DXLT - Securities Analysis
Is DXS Loyalty Token (DXLT) a security? This post covers our analysis.
Securities are fungible and tradable financial instruments used to raise capital in public and private markets. Issuers of securities must comply with securities regulations as dictated by Financial Regulatory Authorities.
The key impetus of securities regulation is to remove information asymmetry between issuers and investors. Financial Regulatory Authorities achieve this through prescribing the information investors need in order to make informed decisions.
Securities regulations help to protect investors, but compliance is time consuming and costly. From DXS's perspective, it’s important to consider securities classification for DXLT so an adequate cost benefit analysis can be carried out.
Whose jurisdiction?
There are many Financial Regulatory Authorities that regulate securities around the world. Whose regulations should be considered?
For the purposes of this evaluation, we interpret guidance by the Securities and Exchange Commission (SEC) of the United States. The SEC is a member of the International Organization of Securities Commissions (IOSCO) whose membership regulates more than 95% of the world's securities markets. One of the key objectives of IOSCO is to guide implementation of consistent standards of regulation.
We look to the SEC’s guidance regarding securities classification, with the consideration that securities classification is treated similarly in the majority of the world’s jurisdictions.
Securities classification
The relevant consideration is the Supreme Court of the United States ‘investment contract’ test from SEC v. Howey - the Howey Test. The SEC framework for an ‘investment contract’ as it relates to digital assets provides clear guidance on the elements of the Howey Test, which are comprised of:
The investment of money;
not satisfied in the case of DXLT
in a common enterprise;
satisfied in the case of DXLT
with reasonable expectation of profits;
not satisfied in the case of DXLT
derived from the efforts of others
satisfied in the case of DXLT
We conclude that DXLT cannot be considered a security. Our analysis is below.
The investment of money
From the SEC framework:
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 satisfied. As the Commission explained in The DAO Report, "[i]n determining whether an investment contract exists, the investment of 'money' need not take the form of cash" and "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 contract." 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.
It’s very interesting that the SEC specifically notes that even airdrops can satisfy the ‘investment of money prong’ of the Howey Test, indicating that even ‘lack of monetary consideration’ does not exempt a token from being an ‘investment contract’.
DXLT does not necessarily fit the description of an airdrop. DXLT is a loyalty point / bounty program. As such, it’s relevant to consider the Tomahawk Exploration LLC case. In Tomahawk, TOM tokens were offered in exchange for:
marketing efforts;
making requests to list TOM tokens on token trading platforms;
promoting TOM tokens on blogs and online forums such as Twitter or Facebook;
creating professional picture file designs;
YouTube videos, other promotional materials; and
online promotional efforts that targeted potential investors and directed them to Tomahawk’s offering materials
The SEC applied the Howey test and stated that “the TOM tokens were offered in exchange for the investment of money or other contributions of value” and that “the representations in the online offering materials created an expectation of profits derived from the efforts of others, namely from the oil exploration and production operations conducted by Tomahawk and Laurance and from the opportunity to trade TOM tokens on a secondary trading platform.” In addition, the Tomahawkcoins also represented a transferable share or option on an equity share of Tomahawk Exploration LLC, which would be considered securities.
Here’s where DXLT falls outside of the considerations of the above scenario:
DXLT is primarily rewarded for active use of DXS. The only case where DXLT are provided in exchange for services designed to advance DXS's economic interests is for referrals of new users
DXLT's only function is to collateralise bounty positions on DXS. DXS is not supporting a trading market for DXLT
DXLT does not represent a transferable share or option on an equity share of DXS
We consider the ‘investment of money’ prong of the Howey Test to not be satisfied in the case of DXLT.
Common enterprise
From the SEC framework:
Based on our experiences to date, investments in digital assets have constituted investments in a common enterprise because the fortunes of digital asset purchasers have been linked to each other or to the success of the promoter's efforts. See SEC v. Int'l Loan Network, Inc., 968 F.2d 1304, 1307 (D.C. Cir. 1992).
Further from the SEC:
Courts generally have analyzed a "common enterprise" as a distinct element of an investment contract. In evaluating digital assets, we have found that a "common enterprise" typically exists.
We consider the ‘common enterprise’ prong of the Howey Test to be satisfied in the case of DXLT.
Reasonable expectation of profits
From the SEC framework [green: DXLT satisfies criteria, orange: DXLT might satisfy criteria, red: DXLT does not satisfy criteria]:
AP means: promoter, sponsor, or other third party (or affiliated group of third parties) (each, an "Active Participant").
The more the following characteristics are present, the more likely it is that there is a reasonable expectation of profit:
The digital asset gives the holder rights to share in the enterprise's income or profits or to realize gain from capital appreciation of the digital asset.
The opportunity may result from appreciation in the value of the digital asset that comes, at least in part, from the operation, promotion, improvement, or other positive developments in the network, particularly if there is a secondary trading market that enables digital asset holders to resell their digital assets and realize gains.
