iI got a pocket full of quarters, and I'm headed to the arcade.
I don't have a lot of money, but I'm bringing everything I made.
I've got a callus on my finger, and my shoulder's hurting too.
I'm gonna eat them all up, just as soon as they turn blue. 'Cause I've got Pac-Man fever;
Pac-Man fever.
It's driving me crazy.[1]
On July 25, the staff of the U.S. Securities and Exchange Commission (“SEC”) Division of Corporation Finance published a response to a no-action request submitted by Pocketful of Quarters, Inc. (“Pocketful of Quarters”) regarding its planned digital asset offering.[2] Like the song on which the company name is based, we are unsure if these digital assets have any more value than the token that were used to play arcade games in the 1980s, the no-action letter is another example of the SEC attempting to provide guidance to the industry. This no-action letter follows the staff’s April 3, 2019, response to TurnKey Jet, Inc.’s (“TurnKey”) request for no-action relief,[3] in which the Division of Corporation Finance stated that it would not recommend enforcement against Pocketful of Quarters for its planned offering of its proprietary digital asset, Quarters, based on a facts and circumstances analysis under the federal securities laws.
Pocketful of Quarters is developing a video game currency platform that leverages blockchain technology[4] to reduce fragmentation in the in-game currency market. The “Quarters Platform” is designed to improve the video game player experience by creating a universal video game digital asset using the ERC-20 standard on the Etheruem pubic blockchain that leverages smart contracts and a system of proprietary hot wallets. Among the factors differentiating Pocketful of Quarters from prior digital asset offerings is that at the time of Pocketful of Quarter’s request to the SEC, the Quarters Platform was fully developed and operational, before any of the Quarters were to be sold. When the Quarters are sold, they can immediately be redeemed for their intended purpose, gaming.
Other factors the SEC viewed favorably in its analysis included that Pocketful of Quarters intends to develop technological and contractual provisions governing the Quarters. The SEC also viewed with favor the fact that the Quarters Platform limits the ability of gamers to restrict or otherwise transfer Quarters outside of the Quarters Platform. Thus, only allowing certain authorized persons to exchange Quarters for other digital assets such as Ether or Bitcoin. The SEC also noted that Pocketful of Quarters will market and sell the Quarters to gamers solely for consumptive use in order to access and interact with video games that are part of the broader Quarters Platform. Finally, the SEC noted there will be an unlimited quantity of Quarters available at a fixed price.
Viewing these factors together, the Division of Corporation Finance determined that it would not recommend an enforcement action against Pocketful of Quarters because they are not securities. The Quarters are similar to the digital assets in TurnKey, in that the technology platform was to be fully developed and operational at the time the digital assets were to be sold, the digital assets will immediately functional for their intended purpose, and the transfer of the digital assets outside of their particular ecosystem was restricted. These factors help move the Pocketful and TurnKey digital assets away from being deemed an investment contract, and thus a security. An “investment contract” analysis takes place under the 1946 Supreme Court case SEC v. W.J. Howey Co.,[5] which is used by the SEC as part of its framework for analyzing digital assets, pursuant to the agency’s April 3, 2019, guidance.[6] In Howey, the Supreme Court defined an “investment contract” as “a contract, transaction or scheme whereby a person invests money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”[7]
The facts in the Pocketful of Quarters no-action letter are distinct from those in other matters before the SEC, including the December 11, 2017, order against Munchee Inc. (“Munchee”).[8] The SEC found that digital assets issued by Munchee as part of an initial coin offer were securities and were not offered and sold in compliance with the federal securities laws. Munchee offered its digital assets under the guise of them being “utility tokens,” a concept the order generally rejected. The digital assets were designed to provide purchasers the ability to access Munchee’s services through its digital wallet, with no outward attributes of equity, debt, or other interest in Munchee itself. The SEC focused on the facts that: (i) Munchee designed its digital assets to raise capital to facilitate the development of its business and platform; (ii) Munchee did not have an operational wallet on which purchasers could use their digital assets at the time the offering was conducted; and (iii) during the offering, Munchee promoted its digital assets as an investment and noted the digital asset’s potential appreciation in value and ability to trade on secondary markets. Given these facts, the SEC concluded that purchasers were given a reasonable expectation of the profits from the digital assets, to be derived solely from the efforts of Munchee, and were thus not offered in a compliant manner and therefore subject to penalties under the federal securities laws.
