Is your airdrop a distribution of securities?

Is your airdrop a distribution of securities?

Is your airdrop a distribution of securities?

Thinking of conducting an airdrop? You’re not alone. This year has seen a marked increase in the number of companies using airdrops to distribute tokens (to the point that some have likened the airdrop to spam). There are a number of reasons behind this surge in popularity – including the heightened uncertainty surrounding the regulatory status of ICO’s. However, while companies conducting an airdrop may consider the practice of giving out tokens free of charge harmless from a securities law perspective, the legal status of airdropped tokens is by no means clear.

Why so popular all of a sudden?

There are a number of reasons behind the airdrop’s surging popularity as a method of token distribution:

1. Rise in private sales

An increasing number of companies have been able to raise sufficient funds to launch their projects in private sales, thus removing the need to hold a public ICO. However, for a project to function well upon launch it still needs a mechanism for distributing tokens fairly and widely. This is where the airdrop comes in – providing companies with a simple way of distributing tokens to the public. David Sacks and Josh Stein have dubbed this method of conducting a private sale, whilst withholding a portion of tokens to be later distributed via an airdrop, the “lockup + airdrop” method.

2. Airdrops enable companies to quickly establish a project’s network effect

The advantage of distributing tokens via an airdrop is that tokens are distributed to all wallet addresses contained on a public blockchain like Ethereum or Bitcoin. As Shaurya Malwa points out, both Ethereum and Bitcoin have millions of users – and represent the majority of the crypto-community. If only 1% of those users actually engage with the project after an airdrop, the project is likely to have achieved broader distribution and engagement than even the most successful of token sales can boast. As such, the airdrop represents an effective way to quickly enlist users and build a community around a project.

3. Many issuers believe airdrops do not attract securities law regulations

To those spooked by the clampdown on public ICO’s in the US, the airdrop may look like an attractive alternative to safely distribute tokens without invoking securities legislation. However, there is growing concern – from a legal perspective at least – that there’s more to these seemingly ‘free’ tokens than meets the eye.

Legal and regulatory considerations

At present the legal status of airdropped tokens remains undefined. However, a number of potential issues have been flagged:

1. In many cases project tokens have often already been treated as a security on direct sale

Sacks and Stein point out that a “lockup + airdrop” distribution may raise issues from a regulatory perspective as the token has already been treated as a security on direct sale. It then becomes difficult to argue that the token ceases to be a security when distributed via airdrop  – for example, to a speculator who trades for profits:

We believe that Private ICOs that comply with Reg D on issuance but disregard the rules on secondary trading will be short-lived, as it is only a matter of time before SEC enforcement turns to this issue. The SEC is unlikely to see 50% compliance as a passing grade. Given the new environment, we think the approach of Private ICOs that rely on “lockup + airdrop” for distribution is too risky, and a more complete approach is needed.

2. Strictly speaking, tokens distributed via airdrop may not be “free”

Airdropped tokens may in fact be provided in exchange for some form of value. Subscribers are often asked to join a Telegram group (at a time when the size of a Telegram group is considered an indicator of a strong ICO community), or to provide their contact information for marketing purposes. Airdrops have been likened to guerilla marketing campaigns – the aim being to build a community for a project with the hope of increasing the value of the tokens. As such, it is clear that users may provide value in exchange for airdropped tokens.

This matters. As Sacks and Stein remind us, it is now clear – in the US at least – that if a company receives or will receive “any value” from the recipients of a token, that distribution will be subject to securities legislation. Viewed in this way, an airdrop may be sufficient to constitute a sale of securities to non-accredited investors in exchange for value.

3. Parallels to dotcom era “free stocks”

Another area of concern is that airdrops are not necessarily without precedent. In 1999 the SEC targeted companies giving away “free stocks” (i.e. free traditional equity). In those cases, investors were required to disclose valuable personal information in order to obtain shares. Free stock recipients were also offered shares if they were able to refer additional investors, or link their own websites to those of an issuer, or purchase services offered through an issuer. Through these techniques, issuers received value by spawning a fledgling public market for their shares, increasing their business, creating publicity, and in two cases, generating possible interest in projected public offerings.

These free stock cases have clear parallels to the way a number of airdrops have been conducted.

4. Impact on Valuation

TokenData recently highlighted that the effect of an airdrop on a project’s valuation was increasingly becoming a source of confusion for some companies – leading to possibly exaggerated statements of value. The example TokenData gives is of a company that raises $36M by selling 36M tokens for $1 in a private round to accredited investors. That company then decides to airdrop 4M tokens. Despite the fact the tokens were originally issued at $1/token, $4M of extra value has not been added to the project simply by creating an extra 4M tokens out of thin air. The project’s value will be $36M, not $40M.

5. KYC and AML Requirements

Projects considering utilizing an airdrop distribution method should seek advice on complying with know-your-customer (KYC) and anti-money-laundering (AML) requirements for public sales.

Conclusion

While the legal status of airdropped tokens remains unclear, the above discussion shows that the prevailing belief amongst companies that tokens don’t trigger securities legislation may be flawed. In a climate of increased scrutiny of the cryptocurrency sector as a whole, companies should seek legal advice and proceed with caution.

The content in this article is provided for general information purposes and does not constitute legal or other professional advice or an opinion of any kind. We advise our readers to seek out qualified legal or professional counsel before making any decisions.

Article by Amanda Pentreath

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