California bill proposes limits on application of securities laws to tokens

Bitcoin farm

California Assembly Bill 2150 (AB 2150), “Corporate securities: exception: digital assets,” would amend Section 25019 of the Corporations Code to provide a safe harbor for digital assets that have characteristics that take the asset outside the definition of an investment contract. The bill was introduced in early March by California Assembly Majority Leader Ian Calderon.

If any of the below factors are met, the asset is presumed to fall outside the definition of an investment contract; however, that presumption may be rebutted upon good cause shown by clear and convincing evidence by the Commissioner of Business Oversight:

  • The asset is not acquired by the holder in exchange for the payment of fiat currency or another digital asset.
  • The asset is used on a fully operational network and the purpose of the asset is for a consumptive purpose, such as the access or consumption of goods, services, data, or the performance of useful functions other than as a medium of exchange or store of value.
  • The asset does not rely on the managerial efforts of others for its success, with the lack of managerial efforts of others evidenced by the absence of any identifiable person, project team, or management entity that is responsible for the development, improvement, oversight, or promotion of the asset or the related network, and either:

    • Any changes to the software code underlying that asset may be made by network participants or
    • Voting rights over the functioning of the network are conferred to each holder of the asset.

The first factor is the broadest and the factor that leaves the most open questions. It suggests that any network in which digital assets are acquired without payment would fall under this factor, assuming there was no sale of digital assets generated outside the network (sometimes referred to as a “pre-mine”). If so, proof-of-work networks such as the bitcoin network could meet this factor, while networks that conducted sales like Tezos would not.

The second and third factors codify recent trends and discussions in the digital asset space. The second factor implements the utility token concept, which many digital assets lawyers had written off as ungrounded in securities law. Such a change would open the door to a variety of token economic models avoiding classification as a security, provided the token is used for a consumptive purpose.

One example where this may be applied is Siacoins (SC), which are used to buy storage space on the decentralized Sia network. In September 2019, the Securities and Exchange Commission reached an agreement with Nebulous, Inc., the development team behind the Sia network, stipulating that Nebulous, Inc. had violated Sections 5(a) and 5(c) of the Securities Act of 1933 due to unregistered sales of Siastock and SiaNotes, but did not take any enforcement action with respect to Siacoins. AB 2150 would go a step further in codifying the utility token concept.

The third factor relates to the efforts of the issuer prong of the Howey test (discussed in more detail here) and applies to both proof-of-work and proof-of-stake networks. This factor is applicable to decentralized networks that have multiple development teams operating independently, where the network is not reliant on one team. Further, the networks must meet one of two additional factors: (i) protocol changes are implemented by the network participants, sometimes called nodes, or (ii) the functioning of the network is influenced by the vote of holders of the assets. The first subfactor implies a network similar to bitcoin and the current version of Ethereum, while the second subfactor relates to proof-of-stake networks like Tezos and the current version of the plan for the Ethereum 2.0 network. Determining what constitutes sufficient decentralization will be challenging, just as it has been in application of the SEC Framework for “Investment Contract” Analysis of Digital Assets.

While the changes to California law proposed under AB 2150 are likely to be well received by issuers considering issuing tokens, digital assets are also subject to federal securities laws. Purely intrastate offerings that meet certain criteria are exempted securities for federal securities law purposes under Section 3(a)(11) of the Securities Act of 1933, but the interstate nature of such sales makes the exemption of limited commercial value. However, California is considered a pioneer in the technology space, and the successful passage of AB 2150 may lead additional states and even the federal government to examine the regulatory regime of digital assets. State securities laws preceded federal securities laws and inspired them, so the spread of such state laws may encourage similar changes at the federal level. Moreover, AB 2150 opens the door to further experimentation with digital assets outside of the framework of traditional securities laws and could encourage the sale of digital assets in California, which is a very large market.

Please contact Mark Radcliffe with any questions about this development.