The requesting parties in both the TurnKey and Pocketful of Quarters no-action letters presented digital asset sale structures that are relatively conservative in their attributes, in that both of these structures are designed to prevent speculative resales on the part of holders on an open secondary market. However, the position taken by the SEC in Pocketful went further than TurnKey in allowing flexibility for the use of the applicable digital assets. Notably, the Quarters use the ERC-20 standard and are built on and exchanged through the public Ethereum blockchain. The Turnkey digital asset is to be built on a private, closed ledger. Pocketful of Quarters also allows the Quarters to be given away to in certain limited circumstances to game developers and other partners. Further, the Quarters are anticipated to be used more broadly as part of a gaming platform with attributes that are significantly closer to those of a traditional currency. The Pocketful no-action letter recommendation by the SEC has brought the market significantly closer to having a legal path way to sell a digital currency.
The Pocketful of Quarters no-action letter represents an important step by market innovators to develop functional and compliant digital assets and in the SEC’s efforts to provide clarity regarding the regulation of digital assets. It remains critically important that companies creating digital assets consult with the SEC and the CFTC and consider the facts presented in both the Pocketful of Quarters and TurnKey no-action letters when designing digital assets and their attendant ecosystems.
Any company planning to conduct an offering of digital assets or to develop a digital asset for use in an ecosystem should proceed with caution. Similarly, anyone looking to resell digital assets that are acquired in an ecosystem should make sure the digital assets are not securities because the resale of digital assets that are securities by a party that is not a broker-dealer could result in that party being deemed a resale of securities by an unregistered underwriter in violation of Section 2(a)(11) of the Securities Act of 1933.
[1] Pac-Man Fever, available at: https://www.songfacts.com/lyrics/buckner-garcia/pac-man-fever.
[2] Response from the Division of Corporation Finance Regarding Pocketful of Quarters, Inc., SEC (July 25, 2019) available at: https://www.sec.gov/corpfin/pocketful-quarters-inc-072519-2a1. Incoming letter to the SEC available at: https://www.sec.gov/divisions/corpfin/cf-noaction/2019/pocketful-of-quarters-inc-072519-2a1-incoming.pdf.
[3] Response from the Division of Corporation Finance Regarding TurnKey Jet, Inc., SEC (April 2, 2019) available at: https://www.sec.gov/divisions/corpfin/cf-noaction/2019/turnkey-jet-040219-2a1.htm. Incoming letter to the SEC available at: https://www.sec.gov/divisions/corpfin/cf-noaction/2019/turnkey-jet-040219-2a1-incoming.pdf.
[4] A blockchain is a type of distributed ledger or peer-to-peer database that is spread across a network and records all transactions in the network in theoretically unchangeable, digitally recorded data packages called “blocks.” Each block contains a batch of records of transactions, including a timestamp and a reference to the previous block, so that the blocks together form a chain. The system relies on cryptographic techniques for securely recording transactions. A blockchain can be shared and accessed by anyone with appropriate permissions. Some blockchains can record what are called “smart contracts,” which are, essentially, computer programs designed to execute the terms of a contract when certain triggering conditions are met.
[5] 328 U.S. 293 (1946).
[6] See Framework for “Investment Contract” Analysis of Digital Assets, SEC (Apr. 3, 2019), available at: https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets.
[7] SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
[8] Munchee Inc., Securities Act Release No. 10445 (Dec. 11, 2017) available at: https://www.sec.gov/litigation/admin/2017/33-10445.pdf.
