Introduction
Imagine an online banking service governed primarily by its most loyal users.1 The banking service rewards its users by provisioning them with governance rights based on the extent to which that individual uses the bank’s services.2 The users, who are most consistently impacted by changes to the service, use their governance rights to guide the service’s decisions using cooperation, collaboration, and voting.3 While this may sound futuristic, blockchain-based services such as Uniswap have made it a reality by issuing governance tokens to reward loyal users.4 Uniswap is a blockchain-based digital asset5 exchange that allows individuals to swap digital assets such as cryptocurrencies.6 Users, referred to as “liquidity providers,” provide the resources to power the exchange protocol.7 Liquidity providers deposit cryptocurrencies into a collective pool and, in exchange, receive a payout when the pool is used to fulfill a trade.8 On September 16, 2020, Uniswap announced a new digital asset called “UNI.”9 Acquiring UNI enables the acquirer to propose and vote on governance questions before Uniswap, such as grants, strategic partnerships, governance initiatives, liquidity pools, and more.10 Uniswap liquidity providers still receive payouts from their liquidity pools, but the protocol also issues UNI to liquidity providers moving forward.11 Curiously, UNI was also awarded retrospectively to historical liquidity providers, effectively decentralizing Uniswap’s governance to its most loyal users.12 By 2021, the continued success of Uniswap and similar protocols validated the potential for customer-controlled protocols as Uniswap’s total monthly volume exceeded $36 billion in April and the fully diluted value of the UNI token at about $24 billion.13
Governance tokens are digital assets14 that confer the token holder the right to vote on governance questions facing her organization.15 Acquiring or holding the token is equivalent to becoming a decision-making member of the organization.16 The token holder’s voting weight is typically proportionate to the number of governance tokens she possesses.17 The Securities and Exchange Commission (SEC) considers many digital assets to be securities under federal law and subject to their regulatory jurisdiction.18 However, it is less clear that governance tokens should fall under federal securities law. The relevant legal test for securities is the Howey test.19 Governance tokens possess unique characteristics that frustrate a simple Howey test application.20 For example, governance tokens may be issued and disseminated not in exchange for money but to reward loyalty.21 Additionally, governance tokens may be distributed with no suggestion or expectation that they will appreciate in value.22 These factors defy a straightforward security classification, and governance token issuers and holders would benefit by knowing whether their governance tokens are subject to the SEC’s regulatory authority.
Uniswap was not the first blockchain-based protocol to decentralize governance through the issuance of a governance token and, considering the success of these tokens, will not be the last.23 This Note addresses a question presented in the growing trend of decentralized governance through the provision and dissemination of governance tokens: Are governance tokens securities?24 This Note will demonstrate that not all governance tokens are securities and will provide a loose framework for designing and issuing governance tokens that are not subject to the SEC’s authority.
Part I of this Note begins by looking at the relevant technical background, namely blockchain, Bitcoin, Ethereum, digital assets, decentralized applications (dapps), and, finally, case studies of governance tokens. Part I then explores modern securities law and its application to digital assets. Part II analyzes several examples of governance tokens under the Howey test. Part III proposes a framework to assist governance token issuers seeking to avoid security classification.
I. Background
A. The Relevant Ecosystem
1. Blockchain, Ethereum, and Smart Contracts
a. The Need for a Digital Currency
For decades, technologists sought a digital currency that could serve as an electronic cash payment system.25 Internet commerce’s explosion in the 1990s demanded advancements in noncash payment systems.26 Noncash payment systems of the time, including digital checking and credit cards, have limitations.27 Both require intermediary financial institutions to process transactions, referred to as trusted third parties.28 Intermediaries add both cost and time in processing transactions.29 These payment systems also require that trusted third parties bear the model’s costs, including the costs of reversing payments, mediating transactions, and mitigating user fraud.30 Payment systems that rely on trust require increasing trust.31 The processing of payment transactions via increasing intermediaries also erodes personal privacy by enabling pervasive government and corporate surveillance.32 Moreover, these systems cannot execute transfers of money amounting to pennies or less, referred to as “microtransactions.”33 As these limitations grew more apparent in internet commerce’s growing wake, technologists sought a digital currency that could enable transactions in a manner that was instantaneous, low cost, and anonymous.34
One notable early digital currency experiment was DigiCash, a company and digital currency that launched in 1994.35 The DigiCash company issued the currency and acted as a central clearinghouse, “fixing the supply of money and processing DigiCash transactions.”36 While DigiCash was, in theory, able to satisfy the need for instantaneous, low-cost transactions, it served as the trusted third party for all transactions, making it a centralized, client-server model.37 The centralized nature of DigiCash proved to be its downfall as a digital currency.38 When the company bankrupted in 1998, the dream of the DigiCash digital currency went with it.39 Technologists continued seeking a digital currency, but one that could operate on a decentralized model.40
In late 2008, one or more anonymous developers working under the name Satoshi Nakamoto answered that dream with “Bitcoin,” a decentralized digital currency.41 Nakamoto’s digital currency moved away from the trusted-third-party model.42 To do so, Nakamoto built Bitcoin on a “blockchain,” a decentralized database.43 In 2009, Bitcoin and its underlying blockchain were launched as open-source software.44
