All Eyes Are on Regulation of Digital Assets as Federal Agencies and Lawmakers Seek to Bring Clarity: Part 1—The SEC, Utility Tokens and Quarters

Pillsbury Winthrop Shaw Pittman LLP

Federal regulators start to address some of the recent questions about digital assets such as tokens and virtual currencies, though many questions remain.

TAKEAWAYS

  • U.S. Regulators and Congress are grappling with how to manage the fast-evolving world of digital assets that is impacting a wide range of commerce and investment.
  • The SEC has taken a broad view of tokens as regulated investments, leaving some question about what space remains for utility and other types of tokens.
  • This summer, the SEC provided helpful guidance when it issued a no-action letter saying that a digital asset issued by Pocketful of Quarters, Inc. to be used to pay for video games, was not a security.

Digital assets such as tokens and virtual currencies continue to garner market interest and press coverage, but significant questions remain about their regulation—are digital assets securities, commodities, banking products, something else? How are their creators regulated, and what are the regulations and tax rules that apply to owners and intermediaries? The summer of 2019 has brought a few helpful clarifications. In this evolving regulatory environment, the U.S. Congress is discussing future legislative steps, and on July 30, 2019, the Senate Banking Committee held a hearing “Examining Regulatory Frameworks for Digital Currencies and Blockchain.”

In addition to Congressional attention, several federal agencies have taken steps to refine their regulatory approach. Investors and entrepreneurs have been seeking greater clarity on what ground remains for utility tokens, given the challenges posed by regulation of securities in the United States. The U.S. Securities and Exchange Commission (SEC) has taken a broad view of tokens as regulated investments over the past year, but on July 25, 2019, it granted a no action letter clarifying that a token for gaming would not be treated as a security—confirming that a utility token would not be deemed a security, even where the asset was not a stablecoin and could fluctuate in value. The Pocketful of Quarters no action letter is discussed below.

On July 8, 2019, the staffs of the SEC and the Financial Industry Regulatory Authority’s Office of General Counsel (FINRA) issued guidance regarding broker-dealers’ responsibilities where involved in custody and trade of digital asset securities and transactions. In a Joint Statement, the SEC and FINRA clarified circumstances that were not subject to custodian rules, and laid out considerations for those market participants that intend to act as custodian of digital asset securities. (The FINRA guidance will be discussed in a second client alert.) Finally, on July 26, 2019, the IRS reasserted the tax implication of transactions in virtual currency or other digital assets that leads to gains. (Some of the issues being considered by the IRS and Congress will be discussed in Part 3 of this client alert series.)

Each of these actions demonstrates a refinement of the regulatory landscape. While additional questions remain and more guidance will be required, the landscape for digital asset regulation has been advancing and additional movement should be anticipated.

SEC: No Action Letter for Pocketful of Quarters, Inc

The SEC’s Division of Corporation Finance issued a no-action letter on July 25, 2019, saying that “Quarters,” a digital asset issued by Pocketful of Quarters, Inc. to be used to pay for video games, was not a security. This no action letter is the second issued by the SEC concerning digital assets and demonstrates that the SEC is reviewing and considering some scenarios presented by the crypto asset industry. The Quarters token is a payment utility token that would be useable both for users to pay for gaming, and to pay game developers and marketers, who can then exchange Quarters into Ether, which can then be converted into dollars.

The factors recited by the SEC mirror those in the Howey test: a utility token must be used solely for a utility purpose; funds raised from token sales may not serve any capital-raising purposes; and token holders must not have any expectation of making a profit. Supporting the “utility” purpose of the proposed Quarters issuance, the SEC stated:

  • Funds from Quarters sales would not be used to build the gaming platform which will be fully functional and operational before any of the Quarters are sold; and
  • Quarters will be immediately usable for their intended purpose (gaming) at the time they are sold.

The following facts recited by the SEC support the conclusion that Quarters would not be used for any purpose other than the utility intended:

  • There would be restrictions limiting the transfer of Quarters only to the company or to wallets on the platform;
  • Gamers will only be able to transfer Quarters for gameplay; and
  • Quarters would only be marketed and sold for consumptive use as a means of accessing and interacting with Participating Games.

The SEC also recited the following facts to support the conclusion that the Quarters would not create any expectation of profit:

  • Only Developers and Influencers with Approved Accounts will be capable of exchanging Quarters at predetermined exchange rates;
  • Quarters will be made continuously available to gamers in unlimited quantities at a fixed price; and
  • There will be a correlation between the purchase price of Quarters and the market price of accessing and interacting with Participating Games.

Finally, the SEC noted that Pocketful of Quarters would undertake compliance programs for anti-money laundering law (AML) and know your customer (KYC) requirements as required by FinCEN, which issued detailed guidance regarding virtual currency surveillance and reporting in May 2019. Based on the above facts, the staff of the SEC took a no-action position to the extent that Pocketful of Quarters offers and sells the Quarters without registration under Section 5 of the Securities Act and does not register Quarters as a class of equity securities under Section 12(g) of the Exchange Act.

The Pocketful of Quarters no-action letter is in the same vein as the TurnKey Jet no-action letter written by the staff of the SEC earlier this year. In TurnKey, the SEC addressed a digital token that was solely useable on the TurnKey network and would not fund the development and operations of the issuing company. The TurnKey no action also relied on the utility being fully developed by the time that the tokens would be sold and the token usage being limited to the payment utility—in that case purchasing air charter services. However, unlike Pocketful of Quarters, Turnkey involved tokens with a stable value that completely eliminated a profit incentive or the ability to market the token as an investment opportunity.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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