Flashback Friday: Revisiting "SEC Burdens FTT with Security Classification"

Welcome to the first “Flashback Friday” where we revisit past articles. Where it makes sense to do so, we will take the time to look at how the law (or, rather, interpretation of the law) has changed since initial publication, but at the very least, this is meant as a way to aggregate more information here, on the Web3 vs. the Law SubStack. 

In a complaint (the “Complaint”) filed on December 21, 2022, against FTX co-founder Gary Wang and the former CEO of FTX’s sister trading firm Alameda Research Caroline Ellison in the United States District Court for the Southern District of New York, the U.S. Securities and Exchange Commission (the “SEC”) classified FTX’s native digital asset or “exchange token”, FTT, as a security. This classification calls into question whether the native tokens of other companies, specifically other exchanges, are likely to be classified in the same way, leading to increased oversight and regulatory requirements.

FTT’s Background

On or about July 29, 2019, FTX launched a digital asset known as “FTT.” FTT was labeled an “exchange token” indicating an asset or token associated with a specific trading platform or exchange (FTT was to be available for trading on FTX Trading Ltd., FTX, but not on FTX US, with FTX US being the d/b/a for a subsidiary of West Realm Shires Inc., a separate legal entity from FTX Trading Ltd. that provided different services and is not subject of the allegations in the Complaint). In the month prior to launching the FTX platform, FTX minted 350 million FTT, 175 million of which were allocated to FTX as “company tokens.” The company tokens were set to “unlock” (or become available for trading) over a three-year period after a so-called “initial exchange offering” (the “IEO”).

According to the SEC, of the 175 million non-company FTT, approximately 73 million were sold in so-called “pre-sales”, at prices ranging from $0.10 to $0.80, thereby raising approximately $10 million from the sale of FTT prior to the IEO. These pre-sale tokens were programmatically locked and set to unlock between one and three months following the IEO.

All proceeds from the pre-sale and IEO were pooled and treated interchangeably. The funds were used to fund the development, marketing, business operations, and growth of FTX.

FTX’s FTT marketing materials (including its whitepaper and other information on the FTX website) described FTT as “the token powering the FTX ecosystem,” with the whitepaper specifically highlighting the profit potential of FTT, including statements indicating that “[FTX had] carefully designed incentive schemes to increase network effects and demand for FTT, and to decrease its circulating supply.” FTT materials stated that the token provided investors with fee rebates and discounts on FTX, and the ability to use the token as collateral for futures positions as well as for “margin trading” that FTX promised to launch “in the future,” and that there was an opportunity for potential gains from FTX’s future repurchase and burning of FTT, to be funded by FTX’s revenues.

Howey and FTT

As previously discussed, classification as a security is an omnipresent concern for issuers of digital assets. When offering or selling securities in the United States, securities must either be registered or exempt from registration. The registration process is onerous and outside the capabilities of most (if not all) web3 projects, and exemptions from registration typically require certain provisions that are not ideal for the iterative development process (including lockup provisions and limitations on transferability).

When determining whether a given digital asset is a security (so long as it is not merely a digital version of a traditional, explicit security), issuers must determine whether it constitutes an “investment contract.” This analysis was provided by the Supreme Court of the United States in the case of SEC v. Howey (which is where we derive the “Howey Test” and which is referred to simply as “Howey”). Howey asks whether an asset involves: (1) an investment of money, (2) in a common enterprise, (3) with an expectation of profit, (4) from the efforts of others. If a digital asset meets all four of these prongs, then it is likely to be considered an investment contract and, in turn, a security for purposes of U.S. securities laws. Here, we aim to provide the SEC’s analysis along with general Howey context and explanation.

Investment of Money

There is rarely meaningful debate as to whether or not the “investment of money” prong has been satisfied – there has either been an exchange of an asset in exchange for money, or there hasn’t. One point of (brief) contention surfaced in instances where the consideration paid was not in traditional, fiat currency, but instead in the form of another digital asset. This was quickly quashed and almost without fail, a sale of a digital asset in exchange for another digital asset or cryptocurrency will be deemed sufficient for satisfying the investment of money prong of Howey. This is not unprecedented, as the SEC and certain courts have previously held that non-monetary consideration can be deemed investment of “money” for purposes of Howey.

Here, as is typically the case, there is no interpretive contention surrounding whether there was an investment of money. Purchasers in the pre-sales and in the IEO contributed cash in exchange for FTT, accordingly the SEC concluded that the first Howey prong was satisfied.

Common Enterprise

When looking at where there is a common enterprise, the analysis hinges on “commonality” – either “horizontal” commonality or “vertical” commonality. With horizontal commonality, each individual investor's fortunes are tied to the fortunes of the other investors by the pooling of assets, typically combined with the pro-rata distribution of profits.  When looking for vertical commonality, which focuses on the relationship between a “promoter” and the body of investors, two kinds have been identified: “broad vertical commonality” and “strict vertical commonality” With broad vertical commonality, the fortunes of the investors need be linked only to the efforts of a promoter. Alternatively, with strict vertical commonality, the fortunes of investors must be tied to the fortunes of the promoter.