Blockchain advanced computer science by weaving together several existing technologies: peer-to-peer networks, public-private key encryption, and consensus mechanisms.45 A blockchain is a network of peer-to-peer participants and a decentralized database that stores all Bitcoin transactions on the network.46 Instead of a single party storing a database, the Bitcoin blockchain is stored redundantly by all computers participating in the network.47 Bitcoin transactions are bundled into blocks and recorded redundantly by all network participants.48 A new block is created approximately every ten minutes, and blocks are linked sequentially to compose a blockchain.49 Network participants each store this distributed database and are continuously working together to reach consensus on incoming Bitcoin transactions such that the network develops the blockchain’s records together; thus, all members of the network bear the responsibility of storing and maintaining Bitcoin’s state.50 To incentivize participation in the network, the protocol issues Bitcoin to participants—through newly minted blocks and transaction fees—in return for answering mathematical puzzles for a given block in a process called mining.51 Mining computations, referred to as “proof of work,” are scaled based on the number of participants to ensure that blocks are added roughly every ten minutes.52 Once a miner solves a block’s mathematical puzzle, the miner broadcasts its solution to the network.53 All the network peers verify the solution and add the block to the collective Bitcoin blockchain.54 This continuous consensus mechanism solves the need for a centralized trusted party to store and maintain a database, thereby removing the transactional costs that trusted parties bear in reversing payments, mediation, and fraudulent transactions.55
Bitcoin refers to both the underlying protocol and its unit of currency, represented by digital assets commonly referred to as tokens.56 De Filippi and Wright conceptualize Bitcoin with an analogy to email.57 Both email and Bitcoin are protocols that constitute open and interoperable networks not managed or controlled by a single party or institution.58 Use of the email protocol, like the Bitcoin protocol, is entirely free and typically accomplished through providers operating over the protocol.59
Email users own and manage email addresses, sometimes tied to their own identity and sometimes pseudonymously.60 Users send and receive email through email providers, such as Gmail.61 These providers take on the responsibility of storing, receiving, and sending emails on behalf of their users.62 Users access and read their emails through email clients, such as Microsoft’s Outlook or Apple’s Mail programs.63 As mentioned above, the use of the email protocol is free and widely accessible.64 Email as a protocol is interoperable, allowing users a variety of providers and clients to select from while still using the same email protocol that all other users enjoy regardless of their underlying provider and client.65
Like email users, Bitcoin participants interact with others through an account address.66 Where email users send and receive email through their email addresses, Bitcoin participants can execute transactions to send or receive Bitcoin to or from other addresses.67 The client that Bitcoin participants use to interact with the Bitcoin network—analogously to how email users access email through email clients like Outlook—is a “wallet.”68 While blockchain’s initial application implicated the financial industry directly as a digital currency, its success encouraged technologists to consider blockchain applications outside of just digital currencies; many of its most recent advancements have expanded to hosting distributed applications, business structures, and more.69
Bitcoin, like the noncash payment systems before it, came with its limitations.70 These limitations encouraged developers to imagine and launch new blockchain applications, including “on-blockchain digital assets,” representing custom currencies and financial instruments, ownership rights for physical property, nonfungible assets such as intellectual property rights, blockchain-based decentralized autonomous organizations, and complex decentralized applications.71 Ethereum enables all of these and more, but its most relevant application here is its use as a medium to deploy, host, and maintain dapps.72
In 2013, Vitalik Buterin proposed the Ethereum protocol in the Ethereum Whitepaper.73 Ethereum launched in 2015, and, like Bitcoin, it is a free and open-source protocol.74 It implemented another digital currency, called ether or “ETH,”75 that incentivized participants in a similar mining or proof-of-work consensus-building system.76 However, the Ethereum blockchain is faster, a new block being generated roughly once every twelve seconds as opposed to Bitcoin’s ten minutes.77 Ethereum also implemented a programming language, which allows programmers to write and deploy code to the Ethereum blockchain in the form of smart contracts.78 Decentralized applications, called “dapps,” are web services or protocols that enable people to interact with smart contracts.79 Just as transactions stored on the blockchain are decentralized and highly resilient, applications deployed on the blockchain are also decentralized and highly resilient.80
Smart contracts can be conceptualized by returning to the email protocol.81 To send and receive emails, users possess an account that has a unique email address; in Ethereum, users and smart contracts each possess accounts with unique addresses to enable them to send and receive tokens.82 A smart contract executes its code when it receives a transaction with some inputs, whether from a user or another smart contract—similar to if a program or task was set to execute whenever an email address receives an email based on the email’s contents.83 A traditional analogy for smart contracts compares them to a vending machine: by entering funds into a vending machine and selecting an option, the user receives her product.84 Through these mechanisms, a dapp enables users to interact with smart contracts to form a decentralized exchange: the user sends some amount of ETH into the decentralized exchange’s dapp account and, in exchange, receives some other digital currency she requests.85
