Tokenization: The Revolution Is Now – Technology

I. OVERVIEW

The future is here. The ideas of tomorrow are happening today.
Practical applications for Digital Ledger Technology
("DLT" or blockchain) are not merely notional exercises
by anti-establishment, disenfranchised free thinkers. No, the
revolution is now. The movement is happening, and investors,
corporations large and small, and industry are jumping on board
every day. Whether a mom-and-pop dry cleaner or a professional
sports league, all are looking for their place in this new
decentralized financial ("DeFi") world. However, with any
movement, with any unconventionality, comes questions. The two most
common perhaps-How can I use this to make money; and, What are
my risks?

The law is not yet mature in this area. However, we know
regulatory agencies are paying attention to this space and, based
on their actions thus far, we know how to mitigate risk so
individuals and businesses can operate within defined parameters
and with less fear of the unknown. To that end, this alert seeks to
provide an overview of the different types of cryptocurrency tokens
(security token, utility token, and non-fungible token), common
regulatory considerations associated therewith, and implementation
strategies to maximize transactional security without triggering
unnecessary regulatory scrutiny.

II. CRYPTOCURRENCY TOKENS

A cryptocurrency "token" is a custom, digital asset-a
string of characters that may provide the holder the rights to an
underlying asset issued on top of a blockchain. A blockchain is a
decentralized, distributed ledger consisting of blocks (records)
used to track transactions. Tokenization, simply, is the process of
converting the rights (ownership, leasehold, license, etc.) to an
asset (anything of value) into digital form on a blockchain.¹ On
blockchain ("on-chain") transactions rely on "smart
contracts" which are a series of conditional (if-then)
statements written in code to form the basis of a self-executing
contract.²

Broadly, tokens fall into two categories: fungible and
non-fungible. While fungible tokens can be used like currency to
facilitate exchanges of value on a particular blockchain,
non-fungible tokens represent an emerging class of unique, digital
assets that are also tracked and traded on-chain.

A. Fungible Tokens

A fungible token-for example, Bitcoin-relates to a unit of value
that can be traded or freely exchanged, and is effectively
indistinguishable from other tokens in the same ecosystem. A
Bitcoin is a Bitcoin, and one Bitcoin is not more valuable or rare
than any other Bitcoin. Fungible tokens often work similarly to
fiat currency-for example U.S. Dollars. Like one $20 bill has the
same value as any other $20 bill, a fungible token, regardless of
when it was mined (minted), who previously owned it, or for what
value the token was previously exchanged, has the same value as its
fungible counterparts. Just as a shopkeeper does not distinguish
one $20 bill from another before accepting it in exchange for
goods, a fungible token provides the same value to transacting
parties as any other like fungible token. Accordingly, fungible
tokens provide the basis of all on-chain payment systems. Fungible
tokens likewise are divided into two primary forms: (1) security
tokens, similar to money-classified by regulators as a security,
and (2) utility tokens, similar to a gaming arcade token-issued for
functionality with a specific purpose.

1. Security Tokens

Security tokens represent tradeable financial assets that are
deemed to be "securities" under applicable law and are
therefore regulated. Just as a share of stock in a public company
comes with the expectation of profit, so too does a security token.
As discussed in greater detail below, it is not uncommon in this
space for tokens distributed through Initial Coin Offerings
("ICO"), originally purposed as utility tokens, to become
security tokens depending on the issuance's underlying facts.
While there is certainly value to security tokens, securities come
with a host of regulations. In lieu of facing such regulations,
issuers often opt to avoid introducing security tokens onto an
ecosystem.

2. Utility Tokens

Utility tokens are the other type of fungible tokens. A utility
token is a blockchain-based asset that a holder can exchange for
something else of value, typically a good or service offered by the
token issuer. Borrowing from the example above, utility tokens work
similarly to game tokens at an arcade. A player exchanges currency
(either fiat or digital) for tokens to play games or ride rides
within the arcade. Even though the game tokens may only have value
within a particular arcade, the tokens themselves are fungible-in
that one is the same as another-and the player uses the tokens for
a specific purpose, limited to the ecosystem of the arcade.

