If you’re thinking of airdropping free tokens or implementing a cryptocurrency bounty program, be careful. The Securities and Exchange Commission just issued a cease and desist order (the “Order”) with respect to an initial coin offering, finding the issuance of “free” tokens through a related bounty program in exchange for online promotional services constituted an unregistered sale of securities and thus a violation of the registration provisions of the federal securities laws. Although courts and the Commission have traditionally held that the transfer of “free” shares of stock is a “sale” of securities where the issuer derives some benefit from the transfer, the Order is the first treatment of the issue in the context of cryptocurrency bounty programs.
Airdrops and Bounty Programs
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. The main 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. Like airdrops, bounty progrms are a means of advertising and have become a useful part of many ICO campaigns. During a bounty program, an issuer provides compensation for designated tasks such as marketing and making improvements to aspects of the cryptocurrency framework. Airdrops and bounties are similar in that both involve issuing seemingly free tokens. In an airdrop, however, the issuer does not assign any tasks to the recipients; they need only meet some effortless requirements. But in a bounty program, individuals must execute assigned tasks before receiving the tokens.
According to the Order, Tomahawk Exploration LLC and its founder attempted to raise money through the sale of blockchain-based digital tokens called “Tomahawkcoins” or TOM to fund oil exploration in California. Although Tomahawk failed to raise money through the ICO, it issued approximately 80,000 TOM to approximately 40 wallet holders on a decentralized platform as part of a bounty program in exchange for online promotional and marketing services to promote the ICO. Tomahawk featured the program prominently on its ICO website, offering between 10 and 4,000 TOM for activities such as making requests to list TOM on token trading platforms, promoting TOM on blogs and other online forums like Twitter or Facebook, and creating professional picture file designs, YouTube videos or other promotional materials.
Section 5 of the Securities Act of 1933 makes it unlawful to offer or sell any security unless a registration statement is in effect as to that security or there is an available exemption from registration. The terms “offer” and “sale” are defined very broadly in the Securities Act. Section 2(a)(3) of the Securities Act defines an “offer” of securities as any “attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value”. Similarly, Section 2(a)(3) defines a “sale” of securities” under Section 2(a)(3) of the Securities Act as “every disposition of a security or interest in a security, for value.”
The Order found that the bounty program constituted an offer of securities under Section 2(a)(3) of the Securities Act because it involved an offer to dispose of a security for value. The Order states that the lack of monetary consideration for the shares doesn’t mean there wasn’t a sale or offer for sale for purposes of Section 5, asserting that a “gift” of a security is a “sale” within the meaning of the Securities Act when the donor receives some real benefit. According to the Order, the value or real benefit that Tomahawk received in exchange for the token distributions under the bounty program was in the form of promotion of the ICO on blogs and other online forums and in the creation of a public trading market for its securities. The decentralized platform on which Tomahawk issued the TOM tokens was publicly accessible to U.S. persons and others throughout the offering period, and bounty recipients subsequently traded their TOM tokens on a platform for digital assets.
Bounty program and airdrop enthusiasts would probably point to the Howey test, identified by the Commission as the relevant standard for determining whether a token is an investment contract and thus a security, to support the proposition that tokens issued in airdrops and bounty programs should not be securities. Howey states that for an instrument to be a security, there must be an investment of “money” (in a common enterprise with a reasonable expectation of earning a profit through the efforts of others); since no money is exchanged, the argument is that there is no security. But the Order makes it clear that the Commission continues to interpret the Howey test’s reference to “money” very broadly. That interpretation was made clear in the 2017 DAO Report:
“In determining whether an investment contract exists, the investment of “money” need not take the form of cash. See, e.g., Uselton v. Comm. Lovelace Motor Freight, Inc., 940 F.2d 564, 574 (10th Cir. 1991) (“[I]n spite of Howey’s reference to an ‘investment of money,’ it is well established that cash is not the only form of contribution or investment that will create an investment contract.”).
Possible Exemption: Rule 701
Just because a token is deemed to be a “security” or its issuance a “sale” of securities doesn’t mean it’s illegal. It just means the issuer needs either to register the offering with the SEC (not happening) or satisfy the requirements for an exemption from registration. One possible exemption that token issuers should consider when pondering a bounty program is Rule 701, which is the primary exemption used by non-reporting companies to issue equity incentive awards without registration to employees and certain consultants. There are three key elements here. First, the issuer would need to have a written instrument evidencing the recipients’ right to receive tokens as compensation for services. Second, the bounty program cannot be related to raising money, so the announcement regarding the bounty program should promote the product or service as opposed to fundraising. Finally, the recipients of the tokens in the bounty program may not be engaged in any securities promotion on behalf of the issuer.