token airdrop

Token Airdrops May Technically Be Unregistered Sales of Securities

by William Restis

published February 28, 2018

It has been all the rage lately for blockchain startups to do a token airdrop instead of an initial coin offering (ICO). Now that the SEC has made clear that ICOs are securities offerings, everyone is trying to find a workaround. Why? Because crypto has democratized investment opportunity.

The notion that ground floor investment opportunities should be available to all –  not just “accredited investors” – is a compelling one. A risky one at that, but necessary if you believe in free markets. And unregulated fundraising is compelling for founders because they get rich quick. What’s not to like?

Token Airdrops Are Free Money

token airdrop

So what’s a token airdrop? Well, instead of selling tokens, founders give them away.

Airdrops are always projects based on, or built upon a certain blockchain. For example, ERC20 airdrops rely on the Ethereum blockchain. There have been airdrops of tokens based on Bitcoin, Ripple, and others.

Founders create an entry on the main blockchain stating that addresses with certain characteristics will be “airdropped” tokens on a given date. Voila, free money.

Project founders can then take the next step, and have the airdropped tokens listed on exchanges. Airdrop recipients are then able to create a market in the tokens, which allows for price discovery. There becomes a trading price. Suddenly, there is a “market cap” for the project: number of issued or potential tokens multiplied by trading price.

Here’s the genius of the token airdrop from a founder’s perspective. The token airdrop is usually only a small fraction of total token supply. Maybe 5-25% of all potential tokens. The founders and their accredited investors retain the rest. Did you catch that? The token airdrop and subsequent trading creates a market for tokens retained by the founders. Need money? No problem! Sell some tokens. And look at that market cap! We’re multi-millionaires, maybe even billionaires…

Seems pretty elegant to me. But there’s a problem. Token airdrops aren’t the first time founders have attempted to create a market for their securities by giving them away. The SEC has something to say about it, and it isn’t all rainbows and gummy bears.

Previous SEC Enforcement Actions Have Found Stock Giveaways To Be Unregistered Securities Offerings

As an illustrative example of how the SEC could treat token airdrops, consider In re Joe Loofbourrow where the agency ordered a founder to cease and desist his stock giveaway.

After years of efforts to raise money for a failed project, the founder attempted to garner excitement by giving away free stock. The project website stated that it would give ten shares of “free” stock to people who filled out an on-line registration form. Subscribers provided their names, as well as home and email addresses. They also had to make some cursory acknowledgment about offer terms and conditions. The website noted that additional free shares would be given to individuals that referred others.

Several affiliate websites began linking to the giveaway, which brought in additional participation.

The SEC found the giveaway violated the registration requirements in Section 5 of the Securities Act of 1933. Section 5 prohibits the sale or delivery of securities unless a registration statement is in effect.

The SEC referred to Section 2(a)(3) of the 1933 Act, which defines a “sale” of securities to “include every contract of sale or disposition of a security or interest in a security for value.”

According to the SEC, the lack of monetary consideration for “free” shares didn’t mean there was not a sale or offer for sale for purposes of Section 5. See also Capital General Corporation, 54 SEC Docket 1714, 1728-29 (July 23, 1993) (Capital General’s “gifting” of securities constituted a sale because it was a disposition for value, the “value” arising “by virtue of the creation of a public market for the issuer’s securities”); SEC v. Harwyn Industries Corp., 326 F. Supp. 943 (S.D.N.Y. 1971). Thus, the stock gift was a “sale” within the meaning of the 1933 Act because the purpose of the “gift” was to advance the donor’s economic objectives rather than to make a gift out of generosity.

The founder benefited from the giveaway because it attracted additional people to his web site, increased the chances that the public would buy additional shares, and by “increas[ing] the possibility that a market would exist for [company] shares” when and if he decided to exit.

Sound like an airdrop? It does to me.

Be careful out there!

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