🤝Securities Law

Securities Law – NFTs and Domicoins as a Utility Token

United States federal law - specifically “Section 5 of the 1933 Act – prohibits the sale of a ‘secu rity’ unless a registration statement is in effect. Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 756 F.2d 230, 237 (2d Cir. 1985). In the cryptocurrency context, the first (and determinative) inquiry is whether either the Domicoin or the in-game NFTs are a security. The Securities and Exchange Commission (“SEC”) has issued limited guidance on “digital assets,” broadly defined as “an asset that is issued and transferred using distributed ledger or blockchain technology, including, but not limited to, so-called virtual currencies, coins, and tokens.”1 The SEC warns that anyone engaging in the offer, sale, or distribution of a digital asset must consider whether the digital asset is considered a “security” under federal law.

The SEC and federal courts use the “investment contract” or Howey test to determine whether a unique or novel instrument/arrangement (such as a token) is a security. Under Howey (a 1946 Supreme Court case) and its progeny, an “investment contract” exists when there is the (1) in vestment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived from the efforts of others. SEC v. W.J. Howey Co., 328 U.S. 293 (1946); see also SEC v. Edwards, 540 U.S. 389 (2004) (applying the Howey test and concluding that a company that sold payphones to the public under a leaseback scheme that offered a 14 percent annual return was an investment contract).

The SEC’s approach and application of the Howey test to tokens is essentially case-by-case, ap plying decades-old analytical frameworks to emerging digital tech. One instructive guide is the SEC’s “Framework for Investment Contract Analysis of Digital Assets.”2

Almost all tokens or digital assets/projects meet the investment of money in a common enterprise prong of Howey. A fiat currency transaction is not the sole consideration that triggers an “invest ment of money” under Howey:

The lack of monetary consideration for digital assets, such as those distributed via a so called “bounty program” does not mean that the investment of money prong is not satis fied. As the Commission explained in The DAO Report, “[i]n determining whether an in vestment contract exists, the investment of ‘money ’need not take the form of cash” and

1 https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets#_ednref2 (internal quotations omitted).

2 Available at https://www.sec.gov/files/dlt-framework.pdf. The guidance was published by the Strategic Hub for Innovation and Financial Technology of the Securities and Exchange Commission and is not considered an official rule or legal interpretation. Nevertheless, the guide provides insight into the SEC’s view of cryptocurrency and NFT markets and the potential application of existing law to those technologies.

“in spite of Howey’s reference to an ‘investment of money, ’it is well established that cash is not the only form of contribution or investment that will create an investment con tract.” The DAO Report at 11 (citation omitted). See In re Tomahawk Exploration LLC, Securities Act Rel. 10530 (Aug. 14, 2018) (issuance of tokens under a so-called “bounty program” constituted an offer and sale of securities because the issuer provided tokens to investors in exchange for services designed to advance the issuer’s economic interests and foster a trading market for its securities). Further, the lack of monetary consideration for digital assets, such as those distributed via a so-called “air drop,” does not mean that the investment of money prong is not satisfied; therefore, an airdrop may constitute a sale or distribution of securities. In a so-called “airdrop,” a digital asset is distributed to holders of another digital asset, typically to promote its circulation.3

Thus, the third (“reasonable expectation of profits”) and fourth (“derived from the efforts of oth ers”) prongs of the Howey test determine whether the in-game Domicoin currency or is a security and therefore must comply with federal registration or exemption requirements.

What is a “reasonable expectation of profits” in securities law?

The SEC utilizes an “economic reality” approach to the transaction, focused on the “character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect.” Tcherepnin v. Knight, 389 U.S. 332, 336 (1967); SEC v. C. M. Joiner Leasing Corp., 320 U.S. 344, 352-53 (1943).

The following factors are especially relevant to determining whether there is reasonable expecta tion of profits:

1. Does the digital asset give the holder rights to share in the enterprise’s income or prof its or to realize gain from capital appreciation of the digital asset?