The uses for utility tokens are limited only by the issuer's
imagination. Most frequently, however, utility tokens are used on
particular platforms-such as on a website or in a mobile game-to
purchase or obtain something of value on those platforms. For
instance, a videogame developer may issue utility tokens to raise
money to fund the creation of a game, and then allow the token
holders to redeem the tokens for in-game purchases upon its launch.
Outside of the game, however, the tokens have no value.
Importantly, utility tokens are not offered as
"investment opportunities." Rather, utility tokens offer
current or future access to a company's products or services,
not an expectation of future profit.

B. Non-fungible Tokens

Non-fungible tokens ("NFTs"), on the other hand,
relate to unique digital assets rather than a standard measure of
value. Therefore, the holder of one NFT cannot necessarily obtain
equal value by exchanging a token for another NFT within the same
ecosystem. If something can be digitized, perhaps even if not, it
can operate as an NFT. Indeed, NFTs have been used to transform
collectibles-for example, a digital work of art-into one-of-a-kind,
verifiable assets that can be traced, authenticated, and
sold/traded on-chain. NFTs are particularly well-suited to prove
ownership, identify the uniqueness of assets, and identify
counterfeits from originals. This is because each asset's
identifiable information is immutable on-chain. NFTs not only
differ in functionality from fungible tokens, but also fall under
an entirely different coding protocol and structure compared to
those of fungible tokens.³

Recently, NFTs garnered the art world's attention when an
NFT created by the digital artist Beeple sold for $69 million. With
the creation of the NBA's Top Shots (which allows users to
purchase a token of a particular NBA highlight clip), the sports
world demonstrated its desire to get in on the NFT action. Although
the digital asset that an NFT relates to may be infinitely
replicable-anyone can run a Google image search for Beeple's
artwork or watch NBA highlights on YouTube-the token itself is
limited by a predetermined quantity and quality the issuer assigns,
which, as with any other asset, creates scarcity and drives demand.
Indeed, an NFT's value stems from collector culture, the desire
for patronage (i.e., supporting a particular artist, player, or
team), and proof of ownership. Think owning a signed 1986 Fleer
Michael Jordan rookie card, versus having a picture of the
same.

Where NFTs and other on-chain assets differ from other assets is
in their immutability, and therefore their transparency. Anyone can
view a painting in a museum, but who's to say that painting is
an original? What if the curator was wrong? What if the provenance
is forged? With DLT and NFTs, the expectation is that those worries
disappear. With NFTs, authenticity is built into the code. The code
is transparent, verifiable, and immutable. The blockchain creates a
certificate of authenticity for each token so the originating
source is identifiable.

III. REGULATORY CONSIDERATIONS⁴

A. Utility Tokens

Tokens are issued through various forms of token offerings, most
commonly through ICOs, where purchasers acquire tokens in exchange
for payment. If an ICO offers a security token-distinct from a
utility token-the offering is subject to regulation by the U.S.
Securities and Exchange Commission ("SEC") under federal
securities laws.⁵ According to the SEC's 2019
guidance framework, the Howey test governs whether a token
is a security (or "investment contract") thereby
triggering registration and subsequent reporting requirements.⁶ It is
worth noting that a token may be characterized as a security even
if the issuer intended otherwise.

In SEC v. W.J. Howey Co., 328 U.S. 293 (1946)
("Howey"), the Supreme Court determined that
"an 'investment contract' exists when there is [1] the
investment of money [2] in a common enterprise [3] with a
reasonable expectation of profits [4] to be derived from the
efforts of others."⁷ The test is conjunctive. An item
must satisfy each of the Howey test's four elements to
qualify as an "investment contract" and therefore invite
SEC scrutiny.⁸ The materials used to promote the
sale of the digital assets, and the manner in which they are
offered, sold, or resold are particularly relevant to whether the
token is a security.⁹ To be sure, the Howey
test applies to any contract, scheme, or transaction, regardless of
whether it has the characteristics of typical securities.¹⁰