Bitcoin, Ethereum, and blockchain all present significant advancements in decentralized technology.86 Decentralized technology presents substantial regulatory challenges.87 Experts have compared the decentralization resulting from blockchain’s adoption to that experienced at the advent of the internet.88 Just as the internet decentralized businesses and presented significant regulatory challenges, blockchain has and will continue to challenge traditional regulatory structures.89 As Wright and De Filippi explain, regulatory bodies often rely on a centralized authority to levy regulations.90 Decentralized technology, thus, is inherently challenging to regulate.91 States and regulatory bodies, including the SEC, have been working to regulate blockchain advancements such as smart contracts, addressing capital-raising enterprises or states enacting legislation to give smart contracts legal enforceability.92
Blockchain transactions represent the transfer of digital assets referred to as tokens.93 Jonathan Rohr and Aaron Wright articulate several token classifications.94 The first classification distinguishes the asset as either a “protocol token” or an “application token.”95 Protocol tokens represent the core assets of their protocol.96 For example, this Note has already discussed two popular protocol tokens: Bitcoin is the protocol token, or digital currency, for its underlying Bitcoin protocol, and Ether is the protocol token for the Ethereum protocol.97
In contrast, application tokens are organized around online services and projects.98 Application tokens run on the protocols that underlie protocol tokens, most commonly on the Ethereum protocol specifically.99 Someone seeking to create an application token deploys a smart contract program that handles how the new application token is minted and issued and records who owns the token.100 While application tokens are often created for narrower purposes than protocol tokens, they can still imbue their holder with rights and privileges that were not previously possible.101
Rohr and Wright divide application tokens into “investment token” and “utility token” subtypes.102 An investment token gives its holder an economic right to share profits generated by some project or organization.103 The SEC has spent significant efforts on enforcement actions involving digital assets that operate as investment tokens.104 For many entrepreneurs, cryptocurrencies represented a unique opportunity to crowdfund from a much broader audience than traditional project funding sources.105 Initial coin offerings (ICOs), or token sales, began to flood the market starting in 2013 as entrepreneurs began imagining new methods of raising capital.106 Many of these were scams, fraudulent, or just never ended up manifesting into value.107 Regulatory agencies immediately began working on clarifying the law surrounding ICOs.108
In contrast to investment tokens, a utility token gives its holder a right to access some service or participate in an organization.109 The investment and utility classifications are not mutually exclusive, and many tokens possess both investment and utility characteristics.110 For example, the token may give the user the right to access a service while also permitting them to profit from the same service.111
Governance tokens are a subset of utility tokens.112 Governance tokens grant their holder a utility in the form of the right to participate in the organization’s governance decisions.113 The token holder manages the token in the same manner that she does her other digital assets such as Ethereum or Bitcoin (protocol tokens).114 However, she uses her governance token to vote on governance decisions presented to her organization.115 Governance token holders establish communities where they debate, propose, and vote on changes in their underlying protocol or organization.116 While a token holder may have acquired their governance token by purchasing it, users may also be awarded governance tokens based on their participation in or use of the organization’s services or protocol.117 Like a managing member of a limited liability corporation has a say over her company’s direction, a governance token holder becomes like a managing member of a decentralized autonomous organization (DAO).118
3. Governance Token Case Studies
Governance tokens are increasingly common within decentralized finance (DeFi).119 DeFi is a term referring to alternative financial systems launched on the Ethereum protocol.120 It encompasses applications that enable digital-asset holders to leverage their tokens to achieve just about any economic utility that a traditional financial institution can typically perform, including lending, borrowing, interest yielding, and exchanging.121
Ethereum’s application-focused design has enabled creators to dive into additional financial applications beyond capital raising122 and into applications that are increasingly less finance-centric.123 For example, entrepreneurs are revolutionizing traditional business structures by forming DAOs.124 A DAO is a digital organization deployed on blockchain smart contracts.125 These organizations can coordinate disparate groups of people to operate much like a corporation of loosely coupled managers.126 A DAO can make governance decisions based on an algorithm, or it may allow its participants to vote on the outcome of governance proposals, effectively decentralizing governance democratically among its participants.127 One way to achieve such a governance mechanism is through the use of a governance token.128 DAOs manage many DeFi protocols today.129
A second use for governance tokens exists in segmenting organizational governance decisions.130 Corporations are legally obligated to act as fiduciaries to their stakeholders and are required to act in the company’s best financial interest.131 In contrast, governance tokens and the general movement of decentralizing governance offer mechanisms by which an organization can part from the limits of traditional business structures by segmenting governance decisions to invested communities. This potentially optimizes the balance of interests between traditional business organizations and the communities that an organization serves.132 Several protocol-based organizations have begun eschewing traditional centralized-governance structures in favor of decentralized governance, which is made possible by governance tokens.133 This Section examines four governance token case studies: The DAO and the DAO Token, MakerDAO and the MKR token, Compound and the COMP token, and Uniswap and the UNI token.