3 The DAO Report, available at https://www.sec.gov/litigation/investreport/34- 81207.pdf, is an investigation report published by the SEC summarizing its investigation into a German company slock.it UG and its potential violations of United States securities laws.

2. Does the opportunity for profit result from appreciation in the value of the digital as set that comes, at least in part, from the operation, promotion, improvement, or other positive developments in the network?

3. Is there is a secondary trading market that enables digital asset holders to resell their digital assets and realize gains?

4. Does the digital asset give the holder rights to dividends or distributions?

5. Is the digital asset is transferable or traded on or through a secondary market or plat form, or is expected to be in the future?

6. Do purchasers reasonably expect that an Active Participant’s (“AP”)4 efforts will re sult in capital appreciation of the digital asset and therefore they will be able to earn a return on their purchase?

7. Is the digital asset is offered broadly to potential purchasers as compared to being tar geted to expected users of the goods or services or those who have a need for the functionality of the network?

8. Is the digital asset is offered and purchased in quantities indicative of investment in tent instead of quantities indicative of a user of the network? For example, is it offered and purchased in quantities significantly greater than any likely user would reasona bly need, or so small as to make actual use of the asset in the network impractical?

9. Is there correlation between the purchase/offering price of the digital asset and the market price of the particular goods or services that can be acquired in exchange for the digital asset?

10. Is there correlation between quantities the digital asset typically trades in (or the amounts that purchasers typically purchase) and the amount of the underlying goods or services a typical consumer would purchase for use or consumption?

4 The SEC uses the term AP to describe the project’s owners or managers or other controlling persons.

11. Has the AP raised an amount of funds in excess of what may be needed to estab lish a functional network or digital asset?

12. Is the AP is able to benefit from its efforts as a result of holding the same class of digital assets as those being distributed to the public?

13. Does the AP continue to expend funds from proceeds or operations to enhance the functionality or value of the network or digital asset?

14. Is the digital asset is marketed, directly or indirectly, using any of the following:

(a) The expertise of an AP or its ability to build or grow the value of the net work or digital asset?

(b)The digital asset is marketed in terms that indicate it is an investment or that the solicited holders are investors?

(c)The intended use of the proceeds from the sale of the digital asset is to de velop the network or digital asset?

(d)The future (and not present) functionality of the network or digital asset, and the prospect that an AP will deliver that functionality?

(e)The promise (implied or explicit) to build a business or operation as opposed to delivering currently available goods or services for use on an existing net work?

15. Is the ready transferability of the digital asset a key selling feature?

16. Is the potential profitability of the operations of the network, or the potential ap preciation in the value of the digital asset, emphasized in marketing or other promo tional materials?

17. Is there an availability of a market for the trading of the digital asset?

18. Does the AP implicitly or explicitly promise to create or otherwise support a trad ing market for the digital asset?

Clearly, the SEC analysis is fact-specific. The following factors weigh towards finding that the Game is a security offering, with respect to the “expectation of profit” prong:

• There is an expected and Developer-encouraged secondary market for the Game-re lated NFTs;

• Domicoins are readily convertible into USDT or USDC, which has a real-world fiat value and exchange rate;

The following factors weigh against the finding that users play the Game with the “expectation of profit”:

• The Domicoin is an in-game currency with primary and significant utility within the game;

• The Developer does not set an inherent price for any in-game assets;

• The Developer intends to expand and develop the independent utility of the in game assets and NFTs by adding and promoting the game aspect of the Domicoins and NFTs, including by growing the Game world, adding game centers, special events, cosmetics, scholarship opportunities, and other factors to enhance the gaming value.

• While the Developer recognizes the existence of the secondary market for the in game assets token, the Developer is not advertising the secondary market value as the primary characteristic in the in game assets and rather emphasizes the secondary util ity aspects of the Game, meaning the gaming aspect.