In the case of FTT, the SEC found that FTX’s whitepaper expressly tied the prospects of FTT’s investors to the growth of the FTX platform, emphasizing the section title “Why Invest? -- All-Star Team,” and the subsequent highlighting of the importance of the management team’s experience and success in developing crypto asset trading systems, going on to note that FTX’s “greatest strength lies in the team behind it” which had a touted “Track Record of Proven Success.” This emphasis on the reliance on and linking to the efforts of the FTX management team satisfied broad vertical commonality and the significant stake in FTT held by FTX management satisfied strict vertical commonality, while the economics of FTT satisfied horizontal commonality. Accordingly, the SEC concluded that the second Howey prong was satisfied.

Expectation of Profits

The expectation of profits is one of the hallmarks of a security, but is not preclusive in and of itself, and is one of the more complicated factors to analyze. After all, certain digital assets can be acquired for a specific utilitarian use, while also expecting that the value of the asset will grow over time and hoping for a possible short term profit. Accordingly, analysis might focus on whether holder of a given digital asset receives some type of passive return, whether through interest, dividends, or other rewards, and whether the asset was marketed in such a way as to create an expectation of profit.

FTT was marketed as an asset that could be used in an “earn program” or in “staking programs,” which are programs promising interest payments on deposited assets, and the FTX whitepaper tied the prospects of FTT’s investors to the growth of the FTX platform, noting that FTX would undertake various “Strategies to Acquire Users and Grow Volume,” including the employment of influential spokespeople. Additionally, the whitepaper indicated that “[t]here are many ways FTT will be used as we add more products and features to FTX. For instance, when we launch a spot exchange in the future, FTT will be used for initial exchange offerings.” The SEC concluded that, as a result of the above representations and the economic reality at that time, FTT investors had a reasonable expectation of profiting from an investment in FTT, thereby satisfying the third Howey prong.

Efforts of Others

The “others” in “efforts of others” include promoters or third parties which, in the case of digital assets, may include the issuer and project team. As opposed to a commodity, such as gold, which may see its value rise as a result of market forces without any effort on the part of a promoter or third party, investment contracts under Howey are those that are inherently dependent on the active efforts of another person or team of persons. This dependence naturally ebbs and flows, depending on the stage of development of a given project or asset (earlier stage projects generally being more dependent on the development team, particularly if the project is pre-launch), so efforts of others analysis for a digital asset will focus on whether the asset and its corresponding platform have an active, full-developed utility and function promulgated by a material number of unaffiliated parties, or whether there is still critical dependency on the development team.

According to the SEC, the FTT offering materials made it clear that FTX’s core management team’s efforts would drive the growth and ultimate success of FTX, and that FTX marketed FTT by encouraging purchasers to believe that its platform would succeed and provide a return based on that success. With that basis, the fourth and final Howey prong was deemed satisfied, thereby labeling FTT as a security and granting the SEC jurisdiction over its oversight and control.

Other Proprietary or Native Tokens

The SEC’s position that FTT is a security and therefore subject to securities law, regulation, and restriction, calls into question the status of similar tokens and digital assets issued by other web3 companies, particularly other exchanges.

In particular, the emphasis of “buyback-and-burn” being indicative of securities status highlights potential risks to other centralized exchanged - such as Binance and OKX – whose native tokens have similar properties and related programs.

Despite this potential risk exposure, the prices for exchange tokens remained relatively stable in the hours following the Complaint’s filing. Whether this is simply a delayed reaction due to the analysis being buried within a district court complaint, or indicative of greater market resiliency and confidence in the structural distinctions between FTT and other similar digital assets, such as Binance’s BNB, remains to be seen. 

In Conclusion – Check and Recheck

Absent clear regulatory guidance and infrastructure, market participants (including digital asset exchanges) must take conservative positions when analyzing the assets associated with their respective projects and protocols. An overly conservative posture may serve to further cool an already downturned market for digital assets, especially those that are either (a) at higher likelihood to being classified as securities, and (2) digital assets that, despite being initially classified as securities, have subsequent legitimate utility and consumptive use. 

Accordingly, developers, issuers, and exchanges should take a proactive posture when structuring (or restructuring) their digital assets. Failure to do so could lead to short and long-term consequences, including delisting, enforcement action, or an inability to launch a particular project or protocol.

By engaging affirmatively and proactively with experienced counsel, web3 industry participants can mitigate the risk of needing to redo the work of a given course of action, whether such course leads to the development of an asset with problematic mechanics or economics, or engaging with such a problematic asset. Guidance is ever-changing, so frequent check-ins can help save problems over time and allow for nimble recalibration.

What kind of lawyer would I be without a disclaimer?

Everything I post here constitutes my own thoughts, should only be used for informational purposes, and does not constitute legal advice or establish a client-attorney relationship (though I am happy to discuss if there is something I can help you with). I can be reached via email (dlopezkurtz@crokefairchild.com or david@bsl.group), telegram (@davidlopezkurtz), twitter (@lopezkurtz), and on LinkedIn here.