This also can be the case where the digital asset gives the holder rights to dividends or distributions.
The digital asset is transferable or traded on or through a secondary market or platform, or is expected to be in the future.
Purchasers reasonably would expect that an AP's efforts will result in capital appreciation of the digital asset and therefore be able to earn a return on their purchase.
The digital asset is offered broadly to potential purchasers as compared to being targeted to expected users of the goods or services or those who have a need for the functionality of the network.
The digital asset is offered and purchased in quantities indicative of investment intent instead of quantities indicative of a user of the network. For example, it is offered and purchased in quantities significantly greater than any likely user would reasonably need, or so small as to make actual use of the asset in the network impractical.
There is little 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.
There is little apparent 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.
The AP has raised an amount of funds in excess of what may be needed to establish a functional network or digital asset.
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.
The AP continues to expend funds from proceeds or operations to enhance the functionality or value of the network or digital asset.
The digital asset is marketed, directly or indirectly, using any of the following:
The expertise of an AP or its ability to build or grow the value of the network or digital asset.
The digital asset is marketed in terms that indicate it is an investment or that the solicited holders are investors.
The intended use of the proceeds from the sale of the digital asset is to develop the network or digital asset.
The future (and not present) functionality of the network or digital asset, and the prospect that an AP will deliver that functionality.
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 network.
The ready transferability of the digital asset is a key selling feature.
The potential profitability of the operations of the network, or the potential appreciation in the value of the digital asset, is emphasized in marketing or other promotional materials.
The availability of a market for the trading of the digital asset, particularly where the AP implicitly or explicitly promises to create or otherwise support a trading market for the digital asset.
Given the above, the key risk factors for DXLT are:
DXLT will be transferable outside of DXS
Secondary markets for DXLT may develop (although they will not be supported or encouraged by DXS)
DXLT represents a proportional claim on a portion of DXS's revenue (collected in a pot). As such, the value of DXLT is not fixed and could be subject to value appreciation, and therefore speculation on the performance of DXS.
We consider the ‘reasonable expectation of profit’ prong of the Howey Test to not be satisfied in the case of DXLT.
Reliance of the efforts of others
From the SEC framework [green: DXLT satisfies criteria, orange: DXLT might satisfy criteria, red: DXLT does not satisfy criteria]:
AP means: promoter, sponsor, or other third party (or affiliated group of third parties) (each, an "Active Participant").
The inquiry into whether a purchaser is relying on the efforts of others focuses on two key issues:
Does the purchaser reasonably expect to rely on the efforts of an AP?
Are those efforts "the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise," as opposed to efforts that are more ministerial in nature?
Although no one of the following characteristics is necessarily determinative, the stronger their presence, the more likely it is that a purchaser of a digital asset is relying on the "efforts of others":
An 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.
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, purchasers would reasonably expect an AP to further develop the functionality of the network or digital asset (directly or indirectly). This particularly would be the case where an AP promises further developmental efforts in order for the digital asset to attain or grow in value.
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).
An AP creates or supports 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 ensuring scarcity, through, for example, buybacks, "burning," or other activities.
An AP has a lead or central role in the direction of the ongoing development of the network or the digital asset. In particular, an AP plays a lead or central role in deciding governance issues, code updates, or how third parties participate in the validation of transactions that occur with respect to the digital asset.
An AP has a continuing managerial role in making decisions about or exercising judgment concerning the network or the characteristics or rights the digital asset represents including, for example:
Determining whether and how to compensate persons providing services to the network or to the entity or entities charged with oversight of the network.
Determining whether and where the digital asset will trade. For example, purchasers may reasonably rely on an AP for liquidity, such as where the AP has arranged, or promised to arrange for, the trading of the digital asset on a secondary market or platform.
Determining who will receive additional digital assets and under what conditions.
Making or contributing to managerial level business decisions, such as how to deploy funds raised from sales of the digital asset.
Playing a leading role in the validation or confirmation of transactions on the network, or in some other way having responsibility for the ongoing security of the network.
Making other managerial judgements or decisions that will directly or indirectly impact the success of the network or the value of the digital asset generally.
Purchasers would 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 realize capital appreciation from the value of the digital asset. This can be demonstrated, for example, 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.
The AP distributes the digital asset as compensation to management or the AP's compensation 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.
The AP owns or controls ownership of intellectual property rights of the network or digital asset, directly or indirectly.
The AP monetizes the value of the digital asset, especially where the digital asset has limited functionality.
We consider the ‘reliance upon the efforts of others’ prong of the Howey Test to be satisfied in the case of DXLT.
Conclusion
We used the Howey test to analyse DXLT from the SEC’s perspective:
The investment of money;
not satisfied in the case of DXLT
in a common enterprise;
satisfied in the case of DXLT
with reasonable expectation of profits;
not satisfied in the case of DXLT
derived from the efforts of others
satisfied in the case of DXLT
We conclude that DXLT cannot be considered a security under this framework.
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