Are player gains derived from the efforts of others?

Besides the “for profit” analysis, there is also the question whether any gains are to be derived from the efforts of others. The following factors are especially relevant to determining whether there is a reliance on the efforts of others:

1. Does the purchaser reasonably expect to rely on the efforts of others? And if so, are the efforts managerial, in that they affect the failure or success of the enterprise, or are they more of a ministerial nature?

2. Is the AP is responsible for the development, improvement (or enhancement), operation, or promotion of the network, particularly if purchasers of the digital asset expect an AP to be performing or overseeing tasks that are necessary for the network or digital asset to achieve or retain its intended purpose or functionality?

3. Where the network or the digital asset is still in development and the network or digital asset is not fully functional at the time of the offer or sale, do purchasers reasonably expect an AP to further develop the functionality of the network or digital asset (directly or indirectly)?

4. Are there are essential tasks or responsibilities performed and expected to be performed by an AP, rather than an unaffiliated, dispersed community of network users (commonly known as a “decentralized” network)?

5. Does the AP create or support a market for, or the price of, the digital asset? This can include, for example, an AP that: (1) controls the creation and issuance of the digital asset; or (2) takes other actions to support a market price of the digital asset, such as by limiting supply or ensur ing scarcity, through, for example, buybacks, “burning,” or other activities.

6. Does the AP have a lead or central role in the direction of the ongoing development of the net work or the digital asset? In particular, does an AP play a lead or central role in deciding gov ernance issues, code updates, or how third parties participate in the validation of transactions that occur with respect to the digital asset?

7. Does the AP have a continuing managerial role in making decisions about or exercising judg ment concerning the network or the characteristics or rights the digital asset represents?

8. Do purchasers reasonably expect the AP to undertake efforts to promote its own interests and enhance the value of the network or digital asset, such as where: the AP has the ability to real ize capital appreciation from the value of the digital asset? This can be demonstrated, for ex ample, if the AP retains a stake or interest in the digital asset. In these instances, purchasers would reasonably expect the AP to undertake efforts to promote its own interests and enhance the value of the network or digital asset.

9. Does the AP distribute the digital asset as compensation to management or is the AP’s com pensation is tied to the price of the digital asset in the secondary market? To the extent these facts are present, the compensated individuals can be expected to take steps to build the value of the digital asset.

10. Does the AP own or controls ownership of intellectual property rights of the network or digital asset, directly or indirectly?

11. Does the AP monetize the value of the digital asset, especially where the digital asset has limited functionality?

The following factors weigh towards finding that the Project is a security offering, with respect to the “efforts of others” prong:

• The Developer is responsible for the initial minting, selling, advertising, and distrib uting the Domicoins and NFTs.

• The Developer is responsible for game development and promotion, which directly affects the demand for, as well as value and utility of the NFTs;

• Purchasers of NFTs and other in-game assets reasonably expect the Developer to con tinue developing the game aspect to promote and increase value, as well as provide support for liquidity in the secondary market.

The following factors weigh against the finding that the value of the Project is based on the “ef forts of others”:

• The Developer does not control, create, or have any influence on the secondary mar ket for the NFTs or any in-game asset;

• The users have control over the use of their Domicoins, meaning they can use them in-game to purchase items, and otherwise interact with the game world;

• Domicoins are pegged to a stablecoin, meaning that they have no speculative value at all and do not fluctuate in value;

• None of the in-game assets are marketed as an investment product, but rather as in game assets, an in-game currency with the primary utility within the Game; • It is not practicable or efficient to treat any of the in-game assets or the Domicoin to ken as a passive investment, and the Developer does not market or promote such use. The primary and Developer-supported utility is in-game use and currency.