The DAO was a digital organization embodied in computer code executed on the Ethereum blockchain.134 Its purpose was to coordinate crowdfunding to raise funds to grow companies in the crypto space.135 Interested parties would invest by purchasing DAO Tokens in exchange for Ether.136 DAO Tokens (1) represented an entitlement to future proceeds on the organization’s investments, allowing the holder to share in The DAO’s anticipated earnings; and (2) entitled the token holder to vote on contract proposals, including investment proposals submitted to The DAO.137 However, many of The DAO’s assets were stolen before its launch.138 The Ethereum community was able to recover the losses, but The DAO shuttered shortly afterward.139
MakerDAO is an open-source management DAO that governs the Maker Protocol.140 The Maker Protocol is a DeFi protocol in which users deposit digital assets as collateral and, in return, are loaned newly minted Dai.141 A holder’s share of governance tokens establishes voting rights, which, in MakerDAO, are reflected by an Ethereum-compliant token named MKR.142 MakerDAO has a variety of voting mechanisms handled via smart contracts on the Ethereum blockchain.143 Anyone, even nontoken holders, may submit proposals.144 A proposal contract is programmed to execute sometime following its approval and could, among other responsibilities, accept a new collateral type, vote to ratify risk parameters or interest rates, trigger an emergency shutdown, allocate funds for infrastructure needs, or upgrade the system.145
Compound is a protocol that establishes money markets for users to supply or borrow digital assets.146 Compound unveiled COMP to start decentralizing the Compound protocol.147 Compound’s leadership retained some protections in launching the COMP token, including the ability to suspend the governance system and a mandatory two-day timelock on approved decisions.148 COMP token holders can propose and vote on changes to the protocol and delegate their votes to others.149 Compound’s founders expressly wrote that COMP was not meant for fundraising or as an investment opportunity.150 Furthermore, until Compound could fully decentralize, COMP would not be available to the public, limiting access to the token until the COMP token was tested and a community ideally developed.151
Uniswap is a decentralized exchange for crypto assets.152 Crypto users can become liquidity providers by depositing two types of Ethereum-compliant153 tokens to Uniswap’s liquidity pools.154 When a user seeks to trade one crypto asset for another, her trade utilizes the liquidity provider’s pool, generating a cut for both the liquidity provider and Uniswap.155 On September 16, 2020, Uniswap introduced its governance token, UNI, to decentralize the Uniswap protocol’s governance.156 The first fifteen percent of UNI tokens were made available to historical users and liquidity providers.157 UNI was earned not in exchange for purchases, but in exchange for providing liquidity to Uniswap’s liquidity pools, and in proportion to the amount of liquidity provided.158 Uniswap announced that UNI holders would immediately have ownership of Uniswap’s governance, the community treasury, and various governance parameters.159
B. The Securities and Exchange Commission
The Securities Act of 1933 and the Securities Exchange Act of 1934 authorize the SEC to regulate securities and security exchanges.160 The SEC may make, amend, and rescind rules and regulations of securities and security exchanges.161 All securities offered and sold must be registered with the SEC or must qualify under an exemption.162 Registered securities have to comply with the SEC’s rules and regulations.163 To enforce its authority, the SEC may bring enforcement actions, seek cease and desist orders, impose fines, investigate violations, perform compliance examinations, publish reports, and more.164 When the SEC attempts to enforce its authority, the enforcement subject may argue that their financial instrument is not a security, requiring the SEC to demonstrate that it has regulatory jurisdiction because the instrument is a security.165
1. The Howey Test: Identifying Securities
Section 2(a)(1) of the Securities Act provides that a security includes investment contracts.166 However, the term investment contract is not defined in the Securities Act and is left to the courts’ interpretation.167 In 1946, the Supreme Court articulated a test defining investment contracts in SEC v. W.J. Howey Co.168
In Howey, a Florida corporation, the Howey Company, sold land sales contracts for strips of farmland to purchasers who had no professional knowledge or experience in agriculture.169 These contracts conveyed the land to the purchaser but retained a leasehold interest for Howey-in-the-Hills Service, Inc.170 The agreement promised the purchasers substantial profits and granted the company complete discretion and authority over cultivating, harvesting, and marketing the crops.171 The Howey Company sought to advertise to prospective purchasers via mail, and the SEC filed for an injunction to stop the practice.172
To define an investment contract’s elements, the Court found no definition in the Securities Act or legislative reports and looked to state “blue sky”173 laws.174 The Court held that an investment contract is a contract, transaction, or scheme in which: (1) a person invests money; (2) in a common enterprise; (3) and is led to expect profits; (4) from the efforts of another.175 To capture the statutory purpose of the Securities Act, the Howey test is flexible.176 Therefore, it determines investment contracts by examining case by case the substance rather than the form of the contract, transaction, or scheme.177
