Are Digital Tokens the Next SPACs?
The evolving regulatory environment surrounding cryptocurrency presents opportunities and risks for boards.
Special purpose acquisition companies, perhaps better known as SPACs, were first introduced in the 1990s as a faster, cheaper and more structured way for small and medium-sized companies to be traded on the public markets. Following a great deal of hype, and a miniature boom around 2020-2021, SPACs are now a rare breed, since some companies failed to find an acquisition target and many that listed had poor post-IPO performance.
Now, a new contender for capital raising and corporate control is emerging: digital tokens. As regulatory interpretations shift and crypto infrastructure matures, directors should ask, “Could tokens be the next SPACs? And, if so, what are the governance, regulatory and strategic implications?”
Digital tokens, built on public blockchains like Ethereum, are being used to raise capital, incentivize user adoption and execute asset acquisitions. These tokens may fall outside traditional securitiesregulation, depending on how they are structured and sold.
The Definitions of Securities Are Changing
The SEC applies the Howey and Reves tests, which are legal frameworks determining whether an investment or transaction qualifies as a security under U.S. securities laws, to digital assets, making them subject to U.S. securities laws and jurisdiction. Crypto companies have the finances and incentive to challenge the SEC interpretations of Howey and Reves and, with the change in administration, the definition of digital assets as securities has been dramatically narrowed. This provokes the possibility of using digital tokens to raise “capital” without being subject to U.S. securities laws, though other laws, such as fraud, still apply.
Digital tokens are traded via a centralized or decentralized crypto exchange. In a July 2023 ruling by U.S. District Judge Analisa Torres, she determined there was a crucial difference when the XRP digital token was sold initially directly to an investor and, hence, there was a legal contract, and sold via a decentralized exchange, where there is no contract between the buyer and the seller. Indeed the seller does not know who bought the tokens because the transaction is conducted via a software agent that effectively has no owner. In the first case, the token was a security, but in the second, it was not – essentially because there was no contract between the buyer and the seller. The SEC appealed this decision, but the current administration seems to be dropping the appeal, leaving this remarkable ruling intact.
Another striking example is the recent SEC staff statement on “meme coins”. The essence of this argument is the raised funds are not pooled together to be deployed by promoters or other third parties for developing the coin or a related enterprise, the value of meme coins is derived from speculative trading rather than the efforts of others and the promoters of meme coins are not undertaking managerial and entrepreneurial efforts from which purchasers could reasonably expect profit. Hence, they fail the Howey test and are not U.S. securities.
At first glance, these decisions appear to be very narrowly applicable to crypto companies and it is tempting to simply ignore them until the relevant case law becomes clearer. But there are a series of situations where they may be relevant to a U.S. public or private company.
Strategic and Competitive Implications
This evolving regulatory environment creates both opportunities and dilemmas for boards.
Fundraising. The cost and availability of capital are huge issues for a start-up. Issuing digital tokens may well be a cost-effective way of raising money and driving user adoption, especially in sectors like gaming, entertainment and news. However, it could equally apply to launching a new consumer brand.
There is a recent example in the bid for the assets in bankruptcy of Infowars by a company called wow.ai. That bid included $3.5 million in cash, along with 51% of the total supply of their $WARS meme coin. This meme coin was sold to the public to raise the capital for the cash component of the bid and to give the coin a value in the market. The sale also gives the meme coin owners the ability to decide the future of the Infowars website.
Governance. How does a traditional company bid against this offer without overpaying? How should these meme coins be valued? They are supposed to be speculative, but their holders might end up owning a revenue-generating media asset.
Acquisition strategy. Suppose the token holders gain control of Infowars and then want to sell the site. Your company might be interested in acquiring it. How do you bid? If you buy 51% of the tokens, do you have control? What happens to the remaining 49% of the token holders who can still trade the token? Do they still have any influence over the site? If you want to own 100%, how do you ensure everyone sells? The regulations and processes for public companies to buy out minorities are well-known, but this is new territory.
Competitive environment. If you are going to compete against a company funded by crypto tokens that may have a lower cost of capital and minimal disclosure requirements, how do you do it? Does this give them an unfair advantage or just the opposite?
If your competitor is buying users by giving them tradeable meme coins and then a speculative market appears, how do you compete? Would your company want to issue tokens as well or find other ways to attract and retain customers?
Potential takeover defenses. Potentially, a company could use tokens as a poison pill, either by issuing tokens with certain rights attached or by selling meme coins that could convert into securities if certain conditions are met. Boards involved with potential hostile takeover situations need to be aware of this.
Today, these examples seem far-fetched and far removed from the realities of the vast majority of board decisions. But the Howey test has been a bedrock of U.S. securities law since 1946 and these recent developments are a huge change in how it is applied. With the creation of the SEC Crypto Task Force, there are likely to be further changes.
Tokens may not replace SPACs, but they signal a broader shift in how companies can raise money, engage users and compete for strategic assets. Just as boards had to learn the mechanics and risks of SPACs, now is the time to consider the implications of developments in the crypto market as this may signal the next disruptive capital strategy.
About the Author(s)
David Crosbie is a former Visiting Fellow at the SEC Cyber and Crypto Unit and senior lecturer at University of Pennsylvania.
Susan Holliday is a director, advisor and Qualified Risk Director.