Airdrops: Are free tokens free from regulation?
Airdrops – a mechanism whereby token issuers effectively give away tokens for free – has become one of the most talked about trends in cryptocurrency so far in 2018.
Why would anyone give away tokens for free, you might ask? There are a number of reasons.
First, giving things away for free is a very effective and well-proven marketing exercise. In the same way that Red Bull gave away free drink samples in the 1990s to eventually become the global leader in the energy drinks market, giving away free tokens can create a marketing buzz and raise brand awareness around new tokens and the related blockchain platform.
Second, giving away free tokens can help to maximize distribution among a broader base of potential users – effectively creating the community and marketplace in which the tokens will ultimately be used. It can be challenging for token issuers, when doing a capital raising token sale, to reach a wide enough pool of investors to generate a meaningful user base for the tokens. An airdrop can help to maximize distribution and drive wider adoption of the tokens. This in turn can help to drive up the price of tokens and help to facilitate listing on cryptocurrency exchanges.
In addition to using airdrops as a market-building and promotional tool, it is likely that some token issuers may be viewing airdrops as a mechanism for distributing their tokens (and maximizing the build-out of their token marketplace) without triggering the complex securities laws questions that arise in a capital raising token sale. However, just because tokens are issued “for free” in an airdrop, it does not necessarily follow that the airdrop is free of consequences from an international securities law perspective.
While the concept of an airdrop is novel, the idea of giving away securities for free is not new. In both the United States and the European Union, securities regulators have previously considered free giveaways of traditional forms of equity and have indicated that, in certain circumstances, their respective securities laws may apply even where stock is issued for free. By analogy, where tokens issued in the context of an airdrop qualify as securities under U.S. and/or EU law, it is crucial to consider the implications of applicable securities laws notwithstanding that the tokens are being given away for free.
The U.S. securities laws position
In the United States, the Securities Act of 1933 (Securities Act) makes it unlawful for issuers of securities to offer or sell securities without first filing a registration statement with the U.S. Securities and Exchange Commission (SEC) or, alternatively, relying on an exemption from registration.
The SEC made it clear in the July 2017 DAO Report and in several statements since, that in its view, certain tokens (and perhaps most tokens) constitute securities for the purposes of the Securities Act.
As a result, many (if not most) token issuers who make their tokens available to U.S. residents seek to structure their token offerings such that they fall within an exemption to the Securities Act - typically, by limiting availability of the tokens to accredited investors. Some token issuers have gone further and have excluded US investors from their token sales altogether in an effort to avoid exposure to the substantial regulatory risk in the U.S.
While the SEC has not yet made any official announcements regarding airdrops, some commentators (including an SEC representative) have suggested that airdrops, like other forms of token generation events, may fall within the scope of the Securities Act. In taking this position, they have been largely informed by a line of SEC cases dating from 1999 known as the “Free Stock Cases.”
The U.S. free stock cases: Does it matter if securities are issued “for free”?
In the Free Stock Cases, the SEC considered whether the distribution of free shares of traditional stock triggered the registration requirements of the Securities Act. In each case, prospective recipients of stock were required to sign up on the respective issuer's website and provide personal information including their names, physical addresses and email addresses, in order to receive free shares. Additional free shares were offered in exchange for referrals and, in one case, with the purchase of a service. The SEC's analysis focused on whether an offer or sale of securities for value took place in each case.
The concept of “value” in an offer or sale of securities
Under the Securities Act, the terms “offer,” “offer to sell,” and “offer for sale” are defined as including “every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value.” Similarly, the terms “sale” and “sell” are defined as including “every contract of sale or disposition of a security or interest in a security, for value.”
In the Free Stock Cases, the SEC indicated that a lack of monetary consideration would not rule out the existence of an offer or sale of securities for the purposes of the Securities Act, taking the view that “a gift of stock is a “sale” within the meaning of the Securities Act when the purpose of the “gift” is to advance the donor's economic objectives rather than to make a gift for simple reasons of generosity.”
In the cases at hand, the issuers had received economic value by creating an interest in their respective websites and a market for their shares, and accordingly there was an offer or sale for value for the purposes of the Securities Act.
Does an airdrop involve an offer or sale “for value”?
The SEC's analysis is directly relevant to airdrops, which, while ostensibly free, will not typically be effected for “simple reasons of generosity.” An airdrop will typically generate some form of economic benefit or value for the issuer – be it by creating a market for the tokens, generating promotional benefits for the related blockchain platform, or perhaps creating more interest in a related token sale, etc. That being the case, there is a significant risk that an airdrop will be subject to registration requirements under U.S. securities laws, unless it is structured to fall within an applicable exemption.