The Court applied the Howey test to the Howey Company’s operation and found that it had been offering investment contracts.178 The Howey Company provided investors the opportunity to contribute money and share its citrus fruit business’s profits.179 The investors provided no equipment, labor, or experience to the enterprise.180 The investors were attracted to the investment by the prospect of earning a profit from the Howey Company’s efforts.181 As a result, the Supreme Court found that the Howey Company’s arrangement involved investment contracts and, therefore, was within the Securities Act’s scope.182
2. SEC Applies Howey to The DAO
The DAO was the first major experiment in decentralized governance.183 Despite The DAO having shuttered, the SEC published a nonbinding opinion analyzing whether its underlying digital asset, the DAO Token, was a security.184 The SEC applied the Howey test and concluded that DAO Tokens were securities.185
The first requirement is an investment of money, and it need not take the form of cash.186 DAO Tokens were received in exchange for a payment in Ether, and such a contribution of value can create an investment contract.187 In token sales, transactions entirely in digital assets still satisfy an investment of money.188 The Howey test disregards the transaction’s form in favor of the transaction’s substance and economic reality.189 Hence, for an investment contract analysis, Bitcoin counts as money.190 Since 2013, the SEC has issued a panoply of SEC actions based on investments made via Bitcoin.191 Investments made with digital assets such as Bitcoin create investment contracts under the Howey test.192
Second, Howey looks to whether the investment is in a common enterprise.193 The SEC determined that investors who purchased DAO Tokens invested in a common enterprise—The DAO.194 The SEC’s treatment of this prong was brief, stating simply that this element was fulfilled without going into detail.195
Third, the Howey test looks to whether the investor had a reasonable expectation of profits.196 The SEC determined that this requirement is satisfied because The DAO’s developing organization, Slock.it, and its cofounders spent considerable efforts advertising The DAO, including producing promotional materials and publishing blog posts.197 The SEC then determined that “a reasonable investor would have been motivated, at least in part, by the prospect of profits” from The DAO.198
The Howey test’s final element requires that the investment’s expected profits are derived from others’ efforts.199 While the managerial efforts of Slock.it’s cofounders and The DAO’s curators were significant in deriving profits, DAO Token holders possessed voting rights.200 The DAO’s token holders may have been deriving profit from their own efforts—potentially obviating the final element of the Howey test—in the form of voting for funding proposals, which would require research and due diligence.201 In the end, the SEC determined that the efforts of Slock.it, its cofounders, and The DAO’s curators were essential to the enterprise and outweighed the limited voting rights possessed by DAO Token holders.202
II. Analysis
A. Applying Howey to Governance Tokens
The Howey test then provides that an investment contract is (1) an investment of money; (2) in a common enterprise; (3) with a reasonable expectation of profits; (4) to be derived from the entrepreneurial or managerial efforts of others.203 In this Section, the Howey test is applied to several governance token case studies.
Case law has established that the investment of cryptocurrencies satisfies the “investment of money” requirement.204 However, many of the governance tokens issued today are not exchanged for an investment of money.205 For example, interested parties accrue the COMP governance token as they use the Compound protocol.206 Thus, the token is accrued not for money, but for the use of the protocol, almost like a loyalty or rewards program.207 This loyalty program then enables the loyal token holder to guide her protocol by voting to adjust the interest rate model or add support for a new asset.208
However, several arguments could be raised that COMP token holders acquired their tokens through the investment of money regardless of how directly they acquired them. First, while the governance token is received in exchange for the Compound protocol, Compound is a financial protocol, and use of the protocol requires an investment of money within the scope of Howey.209 Placing digital assets into the Compound protocol to receive compounding interest necessarily begins with investing money.210 A user seeking to take a loan through the Compound protocol must first deposit digital assets to serve as collateral, which likewise entails transferring money.211 Second, any use of the Compound protocol, including the claiming, transfer, and use of COMP tokens, requires the user to pay Ethereum’s gas fees.212 To the SEC, the placement of assets and gas fees may equate to an investment of money to satisfy the first element of a Howey analysis.213 Finally, the COMP governance tokens are Ethereum compliant and thus freely transferrable assets.214 This allows them to be sold and purchased on secondary markets and traded in exchange for digital assets.215 The token has a market value and can be procured by parties that have never used the Compound protocol.
