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Do Play-To-Earn Games Sell Unregistered Securities?

What do securities laws have to do with gaming?

Securities are traditionally associated with stocks and bonds traded on various exchanges. However, “securities” is actually a much broader term and includes virtually anything that a company sells to raise funds, whether to the general public or to a select group of high net worth individuals in a private placement. In the play-to-earn context, either the in-game currency token or the game asset NFT can be considered securities. Crypto/blockchain/NFT regulation is still at the early stages, but the SEC has taken an active enforcement role in pursuing fraud and illegal token offerings in the digital assets market.

Not all tokens or digital assets are securities. The uses a four-prong analysis called the Howey test to determine whether an offering is a security. More precisely, courts apply the Howey test and examine whether something is an “investment contract,” which is a type of security. The United States Supreme Court created the test in SEC v. WJ Howey, 328 U.S. 293 (1946), when it determined that a company selling shares in an orange grove farming operation was actually selling unregistered securities. If a token does not qualify as a security under the Howey test, it is generally considered a “utility token” and may be sold without the constraints of securities laws (but may still be subject to other regulations).

How do securities laws apply to gaming tokens or NFTs?

An “investment contract” has four elements: (1) an investment of money; (2) in a common enterprise; (3) with the expectation of profit; (4) derived from the efforts of others. With digital assets, the SEC generally assumes the first two prongs are met. Most, if not all, play-to-earn tokens involve an investment of money (either fiat currency or cryptocurrency with value) in a common enterprise (i.e. the game project). Thus, whether an offering is an exempt “utility token” or an unregistered security depends on whether the purchasers are led to expect profit derived from the efforts of others. In other words, does the purchased token function as a passive investment that pays dividends?

Of course, this is a very fact-specific inquiry. The SEC’s Strategic Hub for Innovation and Financial Technology (“FinHub”) has a rather complex set of guidelines and guideposts for the analysis, called the “Framework for Investment Contract Analysis of Digital Assets.” The SEC also relies on the DAO Report, which was a 2017 investigation of the Swiss-based DAO Project that explains the SEC’s application of Howey to digital assets.

In general, the determining factor is how the tokens are used. Do players actively use the NFTs they acquire to play the game and earn rewards? For example, an owner must manually enter the racehorse NFTs in Zed.Run (a hugely popular play-to-earn horse racing game) into various races, deciding on the best course type and distance suited to that particular “racehorse.” If the NFTs “wins,” the owner wins a prize, just like in real-life horse racing. Axie Infinity is another example of where players must actively manage their NFTs and “battle” them before earning rewards. Active in-game management likely negates both the third and forth prongs of Howey, as players purchase the tokens for in-game use and any rewards are not from the efforts of others – they come directly from the efforts of the player/owner. The same logic applies to in-game currencies that can be used to acquire in-game assets, pay entry fees, upgrade NFTs, and for other purposes. Simply put, while the in-game currency may certainly fluctuate in value on the secondary market, it is not a passive investment vehicle. It is an active “utility” component of a play-to-earn game.

Do staking and lending features affect the securities analysis under Howey?

As play-to-earn games become more sophisticated, so does the analysis. Many games now offer “staking” – which rewards players with in-game currency for parking their tokens or removing them from circulation for a set period of time. Additionally, NFT renting and lending are becoming more common, where owners let third parties to borrow their NFTs, actively use them within a game, and in return, receive a share of any winnings. The staking and lending mechanisms effectively enable passive income for token owners. Passive income is a hallmark of a security under the Howey test.

Play-to-earn games are a rapidly growing sector of the overall crypto and NFT market. It is critical for developers to ensure legal compliance, not only to protect themselves and their companies from crippling lawsuits, but to also make their product attractive to potential investors. In 2022, a comprehensive legal analysis of the play-to-earn project is a must-have for any pitch deck. Note that even if the token or NFT is not a security under federal law, state level “Blue Sky laws” may apply. Additionally, a token or NFT may be regulated as a commodity or under money transmission laws. In other words, the securities analysis is only part of a full legal evaluation.

Contact Dan Artaev by email or call or text to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.

Stablecoin Taxation and Securities Regulation: What Every Investor Must Know.

Stablecoins are cryptocurrencies backed by other assets like fiat currency reserves, precious metals, commercial paper, and even portfolios made up of other cryptocurrencies. By pegging their value to another asset, stablecoins attempt to decrease price volatility and achieve a more “stable” price than uncollateralized cryptocurrencies like Bitcoin and Ethereum. As I previously wrote, stablecoins may be particularly useful for international trade and business due to their predictable value and the ability to avoid wire delays and to minimize transaction costs. Stablecoins are also not targets of speculation or artificial price increases due to external events like Elon Musk’s SNL appearances or even China’s clampdown on Bitcoin mining. If the stablecoin is pegged to the value of the dollar, it will still be worth $1 regardless of whether there is a sudden spike in demand or supply.