This position is consistent with (unofficial) comments made by David Fredrickson, Chief Counsel of the SEC's Division of Corporate Finance, at the American Bar Association (ABA) Spring Meeting in Orlando, Florida in April 2018. Noting that the SEC had “wrestled” with the issue of free stock in the 1990s, Fredrickson indicated that where “some value is being conveyed, there could be a sale of a security” in the context of an airdrop.
In his address to the ABA, Fredrickson went on to suggest that there may be situations where an airdrop could be structured to fall outside the remit of federal securities laws (suggesting that one such model could involve airdropping tokens to partners in the context of a general partnership), and added that the SEC would be “curious to look at particular facts.”
Relying on an exemption
While the Securities Act contains many exemptions, the one most commonly used in the context of token sales is set out in Rule 506(c) of Regulation D. The principal benefit of Rule 506(c) is that it allows issuers to raise an unlimited amount of capital. However, Rule 506(c) restricts the potential pool of recipients to accredited investors (essentially, certain categories of high income and high net worth individuals). This is problematic in the case of an airdrop because it limits the democratizing effects that an airdrop seeks to achieve and undermines the core goal of creating a meaningful token user base. In addition, there may be a substantial compliance cost in ensuring that prospective investors meet the applicable regulatory requirements.
Because most token issuers will want to expand their airdrop token distribution to as broad a group as possible, Rule 506(c) may not work for them. Instead, they may seek to avail of another exemption under the Securities Act, such as Rule 504 of Regulation D, which permits issuers to raise up to $5m in any 12-month period from any type of investor. However, under Rule 504, issuers may need to satisfy additional state blue sky requirements, which may include registration with state securities regulators.
Although such an exemption may be available (depending on how one quantifies the “value” associated with the economic benefits of the airdrop), it will be important to assess the airdrop in conjunction with any associated token sale, particularly if the related sale has or will happen in the same 12-month period. In addressing the ABA Spring Meeting, David Fredrickson specifically cautioned against considering an airdrop in isolation from a related token sale, noting that if the related token sale relied on a particular exemption, there could be a securities laws risk if the airdrop itself does not also fall within that chosen exemption.
Summary: A regulatory environment free of certainty
Although airdrops involve “free” tokens, it is clear from the Free Stock Cases that the absence of monetary consideration is not sufficient to bring airdrops outside the scope of U.S. securities laws. While it may be possible to structure an airdrop so that it falls outside the remit of the Securities Act, the analysis will depend on the particular facts and circumstances of the situation, and ultimately, will likely turn on whether or not the underlying tokens qualify as securities.
With the SEC now investigating a substantial number of initial coin offerings, those involved in token generation events in the U.S. are well-advised to thoughtfully consider whether their tokens are securities and whether they are able to conduct an offering that complies with federal securities laws. This applies even if the tokens are being given away for free in the context of an airdrop.
Given the prevailing uncertainty in the U.S., CoinDesk has suggested that “token issuers may experience far less hindrance in the rest of the world.” However, as the analysis in the following paragraphs demonstrates, airdrops can also raise complex regulatory issues beyond the United States.
The application of EU securities laws to airdrops
In the European Union, the European Securities and Markets Authority (ESMA – the EU securities market watchdog) has adopted a similar approach to the SEC on the application of EU securities laws to token sales, taking the view that “depending on how the ICO is structured, the coins or tokens could, potentially, fall within the definition of a transferable security.”
If a token does qualify as a “transferable security,” firms involved in token generation events within the EU may be regarded as conducting certain regulated investment activities under EU law, such as placing, dealing, or advising on financial instruments (which includes “transferable securities“) or managing or marketing collective investment schemes. In those cases, they may need to comply with specific regulatory requirements under Markets in Financial Instruments Directive II (MiFID II), the Alternative Investment Fund Managers Directive (AIFMD) and the Fourth Anti-Money Laundering Directive (4AMLD). Moreover, where the token generation event involves an “offer to the public,” it would be subject to the prospectus requirements set out in the EU Prospectus Directive.
The EU prospectus regime: Does it matter if securities are issued “for free”?
The EU Prospectus Directive, which is being incrementally replaced by the Prospectus Regulation, aims to ensure that adequate information is provided to investors by companies when raising capital in the EU. It requires the publication of a prospectus (approved by a competent authority in an EU member state) prior to the “offer of transferable securities to the public”, unless an exemption or exclusion applies.
In determining whether an airdrop is potentially subject to the EU prospectus regime, an issuer will need to consider three key questions:
- Is the token a “transferable security” for MiFID II purposes?
- If so, does the airdrop involve an “offer to the public?”
- If the answer to the previous two questions is yes, then does an exemption or exclusion apply under the EU prospectus regime?
Each of these questions is considered in turn below.
Is the token a transferable security for MiFID II purposes?