The second element of the Howey test requires that the investment was made in a common enterprise.216 The SEC has stated that in evaluating digital assets, a common enterprise typically exists.217 A common enterprise exists where there is horizontal commonality and sometimes where there is vertical commonality.218 Horizontal commonality is where each individual investor’s fortunes are tied together with the success of the overall venture—investors’ fortunes rise and fall together with those of the common enterprise.219 Horizontal commonality requires the investors to pool their assets, which are often combined with the pro-rata distribution of profits.220
Circuits diverge on whether and in what circumstances vertical commonalities are sufficient to satisfy Howey’s common enterprise requirement.221 Vertical commonalities focus on the relationship between the promoter and the enterprise’s investors. In contrast with horizontal commonalities, investors’ fortunes in vertical commonalities may rise and fall separately.222 Vertical commonality has two forms: broad vertical commonality and strict vertical commonality.223 In broad vertical commonality, the fortunes of the investors are not linked to the fortunes of the promoter, but rather to the promoter’s efforts.224 In strict vertical commonality, the fortunes of the investors are directly linked to the promoter’s fortunes.225 Circuits are more likely to find that strict vertical commonalities are consistent with Howey’s common enterprise requirement than they are with broad vertical commonalities.226
One argument that technologists may raise—which will likely fail—is that DeFi protocols and DAOs are fundamentally of such an incomparably different nature to traditional enterprises that they are not in a common enterprise as has traditionally been defined.227 These arguments will likely fail as courts applying the Howey test focus on the substance underlying the circumstances.228 But DeFi protocols and DAOs still use tokens as a means of collectively pooling assets, tying the investor’s fortunes to the protocol promoter’s fortunes, thereby creating a horizontal commonality and satisfying the common enterprise requirement.229 Thus, an investment in a blockchain-based organization can create an investment contract regardless of novelty in the organization’s structure.230
3. With a Reasonable Expectation of Profits
The third element, requiring a reasonable expectation of profits, is a fact-dependent inquiry.231 Courts look beyond the formal terms of the parties’ agreement to find whether a reasonable expectation of profits was created.232 A reasonable expectation of profits may be created by promotional materials, advertising, or other communications from the organization’s developer or leadership.233 Therefore, a governance token’s promotional advertising circumstances are essential: where the issuing company has issued promotional materials promoting its service and suggesting that the governance token will appreciate in value, a finding of a reasonable expectation of profits becomes more likely.234
4. To Be Derived from the Entrepreneurial or Managerial Efforts of Others
Because a governance token holder has the power to influence governance decisions within her organization, the final part of the Howey test is complicated by her own managerial efforts such as due diligence and voting.235 The SEC’s report concerning The DAO leaves open many questions as to how the last factor of the Howey analysis will apply in governance token regulation moving forward: For example, how much and what kind of involvement should a governance token holder have—and, in contrast, what kind of involvement should DAO creators avoid—so that the holder’s profits are not derived from others’ managerial efforts?236 Indeed, a DAO decentralized governance model can result in too many proposals for the average token holder to keep herself informed—certainly, these systems must allow for governance tokens to be delegated to a third party who would be responsible for voting on the holder’s behalf.237 Services are emerging to fit this very need, as are protocol politicians—individuals in a protocol’s community who research proposals and communicate recommendations to the community.238 While this solves an essential need in decentralizing governance in these organizations, it separates the token holder from the organization and suggests that token holders derive profits from others’ managerial efforts.239
B. Governance Tokens and Regulatory Frameworks
In 2019, the SEC published its “Framework for ‘Investment Contract’ Analysis of Digital Assets.”240 The framework provides an analytical tool to help digital asset issuers determine whether their digital asset falls under securities laws.241 The SEC’s guidance provides that digital asset regimes typically satisfy the investment of money and common enterprise requirements of an investment contract, the first two Howey prongs.242 The main issue in analyzing a digital asset stems from whether the digital asset holder has a reasonable expectation of profits derived from the efforts of others.243 The framework’s listed characteristics suggestive of securities include an issuer whose ongoing presence and work is central to the maintenance of the network or digital asset;244 a digital asset that grants its holder income or profits of the enterprise such as pro-rata rights;245 a digital asset that is expected to accrue in value and may be listed on a secondary market or is expected to be;246 a digital asset that is offered broadly to potential purchasers in contrast with being offered to prospective or actual users;247 an issuer that uses the digital asset to raise funds that it continues to expend on the network or digital asset;248 and a digital asset that upon issuance is ready to be used for its intended utility.249