SEC leadership remarked in 2018 that "where the digital
asset is sold only to be used to purchase a good or service
available through the network on which it was created," it is
unlikely to qualify as a security.¹¹ So by structuring an ICO and its
tokens not as an investment designed to generate profit for the
investor, but rather as a new method of payment accepted on the
issuer's platform-like arcade tokens-an issuer may be able to
avoid regulatory requirements applicable to securities.¹²
While the SEC lists a litany of considerations in its 2019
guidance, issuers hoping to avoid security classification should
ensure that tokens do not give "the holder rights to share in
the enterprise's income or profits, or to realize gain from
capital appreciation of the digital asset."¹³ Additionally,
issuers should maintain "apparent 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."¹⁴

Importantly, the SEC recognized that price appreciation of a
token "resulting solely from external market forces (such as
general inflationary trends or the economy) that impact the supply
and demand for an underlying asset generally is not considered
'profit' under the Howey test[.]"¹⁵ As
such, issuers offering utility tokens used for goods and services,
rather than as a speculative investment designed to increase in
value over time, mitigate the risk of security classification.¹⁶

B. Non-fungible Tokens

Although the SEC has not yet commented specifically on NFTs, it
is reasonable to assume the Howey test and related
considerations likewise govern NFTs. Under the framework discussed
above, an NFT connected to a collectible or an item intended for
use-for example, tickets to an event or other experience-is
unlikely to fall under the definition of a security.¹⁷
The blockchain serves more as a means of authenticating the
underlying asset than creating a market for investors reasonably to
expect to profit from its appreciation. However, if issuers offer
NFTs to the public with the promise of liquidity and/or increasing
the NFT's value through the daily continued services of the
issuer, such a token will likely trigger SEC scrutiny. Marketing,
while not dispositive, is also critical to the analysis. Deliberate
packaging of NFTs is essential. Issuers not intending to create
securities must ensure they do not create an expectation of a
return on a passive investment, and instead need to focus on the
qualities particular to that token.

C. Additional Risk Mitigation

Issuers should also devote the time and resources necessary to
develop and implement comprehensive know-your-customer
("KYC") and anti-money laundering ("AML")
policies that govern both the initial sale of tokens and any
subsequent financial transactions. As with any monetary
transaction, an issuer must be careful not to conduct business with
individuals or entities subject to legal restrictions such as those
imposed by U.S. Department of Treasury, Office of Foreign Assets
Control. Requiring customers to create an account, identify their
location, provide contact information, and agree to terms and
conditions clarifying their rights and responsibilities are an
excellent way to alleviate risk. Likewise, clear disclosures should
describe exactly what a purchaser will receive to ensure compliance
with consumer protection laws. For instance, an NFT may include
ownership rights over a purchased image, but not the copyright to
the original image. Transparency is key. It reduces the risk of
misunderstanding between issuer and customer, and is a fundamental
pillar on which blockchain was built.

IV. MAKING TOKENS WORK

A. Utility Tokens

Again, utility token applications are limited only by the
imagination of the issuer. Indeed, the benefits include the ability
to access a new demographic and expand to an ever-increasing
customer base who prefer cryptocurrency to fiat currency. Utility
tokens, similar to gift cards, provide instant liquidity through
their sale regardless of whether the token is redeemed immediately
or on a future date. Purchasers of utility tokens benefit by
locking in prices and eliminating the risks associated with
volatile cryptocurrency fluctuation, and the uncertainties
associated with inflation-the value of utility tokens are generally
fixed at sale.

The first step in the offering process is selecting (or
creating) a reliable blockchain platform on which to launch the
utility token. Overwhelmingly, issuers tend to prefer the Ethereum
platform for ICOs-over 80% of ICO projects use the Ethereum
platform, while only 8% choose to build a custom platform, with the
remainder launching on an Ethereum competitor's platform.
Ethereum is extremely popular as a platform because it is so
accessible, easy to code on, and very large, thus adding an
additional layer of security while staying true to its foundation
of decentralization and cryptographic application.

Preparing for a launch should involve drafting a
"whitepaper" and developing a marketing campaign to
capture the details of the ICO, describe the terms of sale, provide
legal disclosures, and properly market the token as a utility token
exchangeable for defined goods and/or services. Issuers are
increasingly using dedicated ICO websites, or carveouts on existing
websites, to post whitepapers and to conduct conventional
advertising to generate awareness of ICOs in advance of
launching.

