As we saw in the previous chapters we understood what are securities and how could you fall under the various investor protection laws. In this chapter, we'll cover the first exemption on securities: Airdrops. Airdrops are just like money falling from the sky. In theory, they are not to be considered securities, because they are free money. People are granted free cryptographic tokens based on some representation. Therefore, the requirement under the Howey test for the "investment of money" is avoided.
However; this is not always the case. Let's first understand what is an airdrop and how it works. An Airdrop is a procedure for an initial token distribution. For example, a company (let's call it Hjir) could provide 1 free token for every person who holds a Facebook account. In order to receive this token, that person would authenticate his Facebook account with a Hjir account. Then, he will have 1 Hjir token free for use. He will not have any other way to purchase this token, nor will he be able to mine them in any other way.
He could, in theory, ask a lot of his friendbooks to authenticate with Hjir and send him their tokens. But what he most likely won't be able to do is open multiple new facebook accounts and claim these tokens. Why? because of the first issue: the cutoff date.
An airdrop will have a cutoff date, meaning a date where the eligibility closes. This date should be close to the airdrop date, but not on that date.
The second issue is how to distribute tokens. In our first example, we stated that one facebook account means one Hjir token. But, we can also have other formulae; we can say that "one social media account" is one token. Meaning, that if you connected both your Facebook, Twitter, Instagram and Snapchat accounts, you'll have four different tokens. This gives you an incentive to interact (and give data).
Here comes the interesting first question: in such authentication method, where personal data (meaning, the information conveyed from the social network to Hjir) may be considered "money". There are some scientific papers quantifying the cost of personal information and you may also see my lecture from 2016 about the cost of free apps. The point is that if there is more than mere authentication here, but also an exchange of personal data, then this might be considered as a payment under the Howey test.
The other, more popular way of an airdrop is a pro-rata airdrop. Meaning, that each person receives tokens based on his current clout or balance. The great example for these airdrops are the known "bitcoin forks". In those cases, each person holding a specific balance of coin A, let's say "bitcoin" also receives the same balance in coin B. This is what happened with BCash. Last August, BCash was forked from bitcoin; meaning, that the BCash staff created an additional blockchain, and gave each person who held any bitcoins the same balance in BCash.
This was repeated a few times, where each fork provided a person with a premium on his actual original balance.
While in decentralized cryptocurrencies there is very little risk that such fork shall be deemed as an investment agreement or a security, in other cases it might differ.
Let's take, for example, a simple airdrop for out fictitious Hjir token. Let's say we provide tokens at a 1:1 ratio for any Ether holders. While the first airdrop is not an "investment", the future issuance of tokens via the Hjir environment may change this conclusion. If the Hjir development team decides to issue future tokens only against payment, or to have its own tokens in parallel to the airdrop provided to other people (even free of charge), then this might be later on considered as an investment of money.
This kind of airdrop, the pro-rata, might be a little more leaning towards being an investment agreement. The reason is that while the initiating body does not have control over the initial tokens, they might have two other means of control: the first is the right issue future tokens and the second is the expectation of profit generated by the people. Meaning, people bought Ether one day before the airdrop and sold it the day after. This was their investment as they took the risk of a plummet.
This is why the token cutoff date should be as far away as possible from the airdrop date. Taking the date back removes speculative trading during the airdrop date, as well as allows other factors to affect the airdropped token's value. A good way to avoid speculative trading using an airdrop is to set the cutoff date before the whitepaper is released, so that the cutoff date is the date where the whitepaper was issued.
But here comes the real problem with airdrops: you created a new economic system, with a token to manage payments, and you neither have centralized control on the issuance of new tokens, nor do you have a way to cash out when the system is used. The purpose of having a successful ICO is to raise capital to the new, decentralized, system that is about to emerge. So how could these airdrops later be used to raise capital?
The answer is in the details. Again, there is no specific rule by the SEC or another authority on airdrops; the general law is still the Howey test. Therefore, providing people with an airdrop with a system that also has a pre-mined status may still be considered non-security, if the details are such that there is no "investment of money" by anyone receiving these tokens.
This is the case in some cases, where premined tokens are provided to the original team (see here), but it is not always the case. If you provide your airdrops over a lengthy time (for example, each for each Ether you receive 100 Hjir, each vested over a week), and use it to build a community, then the tokens by themselves not be securities, but you may use the network effect to grow your community. (Galicoin is a joke cryptocurrency, but it did premine for the developers).
Assume, for the purpose of discussion, that the ICO itself is an event meant to generate some funding for a project. In such case, the funding may be provided over a long duration (as the project evolves), and not always at the token generating event.
How can you succeed with an airdrop? well, airdrops are meant for a specific project and not for all relevant projects. A good airdrop project may be one that creates new coins for every transaction on the parallel network. Let's use Ethereum and Hjir for my example. Let's say that our Hjir network generates Hjir tokens indefinitely, based on Ether transactions, meaning that the airdrop is based on the total Ether sent to your address, regardless of your balance, and that it keeps rolling forwards: meaning, that new Hjir are created by transactions on the original network. This gives people incentive to use the original network, and creates value (provided that there is some connection between Hjir and Ether).
In our next chapter we'll cover reward clubs: airway miles, gift cards and other non-tangible payment methods, to see how there is a way to issue new tokens without being considered a security when you take another point of the Howey test out.
I'm Jonathan Klinger, I'm a master of law, certified to practice in Israel. I've explored the blockchain, and now I'll be helping you in deciding on whether you should raise funds via a token generating event. I highly recommend you avoid it. Read my blog for more info.Previous Chapters:
Preface
Chapter One: Other People's Money, an Introduction.
Chapter Two: Scams, or why do we need investor protection?
Chapter Three: The Investors, or who doesn't need protection.
Chapter Four: What is a security, or: the Howey test, simplified.
Chapter Five: Avoiding the Howey Test.