Illustrative Examples of Blockchain Projects and Tokens Considered Securities by the SEC

Given the intensive fact-specific analysis that goes into determining whether a given token or project is a security, it is useful to review real-world examples. As of the date of this memoran dum, the SEC has not investigated or prosecuted an NFT projects for selling or marketing unreg istered securities. The SEC’s focus has been on token/ICO-type projects.

The SEC has investigated the following projects as unregistered (and therefore illegal) securities offerings:

Name of Token/Project	Factual Summary
Kik Interactive Inc. and KIN Token (SEC filed a complaint and obtained final judgment)	- Kik offered and sold one trillion digital KIN to kens to 10,000 investors across the world totaling $100 million. - Kik claimed that it was planning to develop a KIN ecosystem where (at an unspecified time in the fu ture) KIN token could be used to buy goods and services (i.e. function as a currency). - Kik promoted and promised the following aspects: • Finite number of tokens and rising demand would increase value of tokens. • KIN would be tradable on secondary trad ing platforms. • Kik would implement a “rewards engine” to compensate companies that fostered Kin transactions (similar to staking). • Kik would own its own tokens to align its own financial interests with the buyers. • Kik emphasized KIN as an opportunity to profit. • Kik’s promised economy did not exist and there was not a marketplace to buy and sell goods or services for KIN. • Kik also sold convertible notes called SAFTs to sophisticated investors, which then accelerated the ecosystem’s launch date and forced the premature conversion of the SAFTs into KIN tokens before there was any actual use for the tokens.
Munchee Inc. and MUN Token (SEC issued a cease-and-desist order).	• Munchee is a California business that created an app for people to review restaurant meals. Munchee issued the MUN token to essentially raise capital. • Munchee advertised the MUN token as an invest ment due to its increased in value and ability to trade on the secondary markets. • Munchee expressly disclosed that it would use the token sale proceeds to fund its operations. • MUN was promoted as eventually being used by restaurants to reward users, but that utility was de termined to be illusory and secondary to the profit/investment characteristic. For example, the use of MUN tokens for advertising and for users to increase their tier on the Munchee app was techni cally possible, but not actively marketed.
Gladius Network LLC (SEC issued a cease-and desist order).	• Gladius was a Nevada LLC that leased storage space and bandwidth to companies to enhance content delivery speed and improve cybersecurity. • Gladius issued GLA tokens that served as the sole currency to purchase their services, to deliver the transactions, and enable content to servers. • Gladius publicized the rise in value of the token through Gladius development efforts. Gladius also publicized its efforts to have the GLA tradable on the secondary market. • It is unclear to what extent the GLA token ac quired an actual utility or functionality outside the investment/secondary market parameters because Gladius self-reported to the SEC and worked with the SEC to achieve compliance.
Airfox and AirTokens (SEC issued a cease-and desist order).	• Airfox was a Massachussetts company in the wireless communications business. It issued AirTokens, advertising their investment and sec ondary market potential. • The purported utility use - i.e. the conversion of AirTokens to prepaid wireless minutes - did not actually function. • Airfox and its executives publicly acknowledged that buying AirTokens was a contribution to devel opment. They also knew of and encouraged a sec ondary market for the tokens.
Paragon Coin (SEC issued a cease-and-desist or der).	• Paragon is a Delaware corporation and an online entity that offered and sold PRG tokens. • Paragon sold the PRG token at a discount as a “pre-sale” touting that it would use proceeds to develop its various products and advance its mis sion of cannabis legalization. • Paragon advertised that it would use proceeds from the sale to build an “ecosystem,” but also to buy physical real estate (which it actually did). • Despite the promises of an “ecosystem” where PRG coin holders would be able to buy broad goods and services, no one was actually able to use the tokens. • Paragon emphasized deflationary “burn” mecha nisms that would drive value of the PRG token up.

While the individual facts and factors differ in these situations, they do have common threads that inform the SEC analysis and ultimate determination that the coin offering was an unregis tered “security” rather than a true consumptive product (or utility token).