At least at the outset, developing and launching on the Ethereum
platform allows the issuer to create tokens using the code provided
by Ethereum. The industry-standard ERC-20 token outlines smart
contract parameters, which provide the protocol to automatically
execute and document events related to the tokens with the terms of
the agreement between buyer and seller directly written into lines
of code. Prior to launch, issuers should audit smart contracts and
conduct test transactions to ensure transactions will appear on the
Ethereum blockchain as designed. Finally, launch the ICO and
standby as the information necessary for accounting and
recordkeeping appears on-chain.

B. Non-fungible Tokens

Individuals and companies are just beginning to explore the
possibilities of tokenizing assets. Thus far, we have seen art,
videos, and the first Tweet tokenized and sold (to name a few).
However, as NFTs expand in popularity, so too will the product
base. And why not? NFTs and DLT reduce the risk of counterfeit and
fraud. Using an event ticket as an example, tokenization allows,
and ensures, the ability to track each individual ticket sold in
case an issue arises with a particular ticket-for instance,
policing an anti-scalping policy, the need to ascertain who holds
the valid ticket when two fans show up with identical printouts, or
if a security concern arises and there is a need to quickly
determine the identity and location of ticket holders.

Establishing an NFT is relatively easy. First, decide which
blockchain to use. Ethereum again dominates the market. Minting an
NFT on the Ethereum blockchain requires only an Ethereum wallet
that supports ERC-721-the Ethereum-based NFT token standard. Next,
build a marketplace or use an existing NFT marketplace. Tokenize
the assets and upload them to the marketplace. Finally, start
selling NFTs on the marketplace by setting conditions of
sale-including the date and time a token becomes available, whether
it is available for a fixed price or in an auction format, and any
other information necessary to compose a smart contract. Again, the
blockchain records all transaction information thereby making
accounting and recordkeeping information instantly retrievable.

V. CONCLUSION

The economy of tomorrow has arrived. Enterprise built on
blockchain. While we have only just begun to scratch the surface on
new applications for blockchain and tokenization, the possibilities
are endless. Tokenization is the way of the future. Now is the time
to enter this growing space and capture the benefits of
innovation.

Whether launching utility tokens that holders redeem for
products and/or services, or transforming unique items into NFTs,
tokenization provides access to a growing market of cryptocurrency
users and creates new and unique revenue streams. Innovation
beckons opportunities that will shape businesses for years to come.
Welcome to the new era.

Footnotes

1. A
token itself is merely a cryptographic string of numbers and
letters that contains no independently meaningful data. It relates
back to potentially valuable data or another digital asset (the
cryptographic code is a "stand-in" for real
data).

2. On the
Ethereum blockchain, for instance, smart contracts are written in
an Ethereum-based contract code called Solidity. By relying on DLT,
smart contracts are both immutable and distributed, which
eliminates the need for an intermediary to verify or facilitate
transactions that automatically execute upon the satisfaction of
objective criteria.

3. On the
Ethereum blockchain, for instance, NFTs use a different source code
than fungible tokens and follow the protocols in ERC-721, rather
than ERC-20 for fungible tokens.

4. This
section is meant to provide an overview of the regulatory
considerations when classifying tokens. It by no means is a
complete discussion of potentially applicable securities laws and
regulations. As "security tokens" are, by default,
securities and therefore subject to securities laws, this section
and the sections that follow focus on the regulatory considerations
of the remaining categories of tokens.

5. SEC,
Framework for "Investment Contract" Analysis of
Digital Assets (Apr. 3, 2019) [hereinafter SEC Guidance],
available at
https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets.

6.
Id.

7.
Id.

8.
SEC v. W.J. Howey Co., 328 U.S. 293, 300
(1946).

9. SEC
Guidance.

10.
Id. at 298.

11.
William Hinman, Digital Asset Transactions: When Howey Met Gary
(Plastic) (June 14, 2018), available at https://www.sec.gov/news/speech/speech-hinman-061418.

12.
Id.

13.
SEC Guidance.

14.
Id.

15.
Id.

16.
Id.

17.
Id. The facts and circumstances regarding any particular
NFT would, of course, need to be examined against the SEC's
guidance to ensure the token does not qualify as a
security.

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