The definition of “transferable security” is set out in the MiFID II and is defined broadly to include:
“classes of securities which are negotiable on the capital market, with the exception of instruments of payment, such as:
- shares in companies and other securities equivalent to shares in companies, partnerships or other entities, and depositary receipts in respect of shares;
- bonds or other forms of securitised debt, including depositary receipts in respect of such securities;
- any other securities giving the right to acquire or sell any such transferable securities or giving rise to a cash settlement determined by reference to transferable securities, currencies, interest rates or yields, commodities or other indices or measures.”
ESMA has not issued further guidance on the type of tokens that would qualify as “transferable securities” for the purposes of the above definition, and this would require a case-by-case analysis of the characteristics and features of the particular token in question. However, generally speaking, the closer a token is to a “pure utility” token, the less likely it is to fall within the definition of “transferable securities.” Conversely, the closer the token is to traditional equity (and the more it is “equivalent” to shares), the more likely it is to be construed as a “transferable security” for MiFID II purposes.
If the tokens being issued in the context of an airdrop are or may be “transferable securities,” then EU prospectus requirements potentially apply to the extent there is an “offer to the public.”
Is there an offer to the public?
While ESMA has not specifically considered airdrops, it has, like the SEC, previously considered the concept of free stock offers and has outlined some helpful guidance in its Q&A on Prospectuses (the Q&A).
In the Q&A, ESMA indicates that “where securities are generally allotted free of charge, no prospectus should be required.” While this comment, on its face, would seem to suggest that airdrops (which are issued free of charge) should not be subject to EU prospectus requirements, the stated legal basis for ESMA's position is nuanced and pertinent in the case of airdrops.
In the Q&A, ESMA notes that it referred certain questions to the Commission Services and, in particular, had asked them to confirm the correct legal basis for ESMA's conclusion that “no prospectus should be required.” In responding to ESMA, the Commission Services outlined two possible legal bases that could apply, depending on the circumstances. They commented that in the case of allocations of free securities where there is “no element of choice” on the part of the recipient, there is in fact no “offer of securities to the public” for the purposes of the Prospectus Directive. On the other hand, an offer of free securities, where the recipient “decides” whether or not to accept the offer, was regarded by the Commission Services as an offer for zero consideration. As such, it would be an offer to the public, albeit that it should fall within one of the financial exclusions or exemptions outlined the Prospectus Directive (see below).
In either case, the Commission Services (and ESMA) reached the fundamental conclusion that the allotment of free securities would not be subject to the requirement to publish a prospectus. However, the distinction they made between free stock issued with or without an element of choice is pertinent for airdrops, as airdrops can be, and frequently are, structured in both ways: Some airdrops are structured such that all holders of a particular token type automatically receive new tokens, while others are structured so that there must be an opt-in by the existing token holders. Applying the Commission Services’ approach, airdrops in the first category would per se fall outside Prospectus Directive (since there is no choice on the part of the beneficiaries and therefore no “offer”). On the other hand, airdrops in the second category may fall within the scope of the Prospectus Directive albeit that a financial exemption or exclusion should apply on the basis that the offer is for zero consideration. This leads us to the final key question that issuers must consider before EU prospectus requirements can generally be ruled out, that is, whether an airdrop that involves “an offer of securities to the public” falls within one of the financial exclusions or exemptions to the Prospectus Directive.
Does an exemption or exclusion apply under the EU prospectus regime?
The most relevant exclusion to the Prospectus Directive for the purposes of an airdrop is the financial threshold exclusion set out at Article 1(2)(h). That article generally disapplies the provisions of the Prospectus Directive to securities included in an offer with a total consideration in the EU of less than EUR 5m. This threshold will be reduced by the Prospectus Regulation to EUR 1m effective July 2018, albeit that member states have an option to exempt offers between EUR 1m and EUR 8m.
On its face, an airdrop should clearly fall below the EUR 5m threshold (or even the reduced EUR 1m threshold under the Prospectus Regulation). However, the analysis in the case of airdrops is not completely straightforward.
Related transactions: Timing matters
Like in the United States, an airdrop should not be considered in isolation from a related token sale, particularly if the token sale happens in the surrounding 12-month period. This is because under Article 1(2)(h), the EUR 5m threshold (or the EUR 1m threshold under the Prospectus Regulation) must be calculated over a period of 12 months. Because airdrops are frequently structured to happen shortly before or shortly after a related token sale, this 12-month calculation period is important, as any capital raised in the context of the prior or subsequent token sale can potentially count (subject to applicable exemptions) for the purposes of determining whether the EUR 5m threshold has been met (assuming both events happen within a period of 12 months). Taking into account the proceeds of any prior or subsequent token sale that falls within the calculation period, it is possible for an airdrop (though ostensibly a “zero consideration offer”) to exceed the financial threshold. In these situations, the EU prospectus requirements may apply.