Other than potential business use, stablecoins are also a popular investment medium. Certain exchanges have offered attractive interest rates on stablecoin holdings, ranging from Coinbase offering 4% on USD Coin (USDC) to double-digit returns on some lesser exchanges and stablecoins. As always, do your due diligence and make sure you know where your money is going before transferring any significant amount of cash. Also, it may be worthwhile to test the liquidity or withdrawal time with smaller deposits before investing any large amounts.

Just like with traditional cryptocurrency, there are two main legal areas that affect stablecoins: tax and securities regulation. Here are the latest “must knows” in each area:

Stablecoins are taxed like property and are subject to capital gains tax. Cryptocurrency is not “currency” as far as the IRS is concerned – rather, for taxation purposes, it is treated like property and subject to capital gains tax. This gets tricky, especially with stablecoins that are pegged 1:1 to the dollar. Buying stablecoins (or any crypto) for dollars is not a taxable event. However, using stablecoins to purchase goods and services is a taxable event that must be reported, even if your capital gains are zero.

For instance, if you buy 1,000 USDC for $1,000, that is not taxable. Then, when you pay a Romanian engineer 1,000 USDC in exchange for a circuit board design, the IRS deems that you have sold the USDC at the market rate in exchange for the engineering services. The difference between your cost basis and your sell price is the capital gain. Where the stablecoin is pegged 1:1 to the dollar, the capital gain will be $0 (your purchase price and sale price are the same). In fact, you may even realize a loss that you can use to offset your income if you paid a transaction fee. Transaction fees are added to your cost basis, so if you paid a $10 transaction fee to buy 1,000 USDC, your cost basis is $1,010 and when you sell for $1,000, you just netted a $10 loss. Also, you can end up with capital gains or losses if you are transacting large amounts of stablecoin – for example if you sell 50,000 USDT (Tether) when it’s price fluctuated slightly to $1.01, you just received a $500 capital gain.

Additionally, if you are earning interest on your USDT holdings, interest is taxable like ordinary income. In other words, buying stablecoin for fiat currency is not taxable, but earning stablecoin through staking is taxable. Just like you pay income tax on interest earned from your savings account, you will incur income tax on cryptocurrency gains. Finally, when you use your earned USDT to buy something or convert to cash or another cryptocurrency, that is a reportable taxable event subject to capital gains tax because for IRS purposes, you just sold property – your cryptocurrency.

Some stablecoins may be regulated like securities. The Securities and Exchange Commission (SEC) enforces U.S. securities laws, which apply to a wide range of publicly-available investment products like stocks, bonds, mutual funds, and investment contracts where investors provide capital in exchange for expected returns. Cryptocurrencies like Bitcoin and Ethereum are not considered securities because they are exchange mediums and in the SEC’s view, are no different than a foreign currency like the Euro or the Japanese Yen. At the same time, the SEC has scrutinized new coin offerings (also called initial coin offerings or ICOs) and concluded that they may constitute investment contracts if there are facts that indicate the buyer is “expecting a profit to be derived from the efforts of others.” See generally SEC v W.J. Howey Co., 328 US 293 (1946) (where the Supreme Court held that shares in a citrus grove operation were investment contracts subject to securities laws because the investors provided capital with the expectation that workers’ efforts in harvesting oranges would yield profits). Certain stablecoins, especially those that seek capitalization through ICOs and promise a percentage return through “staking,” will be considered “investment contracts” required to register with the SEC and provide public information like any other security.

There are also some stablecoins that are backed by securities like corporate and municipal bonds, mutual funds, and other publicly-traded instruments that are themselves regulated by the SEC. There is little doubt that these security-backed stablecoins are considered derivatives because their value is derived from the value of regulated securities. SEC regulation will require stablecoin issuers to disclose additional information about their companies to the public. Already there is some concerning information release ahead of Circle’s (the issuer of USDC) intent to go public – USDC reserves are only61% cash and money market funds, with the rest divided between U.S. and foreign treasury bonds, municipal, and corporate debt. Previously, the 1:1 stablecoin issuers represented that each coin was backed by actual cash reserves, which were regularly audited. Apparently, that is not the precise reality.

Finally, stablecoins are also facing increased regulatory scrutiny from central bank authorities. Federal Reserve officials have expressed their concerns about the effect of stablecoins on the credit markets. Stablecoins also threaten the ability of the Federal Reserve to regulate monetary supply to stimulate the economy and control inflation. For instance, if a coin like USDC gains widespread adoption, a private company like Circle will be able to regulate monetary supply by increasing and decreasing interest rates. Expect to see increased guidance and regulation from the U.S. Treasury and the Federal Reserve in the near future. It would not be surprising to see stablecoin issuers to be treated as banks in certain circumstances.

Want to know more? Contact Dan Artaev by email or call or text to set up your initial consultation.

What do securities laws have to do with gaming?

How do securities laws apply to gaming tokens or NFTs?

Do staking and lending features affect the securities analysis under Howey?