Recall that an application token is a digital asset and that application tokens include investment token and utility token subtypes.250 Investment tokens, much like investment contracts, are meant to give its holders an economic right to share in the profits generated by a project or organization.251 In contrast, a utility token, the superset of a governance token, finds its purpose in granting the holder a right to access some service or participation in an organization.252 Governance tokens are meant to grant their holder a utility in the form of the right to participate in the network’s governance decisions and, by themselves, do not reflect on the holder’s economic rights.253 The characteristics outlined in the SEC’s framework implicate the digital asset as a provisioner of economic rights; utility rights are less affected.254 These characteristics bear primarily on a digital asset’s qualities as an investment token and not as a utility or governance token.255
This conclusion under the SEC investment token framework is consistent with the Swiss Financial Market Supervisory Authority’s (FINMA) framework.256 FINMA’s framework explicitly excludes utility tokens from securities if the token’s sole purpose is to confer digital access rights to an application or service—such as governance rights—and if the utility token can actually be used when the security inquiry is performed.257 However, if a utility token has an investment purpose, the digital asset will be treated as a security.258 Likewise, the Monetary Authority of Singapore has published guidance that digital assets are not subject to securities laws where they provide rights of access with limited accompanying economic rights.259
C. Distinguishing from The DAO
While the SEC determined in its nonbinding 2017 report that The DAO’s underlying token, the DAO Token, constituted a security despite its characteristics as a governance token, the SEC’s determination is not applicable to all instances of governance tokens.260 The DAO’s token had governance token characteristics in that it permitted its holder to vote on proposals such as into which projects to invest.261 But it also had investment token characteristics in that it entitled its holder to earnings on those investments.262 DAO Tokens shared qualities of investment and governance tokens, making it a hybrid token.263 The DAO Token’s characteristics as an investment token and not as a governance token motivated the SEC’s decision.264
For example, the investment of money was the exchange of a cryptocurrency, Ether, for DAO Tokens.265 This structure is common to investment tokens, especially in application token sales or ICOs—investment tokens are issued in exchange for investments in the form of digital assets.266 In contrast, governance tokens may be given in exchange for the use of the protocol.267 Second, the reasonable expectation of profit in The DAO reflected a fundamental interest specific to the investment token—the Slock.it cofounders spent considerable efforts promoting the token for its use as a capital-raising tool.268 The DAO was dependent on the capital-raising effect of DAO Tokens: to invest in other projects, it had to raise capital through its value proposition.269 Finally, the SEC found that the final Howey element was satisfied because the profit was not sufficiently derived from the token holder’s work but rather from The DAO’s organizers’ managerial efforts, Slock.it, Slock.it’s cofounders, and The DAO’s curators.270 Slock.it and its cofounders opted not to launch The DAO fully decentralized but gradually.271 While this may have been responsible, the SEC saw the cofounders’ retention cut against a token holder’s argument that their efforts were an influential factor in deriving profits from their investment.272 The more control the cofounders were able to leverage, the less work the token holders would legitimately put into deriving profits on their investments.273 Participants’ trustless nature was also an issue for the SEC; the participants did not know each other and did not communicate meaningfully for votes.274
The elements of DAO Tokens that drew the SEC’s focus in its report were its qualities as an investment token, the features necessary for its use in raising, deploying, and distributing capital.275 DAO Tokens were obtained in exchange for an investment and, most notably, they were obtained with the intent that there would be a return on its investment.276 The asset’s characteristics as a governance token raised a meaningful argument that the Howey analysis’s last element was not satisfied because the token holder participated in deriving profit by voting for proposals.277 Unfortunately, the level of control that token holders possessed was not enough, but more recent governance tokens grant even greater control to token holders.278
A governance token issuer may reasonably look at the SEC’s report on The DAO and mistake it for meaning that all governance tokens are securities. But as discussed above, not all governance tokens are securities.279 The DAO’s SEC report based its decision on the nongovernance token features of the DAO Token.280 This Note will proceed by articulating a framework to help practitioners design and issue governance tokens that are not securities and assist courts in differentiating governance tokens from investment tokens.
III. Proposal
Not all governance tokens are securities.281 But some are, and how will a governance token issuer know when their governance token is a security? What features should a court or the SEC examine to differentiate a governance token from an investment token? Whether a governance token is a security is a fact-heavy inquiry, turning on case-by-case evaluations of the totality of the circumstances ranging from the token’s functionality to the underlying organization’s control and marketing.282 This Note proposes a four-factor framework that, when satisfied, minimizes the likelihood that a governance token is a security. This framework does not replace the Howey test. Instead, in fulfilling this framework, a governance token will be less likely to satisfy the Howey test. A governance token is less like a security where: (1) the token’s issuance resembles loyalty rewards; (2) the token is not issued for capital raising or fee splitting; (3) marketing or promotional materials do not suggest monetary value behind the token; and (4) governance rights are substantially decentralized, with minimal control retained by individual private parties as opposed to token holders.