Hidden consideration: Nothing comes for free?
In a similar approach to the SEC in the Free Stock Cases, the Commission Services expressly recognized in the Q&A the concept of “hidden consideration” as a relevant factor in determining whether the relevant financial thresholds in the Prospectus Directive have been met, noting that “an offer presented as an offer of free shares” may in fact “disguise” a “hidden consideration.” That being the case, the provisions of the Prospectus Directive could still apply to a “free offer” if the value of the “hidden” consideration exceeds the relevant financial thresholds.
The “hidden consideration” concept is relevant to airdrops, because, although ostensibly free, they still typically generate some benefit to or value for their issuer (e.g. new customers, the build-out of a marketplace, etc.). Indeed, certain airdrops involve more tangible benefits for issuers, for example, where they incorporate referral schemes such that tokens are issued to recipients conditional upon them recommending the airdrop to others and/or sharing information and promoting the airdrop among their network. While it could be difficult to argue that the value of this “hidden consideration” exceeds the financial thresholds set out under the EU prospectus regime, it nevertheless needs to be considered as part of the analysis. If the value of any hidden consideration (with or without the proceeds of any prior or subsequent token sale in the surrounding 12-month period) exceeds the financial thresholds, EU prospectus requirements may apply.
Summary: There is no short answer!
In summary, while it is possible for an airdrop to fall outside of or benefit from an exemption from EU prospectus requirements, it is certainly not safe to assume that this is the case. A detailed analysis of the particular features and structure of the airdrop would need to be carried out - taking into account the questions outlined above - in order to determine whether EU prospectus requirements are relevant.
Even if EU prospectus requirements do not apply, other EU financial regulatory requirements may still be applicable under MiFID II, AIFMD and 4AMLD to the extent the issuers are regarded as carrying out regulated investment activities, such as placing, dealing, or advising on financial instruments (which includes transferable securities) or managing or marketing collective investment schemes. Additional regulatory and securities law requirements may also apply at local level in the EU member states in which the recipients of the tokens reside, and these would need to be separately considered.
The above analysis demonstrates that while it may be possible for certain airdrops to fall outside securities laws requirements in the United States and the European Union, this is certainly not a foregone conclusion.
It would appear that the blockchain community is beginning to take note of the regulatory risk associated with airdrops, with CoinDesk reporting in March that “many advise against airdrops for now.” Indeed, the blockchain-based video streaming platform, Stream, cited regulatory uncertainty as the reason for “indefinitely delaying” its scheduled airdrop in March of this year. CoinDesk reported that “the sticking point is whether or not all tokens are securities [for U.S. purposes]. If they are, it could be that an airdrop is dangerous.”
CoinDesk went on to suggest that “until the regulatory environment in the US becomes more clear, token issuers may experience far less hindrance in the rest of the world.” However, as the analysis outlined above demonstrates, airdrops can also raise complex regulatory questions beyond the United States.
To address some of the regulatory complexities around airdrops, CoinList, an ICO facilitator spun out of the renowned startup incubator, AngelList, recently launched a new product called “Airdrops.” The purpose of the product is to “streamline the process of airdrops in a way that doesn't fall foul of the law” by effectively shifting the regulatory compliance burden from issuers to CoinList.
While the current version of the CoinList product aims to address U.S. securities laws’ risk, CoinList is reportedly also carrying out a “country-by-country analysis to determine what sorts of checks issuers will need to do in order to airdrop to users around the world.”
It is clear from the analysis outlined in this article – which only examines securities laws and only under two legal frameworks – that a country-by-country analysis will be a huge endeavour. Nevertheless, it is an impressive initiative by CoinList, and, once completed, could be extremely beneficial to the global blockchain community.
In the meantime, it is important for those involved in airdrops to remember that just because tokens are issued “for free” in the context of an airdrop, it does not necessarily mean that the airdrop is free of consequences from an international securities law perspective. A comprehensive jurisdictional analysis needs to be carried out in each case to confirm the applicable legal and regulatory requirements and ensure that these can be complied with.
Bloomberg Law, which tracks U.S. federal, state and global developments in the ICO, digital currency and blockchain spaces, may be a useful resource for issuers and their advisors as they carry out that multi-jurisdictional analysis.
This article was written by Gina Conheady (Corporate and M&A Partner, at A&L Goodbody) and Christian Munoz (member of the legal and compliance team at Oportun). First published by Bloomberg on June 4 2018 - Reproduced with permission from Copyright 2018 The Bureau of National Affairs, Inc. (800-372-1033) www.bna.com.
Date published: 04 June 2018