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SEC Staff Says Tokens to Be Used for Video Games Are Not Securities

Steven.Lofchie@cwt.com's picture
Commentary by Steven Lofchie

The SEC Division of Corporation Finance granted no-action relief to a tech company that has developed, and seeks to distribute, a blockchain-based token (the "Quarter") for use on online gaming platforms. The company, Pocketful of Quarters, Inc. ("PoQ") developed tokens that allow users to pay for upgrades and other items in video games and to participate in game competition events. PoQ will sell an unlimited amount of the Quarters, which must be paid for using Ether.

According to the letter, 15% of the proceeds from the sales of the Quarters will go to the owners of the system. A portion of the remaining 85% of the revenue would be spent by holders of Quarters paying owners of games for access to game features. The game owners, not PoQ, will determine the value of the Quarters in each individual game. Game owners would be able to convert the Quarters they received into Ether, and presumably from Ether into dollars. PoQ also could use a portion of the 85% of revenue that did not go to the system's owners for the purpose of marketing the Quarters by payments to game owners, developers and influencers. In addition, these recipients of marketing payments would be able to convert their Quarters into Ether, and then into dollars.

The SEC staff highlighted that the Quarter was fully developed without the use of any proceeds from the sale of the Quarters. Ownership interests in the Quarter system, or at least parts of the system, are represented by a security that is evidenced on the blockchain. No relief from the securities laws was sought with regard to the token representing an ownership interest in the Quarters system.

Ordinary game players who purchased Quarters would not be able to transfer their Quarters to other persons or game players, and they would not be able to redeem them for Ether. The only permitted use of a Quarter by an ordinary holder would be to spend it in connection with the playing of video games.

Commentary

This is the first significant no-action letter that the SEC staff has issued providing that a blockchain-based token is not a security. A previous no-action letter, Turnkey Jet, also determined that a blockchain-based token was not a security, but that case concerned a simple payment system for transferring tokens (Stablecoins) representing dollars, i.e., the payment system just replaced payments by wire transfer or credit card.

Unlike Turnkey Jet, this letter permits the distribution of a blockchain token that is to be used to create a business, and not merely as a payment system for a business that has nothing to do with the blockchain. The imposed conditions on the use of revenues from the token may prove to be unduly limiting for a business in a dynamic environment. The prohibition on the transferability of Quarters, for example, should probably allow for some exceptions (death of a holder, to take the most extreme example). There are AML implications as well, including whether the AML requirements imposed go beyond what should be necessary. Notwithstanding those negatives, which are very material and which will have to be addressed eventually (whether as to the Quarters or to other products), this staff letter provides meaningful direction for firms seeking to use blockchain-based tokens as the underlying foundation for a real operating business.

A few observations: it was key to the Staff's conclusion that the Quarters system was built and is fully operational without using any of the proceeds from the sales of the Quarters. However, the revenue split sanctioned by the letter, with 15% going to the owners of the system and 85% staying available to the holders of the Quarters and for certain other limited uses, is wholly arbitrary. There is no reason to expect that 15% of a business' revenues going to the owners is the "right" number: it may be too high at some times and too low at others. There is no obvious logic why revenue from the sale of the Quarters may be used for certain prescribed forms of marketing of the product, but not for further development of the underlying technology or even for other types of marketing. It may very well be that technology development is more important to the success of the product than the prescribed forms of marketing expenses.

In addition, and in contrast to the Turnkey Jet letter, the holders of the Quarters are in no way in the same position as are holders of Stablecoins. The value of the Quarters, expressed as a dollar amount, may vary dramatically. Because the residual purchase price of the Quarters will be maintained in Ether, the value of the Quarters as against the value of the dollars will fluctuate with that of Ether. Quarters cannot be used as a means to speculate in Ether because they are not freely redeemable for either Ether or dollars. Thus, if the value of Ether were to double, a holder of Quarters might receive more value in that video games would provide the holder more rewards for a Quarter. The holder, however, would not be able to redeem the Quarter for Ether (and thus could not cash out and realize any appreciation in the value of the Ether).

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