A. Governance Tokens Provisioned as Loyalty Programs
The first factor in the framework is that the token is used as a loyalty or reward system rather than an exchange of money.283 The more internally the token is kept and maintained, the better.284 Many governance tokens are Ethereum compliant, which jeopardizes their status as nonsecurities because they can be acquired for money on secondary exchanges and their value can appreciate.285 It follows that if the digital asset has a value that can appreciate, then a reasonable expectation of increasing value could be established. In contrast, a governance token that is untransferable or otherwise not listable on a secondary exchange has a stronger claim against being found a security—in such a scenario, the asset does not have a secondary value for which a party could have a reasonable expectation of appreciating value.286 A token that has the sole purpose of conveying governance rights—as opposed to possessing investment purposes—has the most substantial claim to avoiding classification as a security.287 Indeed, the SEC’s token framework provides that a purchaser can reasonably expect profits derived from others consistently with Howey by selling tokens on secondary markets for appreciating returns.288 The digital asset’s transferability on a secondary market, or the expectation that it will become tradeable, may suggest that an asset is a security.289 At the least, this suggests that some restrictions on the transferability of a token would be recommended to limit exposure on edge cases where a digital asset is more suggestive of a security.290
Uniswap’s UNI token, as initially announced in September 2020, is an example of a governance token that closely resembles a loyalty program.291 Uniswap awarded the first fifteen percent of UNI’s tokens to liquidity providers and announced that sixty percent of UNI would go to Uniswap’s community members over a four-year schedule.292 UNI was not acquired directly in exchange for money in the form of cryptocurrency.293 A governance token implemented as a similar loyalty program decentralizes governance to loyal members of the community and cuts against the first element of the Howey test in requiring an exchange of money.294
B. Avoidance of Capital Raising
The second factor in the framework is that the token is not used as a capital-raising or fee-splitting tool.295 Here, timing is vital—an investment token sold earlier in the development of an application to fund development is more indicative of an investment.296 The SEC’s token framework recommends that any funds raised for the digital asset be limited to those required to establish a functional network or digital asset.297 And the issuer should avoid spending funds from proceeds or operations to continue enhancing the functionality or value of the network or digital asset.298 A DAO’s organizers will have a stronger argument that their token is not a security where it is not used as a source for raising capital.299 The DAO was first and foremost a venture capital fund.300 Users provided the capital and would execute on their governance tokens to vote on governance decisions, such as in which projects to invest.301 Holders of The DAO’s governance token earned value based on the success of their token.302 The DAO Token appears like an investment token in this regard.303 A governance token with no capital-raising element will likely be free of the security aspects of investment tokens, and the appearance of an expected profit in a contract acquired in exchange for money becomes less clear.304
C. Avoidance of Marketing that Creates a Reasonable Expectation of Profit
The third feature in this framework is that marketing materials do not convey to users that the token will accrue interest, making them profitable.305 While there is no requirement that the user’s reasonable expectation of profit be established off of the organization’s activities, its activities are substantial in setting reasonable expectations.306 The SEC recommends avoiding marketing a digital asset, directly and indirectly.307 The public’s perception of a governance token speaks to the issuer’s and token receiver’s purposes, and the issuer’s advertising and representations set public perception.308 Where a user may have had a reasonable expectation based on a third party, that reasonable expectation may be canceled out if due diligence would have shown the DAO’s express statements that there was no such expectation or goal.309 For example, expressly disclaiming it as an investment opportunity supports that the token is not an investment token or investment contract.310
D. The Extent of Decentralization
The last factor in this framework analyzes the extent to which the model adopted is substantially decentralized such that there is no special-manager class that retains significant control over the organization.311 This factor is consistent with the SEC’s framework for analyzing digital assets, which inquires into the level of control and any lead, central, or managerial role that the issuer retains, as well as whether the issuer continues to be important to the value of the digital asset or the success of the common enterprise.312 Like many governance tokens, Uniswap’s is awarded to those who use the underlying protocol.313 While users of the platform stake money, the UNI token is awarded not in exchange for the money but as a reward or loyalty point.314 Uniswap developers allocated forty percent of UNI’s first issuance to team members, investors, and advisors,315 but retained no special control unique from community UNI holders who received the remaining sixty percent of issued tokens, and Uniswap immediately vested ownership rights among UNI holders.316 Even more interesting, the first UNI token holders were not aware that they were accruing UNI tokens.317 There is no reasonable expectation of deriving profits from others’ managerial efforts in these circumstances on the part of the users who were granted this token for using Uniswap.318 With regard to whether any party retains control such that the SEC would say that token holders benefit from the managerial efforts of others, the UNI token’s analysis is more straightforward than The DAO’s circumstances in that governance-right retention is significantly limited.319
Conclusion
Since its inception, blockchain has captured the creativity of a generation of entrepreneurs. Blockchain’s novelty and its earliest adopters’ innovative nature have made it a regulatory target and the subject of market speculation. Like other decentralized technologies, blockchain assets naturally defy regulatory authority.320 DeFi and DAOs raise many novel legal issues: ICOs,321 token sales,322 and now governance tokens. The SEC has spent significant resources to clarify that investment tokens are securities—but not all governance tokens possess investment characteristics.323 Thus, the question remains as to how protocols build and issue their governance tokens to determine whether they will fall under SEC regulatory guidance.324
The SEC has invested considerable resources in recent years to clarify the relationship between digital assets broadly and securities laws.325 Yet, governance tokens have not explicitly been analyzed.326 Indeed, many current governance tokens defy security classification327 under the Howey test.328 The four-factor framework proposed in this Note emphasizes the specific characteristics by which governance tokens may avoid security classification.329 These factors include how the token resembles a loyalty rewards program, avoidance of capital raising, the use of marketing, and the extent to which the organization has decentralized governance.330