The US-based Token Launch: Avoiding Traps for the Unwary

Token projects in the US face a variety of complex legal issues, requiring careful project architecture to ensure compliance with law.

This article discusses just a handful of the emerging issues facing digital token projects in the United States. Specifically, this article focuses on issues related to sufficient decentralization of a token project, applicable regulatory regimes (including US securities, commodities, and money-transmitter regimes), and novel issues pertaining to whether or not a token project may constitute a partnership under state law.

Decentralization as an essential North Star

Recent guidance from the US Securities and Exchange Commission (SEC) has continued to emphasize the need for token projects to achieve sufficient decentralization to the extent they wish to be exempted from US securities rules. In recent public comments, SEC Commissioner Hester Pierce has discussed the possibility of a safe harbor regime that would permit crypto asset projects to achieve decentralization. At the end of the safe harbor’s term, “token transactions may not be securities transactions if the network had matured into a decentralized or functioning network that is not dependent on a single person or group to carry out the essential managerial or entrepreneurial efforts.” At this time, there is no further concrete guidance on possible metrics that might be used to evidence sufficient decentralization. Framework guidance updated by the SEC as of July 5, 2024 could also be relevant, but it is unclear how such guidance might be presently applied. Presumably, digital asset projects that achieve a sufficient decentralized user base akin to Bitcoin and Ethereum would qualify, but nothing is certain. It is therefore essential that digital token projects continue to monitor forthcoming rules related to decentralization and consider how to structure their token infrastructure to take advantage of regulatory guidance related to the same.

Complying with US securities, commodities, and money-transmitter regimes

The structuring of a token project may implicate a variety of US regulatory frameworks, including securities, commodities, and money-transmitter regimes. 

The federal securities laws can be further subdivided into the four major securities laws:

● the Securities Act of 1933 (governing the initial offering of securities);

● the Exchange Act of 1934 (governing secondary market transactions and the conduct of intermediaries);

● the Investment Company Act of 1940 (governing pooled investment vehicles); and

● the Investment Advisers Act of 1940 (governing those providing advisory services relating to securities investment or trading).

For US securities laws to apply, there must be: (a) a jurisdictional nexus with the US; and (b) the presence of a “security” as defined under the US securities laws. See SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (defining “investment contract” under the Securities Act of 1933); Morrison v. National Australia Bank Ltd., 561 U.S. 247 (2010) (limiting the extraterritorial application of U.S. securities laws).

Under the Howey test, “a variety of tangible and intangible assets can serve as the subject of an investment contract.” SEC v. Ripple Labs, Inc., et al., Case No. 20 Civ. 10832 (AT) (S.D.N.Y. July 13, 2023) p. 14.

Digital tokens are often commodities under Section 1a(9) of the Commodity Exchange Act (CEA), subject to the jurisdiction of the CFTC, which includes enforcement authority over fraud related to virtual currency sold in interstate commerce and fraud or manipulation in derivatives markets, as well as the underlying spot markets. 

Money transmitter laws and registration requirements apply at the federal and the individual state level. At the federal level, in 2011, FinCEN was one of the first U.S. federal agencies to think about cryptocurrency regulation, culminating in guidance in 2013: FIN-2013-G001, Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies (Mar. 18, 2013). This guidance sets out three categories of virtual currency participants: users, exchangers, and administrators. A user who uses currency to purchase real or virtual goods is not a “money transmitter business”. In contrast, administrators or exchangers that (1) accept and transmit convertible virtual currencies or (2) buy or sell convertible virtual currencies for any reason are generally considered to be money transmitters under the FinCEN regulations. The 2013 guidance is very broad, and digital token projects must carefully consider whether the FinCEN rules apply to their business model based on the factors outlined in the guidance.

Digital token projects must finally keep apprised of applicable state money transmitter laws and examine whether digital infrastructure may qualify as money transmitter activity. Some states, such as New York, even take the position that out-of-state businesses that advertise, offer or provide money transmission services or virtual currency business activities for New York businesses or individuals are subject to New York’s laws and licensing requirements. 

Avoiding claims that the token constitutes a partnership

Absence of proper documentation, the failure to honor corporate formalities (including important formalities associated with offshore entities or foundations that comprise part of the token decentralized infrastructure), and aggressive investor rights could lead to arguments that token holders are part of a common law partnership in certain jurisdictions. In Samuels v. Lido DAO et al., Case No. 23-cv-06492-VC (N.D. Cal. Nov. 18, 2024), an investor of the Lido DAO sufficiently made allegations that the DAO was a general partnership under California law, and that institutional investors, including Paradigm Operations, Andreessen Horowitz, and Dragonfly Digital Management were potentially general partners of the partnership and therefore liable for the conduct of the DAO. Relying heavily on these investors’ statements that they were to be actively involved in the DAO’s governance, the court held that these investors could be potentially liable as general partners for the acts of the DAO. Id. at 5-6, 15-18.

The Samuels case illustrates how common law or traditional corporate law principles are being extended to token projects. The direct participation of venture capital funds in the governance of a token project without sufficient decentralization, and in the absence of other governance protocols, could expose such investors to significant liability. The possibility of exposure can also vary by jurisdiction and applicable law. Care must therefore be taken to ensure a robust decentralized governance framework. Traditional VC “investor rights” may have to be structured in an entirely different way, or may have to be dispensed with in the context of the actual governance framework itself.