- First, each token was actively marketed for its potential to go up in price and its tradability on a secondary exchange;

- Second, any actual “utility” of the token was illusory - meaning it was never developed or its purported utility was so far down in the priority chain that it was not a material factor in any purchaser’s decision;

- Third, the companies took active steps to promote the tokens as investments, took steps to en sure liquidity, stability, and controlled supply through token burns.

Based on the relevant factors and application of those factors to the Project, it is unlikely that the any NFTs or Domicoins sold as part of the Game will qualify as a “security” under federal law. The Developer is encouraged to consider the factors that impact the fact-specific analysis of whether or not the Game constitutes a security, and to be mindful of those factors as the Game expands in the future.

Scholarship Program and Staking

The Scholarship Program allows NFT owners to find skilled players to use their NFT Avatars to play domino games in exchange for a portion of the prize pool. This rental process is similar to “staking,” where a cryptoasset owner will lock-up an asset for a preset period of time in ex change for in-game rewards or additional in-game tokens. A utility (non-investment) purpose is essential for the staking mechanism to avoid being classified as an “investment contract” and having to register under federal and state securities laws.

“Staking” is a fundamental element to proof-of-stake networks, but neither the SEC (nor any other regulatory body) has definitively stated that a proof-of-stake token is a security. Accord ingly, the four-element Howey test set out above still applies. An “investment contract” (a type of security) exists when there is the (1) investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived from the efforts of others. SEC v. W.J. Howey Co., 328 U.S. 293 (1946).

The ability to directly “stake” the NFT does not affect either the “investment of money” or the “common enterprise” prongs of the analysis. To acquire the NFT, persons are trading value for that NFT. The NFT/Token network are likely a “common enterprise” regardless of whether “staking” is offered or involved. At the same time, it is important to note that “staking” itself is an independent activity. Each individual holder of an NFT gets to decide the NFT they wish to stake, for how long, and under what conditions. This means that the impact of their activity is in dividual and not tied together with the “staking” activities of any other individual.

The third element - “with a reasonable expectation of profits” - has several facets. On one hand, individuals who “stake” are trading NFT liquidity for additional Domicoin rewards (similar to dividends or interest). In this context, “staking” is another example of a for-profit activity that is available to NFT holders - in other words, it is a way to make more money (i.e. earn more To kens). On the other hand, “staking” has other non-economic uses, such as increasing the security of the network, making it more stable and more usable for the Token holders. Further, “staking” allows a user to actively participate in block validation and gives them a direct interest in main taining the Token’s integrity and value. Additionally, merely allowing another player to “rent” or use the Avatar NFT does not result in any profit. The player must successfully and skillfully play dominos (a skill-based game) to realize any reward and to share any reward with the Avatar NFT owner.

The fourth element - derived from the efforts of others - also has several aspects. Direct “stak ing” is an individual activity where the holder decides whether to “stake,” how much to “stake,” for how long, and under what conditions. The holder then will be involved in block validation (or block proposals) by virtue of their staked NFT/Token. Thus, to the extent there are any profits from “staking,” they are based on the holder’s individual decision-making and efforts, not the ef forts of others. At the same time, the mere fact that an NFT offers “staking” is not determinative to its status as a security. The value of the NFT or Token on the secondary (decentralized ex change) market depends on the support provided by the Developer and their efforts to increase usability and other desirable factors.

Additionally, here the scholarship program is highly individualized and any “rewards” depends on the individual skills of the player. It does not involve profits from central managerial efforts or the success of the enterprise. Rather, for an NFT owner to be successful through the scholar ship program, they have to identify skilled domino players. The scholarship recipients likewise have to actively play the game to earn any rewards. In other words, the scholarship program is an active gameplay alternative – it is not a “passive” investment scheme that allows NFT owners to earn money based on simple investment of money. There still needs to be skillful and successful gameplay for there to be any reward.

