A plain English explanation of the Howey test and investment contracts.

TLDR: An investment contract is a type of security. Many securities exist, and they don’t have to be typical stocks and bonds. When selling an investment contract in the US, companies and DAOs are subject to federal securities laws. All they have to do is register their token with the SEC, and disclose complete and truthful information to the investors who buy that token.

Crypto companies and DAOs issuing tokens must determine if they are (or will become) subject to U.S. federal securities laws. Tokens that are sold as investment contracts are securities, which means the laws would apply. Many things can be categorized as securities — stocks, bonds, transferable shares, governance and utility tokens, income share agreements (which is what most “creator tokens” are) and more.

Any contract or agreement that is sold to investors with implied or promised expectation of future profit should be considered a security. Using the money raised from token sale to build the product offering classifies the token as an investment contract.

When selling an investment contract or a security, certain information must be disclosed to investors. The purpose of disclosure is reduction of informational asymmetries that may exist between the builders and the investors. One important piece of disclosure covers how the builders (and their effort) will affect the success of the enterprise.

Framework for analyzing an investment contract

Because investment contracts fall under securities, the same reasoning as the Howey test applies. The SEC staff offers a framework for figuring out if a token is a security in their effort to help. The SEC itself neither approves nor disapproves its content.

  1. The investment of money is satisfied when the token is purchased. It can be bought using fiat currency, another token, or other methods that exchange value for value. For example, giving tokens in exchange for services rendered to further the goals of the token issuer would qualify the sale as the investment of money.

  2. In the common enterprise means pooling each individual investment with other investments into the same enterprise, where distribution of future profits is proportional to the amount invested.

  3. Relying on the efforts of others whose expertise and decision-making impacts the success of the business that sells the token. This includes creating or supporting a market for the token and its price. One example of how price can be supported is by limiting token supply to ensure scarcity, and building-in burning mechanisms or buyback schemes.

  4. With reasonable expectation of profits that range from capital appreciation to participation in income sharing. The first part is applicable when investors can sell their tokens on a secondary market to realize their gains. The second part applies when holding a token gives investors rights to dividends or distributions earnings.

When the token might not be considered an investment contract

When assessing if there might be a reasonable expectation of future profits, US federal courts look at whether the token is bought to be used or consumed. If people buy the token not as an investment, expecting it to become more valuable over time, a few characteristics of its use are considered.

  • The network on which the token can be used is operational and holders are able and incentivized to use their tokens immediately

  • Token is built to maintain constant value or degrade over time, making it unattractive as an investment

  • If it’s meant to be used as currency, holders can use it without converting it to another token or fiat

  • Token can be used to buy goods or services on the network it runs on, and is the easiest way to pay for them

  • Increase in token price is incidental and corresponds with how much demand there is for it

  • Token is marketed for use on the network and not as an investment

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#regulation#investment token#sec