Lewis Cohen is a partner at Hogan Lovells, Caitlin Long is a co-founder of the Wyoming Blockchain Coalition, Rich Slater is an attorney and registered agent in Cheyenne, and Andrea Tinianow is the chief innovation officer for Global Kompass Strategies.
The views here are those of the authors. This article is not legal or investment advice.
On February 19, Wyoming’s House of Representatives became the world’s first elected body to exempt certain blockchain-based tokens from money transmission and securities laws, provided they have a clearly defined “utility” and are not marketed as investments.
News of Wyoming’s progress prompted debate within the blockchain community about just how meaningful the action may be if the bill becomes law – especially in light of the recent statement by Securities and Exchange Commission (SEC) Chairman Jay Clayton that “I believe every ICO I’ve seen is a security.”
We believe Wyoming’s utility token bill, if it becomes law, is likely to be highly significant and to have influence beyond state borders because it provides a model that other states may follow and a standard for the federal government to consider.
Skeptics argue that federal securities law would preempt Wyoming’s law and render it moot. But, even if skeptics are eventually proven correct, that does not mean Wyoming’s law has no value.
Federal law often looks to the states — the living laboratory — for guidance on federal questions with far reaching impact, as is the case here. And, until there is clear authority from the federal government regarding the sale of utility tokens, isn’t it better to have clear state guidelines to enable predictability, compliance and a fair marketplace?
Further, since property law is generally a state law matter, it may be well within Wyoming’s right to develop state legislation regarding what it deems a new form of property.
The legal status of digital tokens that have a functional utility is unsettled at the national level and Wyoming’s action is the first step toward clarifying a critical gray area of the law – one which could take years to resolve, and may very well require Congressional action or litigation before a nationwide position is reached.
H.B. 70 is one of five blockchain-friendly bills moving through the Wyoming legislature during its 20-day session. Indications are that Governor Matt Mead will sign the blockchain bills if they reach his desk, since he praised the blockchain efforts during his recent State of the State speech.
An important distinction
The very “utility” of a true utility token, when specifically designed to be exchanged for goods and services, is a potentially critical differentiating characteristic that distinguishes it from debt, equity or other securities. These types of traditional securities do not serve such a “utility” purpose.
The use of a utility token in a blockchain network poses a number of interesting challenges for the SEC. For example, securities custody arrangements for investment funds are not designed to allow securities to be used outside of the trading, clearing and settlement infrastructure of Wall Street. But it won’t be long before an SEC-regulated mutual fund wants to buy a utility token and confronts this crucial “plumbing” distinction.
And it’s useful to think about this distinction from the perspective of a utility token user, who may not have a securities brokerage account.
Take the proposed KODAKCoin blockchain as an example. If the SEC were to find that the utility token itself is a security, and a photographer wants to sell a photograph on the KODAKCoin blockchain, would the SEC really require the photographer to open a brokerage account (at Schwab, for example) just so she can upload her photograph to the blockchain? This strikes us as extreme and likely to push such networks offshore or into decentralized versions, which are even more difficult to regulate.
Utility tokens create a plethora of regulatory gray areas that will take years for regulators, issuers, litigators and legal scholars to sort through definitively, and this is even true if all utility tokens were to be deemed securities by the SEC. It would be most unfortunate if the SEC were to require all token sales to be structured as legally compliant sales of securities and such securities “plumbing” complications caused the projects to be unable to operate in the U.S.
Best- and worst-case outcomes
So what does this mean for Wyoming, the first state to clarify that a utility token is a unique asset class under state law?
In the best-case scenario for the blockchain sector, other states would similarly regulate utility tokens as digital assets (a new type of property) and utility tokens would be exempted from state securities and money transmission laws. (Note that this approach would still allow state securities regulators to protect investors who are sold utility tokens under a sales arrangement that constitutes an “investment contract”.)
In the worst-case scenario for the blockchain sector, the SEC would follow through on Chairman Clayton’s statements and fail to develop a more nuanced interpretive position that recognizes certain digital tokens are not themselves “securities” and should not be regulated as such.
Under this scenario, functional utility tokens get conflated with the investment schemes that many companies have been using recently to sell digital tokens on an unregulated basis, and the benefits of utility tokens would be lost.
This would likely lead to two consequences.
First, litigation would likely ensue regarding whether federal securities laws will preempt state utility token laws. It is worth noting that many blockchain companies have the financial resources to finance such litigation and many advocacy groups would likely lend their support, but the outcome may not be known for years.
Second, Wyoming-based issuers could restrict the sale of their utility tokens to Wyoming buyers only. In practice, this isn’t as restrictive as it sounds.
Crypto Valley, USA?
For example, Wyoming buyers could be either Wyoming residents or Wyoming-registered LLCs owned by non-Wyoming residents. In fact, many crypto owners already hold their crypto assets via LLCs to mitigate potential liability exposure, and Wyoming-registered LLCs are consistently favored by wealth advisors due to Wyoming’s strict privacy laws.
Non-residents of Wyoming could form Wyoming LLCs, which, when properly established, may make them eligible to purchase utility tokens as a “Wyoming buyer” despite not residing in the State.
Wyoming invented the LLC in 1977, and the State has made setting up LLCs easy, quick and cheap. And if the bill to authorize a type of LLC known as series LLCs in Wyoming (H.B. 126) also passes, Wyoming LLCs may be even more attractive for issuers to manage myriad token purchasers, or owners to manage their myriad coins.
Many blockchain entrepreneurs have already demonstrated their interest in Wyoming by visiting the legislature in Cheyenne, so perhaps it won’t be long before a U.S. version of Switzerland’s Crypto Valley forms in the Rockies.
In any event, the early clarity provided by Wyoming’s H.B. 70, if it becomes law, would be extremely helpful to the dialogue defining the boundaries of compliant actions in the exciting new token economy.
Special thanks to Joshua Ashley Klayman, chair of the Wall Street Blockchain Alliance’s Legal Working Group.
Wyoming image via Shutterstock