KYC and AML Compliance and Registration

United States Anti-Money Laundering (“AML”) and Know-Your-Customer (“KYC”) regula tions apply to “financial institutions” as defined under the federal Bank Secrecy Act. This means that not all businesses are considered “financial institutions” or required to have a KYC/AML policy in place by law. Some companies – especially in the less-regulated real-money gaming, blockchain, and crypto industries – implement voluntary KYC/AML programs and policies as “best practices.” Voluntary KYC/AML programs create confidence in business partners and po tential investors that the Developer is a transparent operation that takes the necessary steps to en sure its project is not used for money laundering or other illicit purposes. Additionally, failure to do AML/KYC compliance checks could potentially expose a Developer to criminal charges, such as aiding and abetting money laundering under 18 USC 1956 or similar.

The Bank Secrecy Act generally requires financial institutions and certain specifically designated businesses to (1) have an AML/KYC policy in place; (2) report suspicious transactions; (3) Iden tify and verify accountholders. 31 USC 5318.

The Act lists the following types of businesses as “financial institutions”:

(2) “financial institution” means—

(A) an insured bank (as defined in section 3(h) of the Federal Deposit Insurance Act (12 U.S.C. 1813(h))).

(B) a commercial bank or trust company;

(C) a private banker.

(D) an agency or branch of a foreign bank in the United States;

(E) any credit union.

(F) a thrift institution.

(G) a broker or dealer registered with the Securities and Exchange Commission under the Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.).

(H) a broker or dealer in securities or commodities.

(I) an investment banker or investment company.

(J) a currency exchange, or a business engaged in the exchange of currency, funds, or value that substitutes for currency or funds.

(K) an issuer, redeemer, or cashier of travelers’ checks, checks, money orders, or similar instruments.

(L) an operator of a credit card system.

(M) an insurance company.

(N) a dealer in precious metals, stones, or jewels.

(O) a pawnbroker.

(P) a loan or finance company.

(Q) a travel agency.

(R) a licensed sender of money or any other person who engages as a business in the transmission of currency, funds, or value that substitutes for currency, including any per son who engages as a business in an informal money transfer system or any network of people who engage as a business in facilitating the transfer of money domestically or in ternationally outside of the conventional financial institutions system.

(S) a telegraph company.

(T) a business engaged in vehicle sales, including automobile, airplane, and boat sales.

(U) persons involved in real estate closings and settlements.

(V) the United States Postal Service.

(W) an agency of the United States Government or of a State or local government carry ing out a duty or power of a business described in this paragraph.

(X) a casino, gambling casino, or gaming establishment with an annual gaming revenue of more than $1,000,000 which—

(i) is licensed as a casino, gambling casino, or gaming establishment under the laws of any State or any political subdivision of any State; or

(ii) is an Indian gaming operation conducted under or pursuant to the Indian Gaming Regulatory Act other than an operation which is limited to class I gaming (as defined in section 4(6) of such Act [25 USCS § 2703(6)]).

(Y) any business or agency which engages in any activity which the Secretary of the Treasury determines, by regulation, to be an activity which is similar to, related to, or a substitute for any activity in which any business described in this paragraph is authorized to engage; or.

(Z) any other business designated by the Secretary whose cash transactions have a high degree of usefulness in criminal, tax, or regulatory matters.

31 USC 5312(2).

The Developer is not any of the listed business types. Even if the Game were considered a “gam ing establishment with an annual gaming revenue of more than $1,000,000” under subsection (X), the Developer is not operating pursuant to a license because one is not required for games of skill. Accordingly, the Firm concludes that the Developer is not any of the business types listed in the statutory definition of “financial institution.”

The Firm has reviewed applicable federal regulations and was not able to find any additional reg ulations that are applicable to blockchain skill-to-earn gaming platforms or businesses.

Accordingly, the Firm is of the opinion that the Bank Secrecy Act and the AML/KYC obliga tions of a “financial institution” are not applicable to the Game.