Airdrops: Safe, legal, frequent
Airdrops are a crucial mechanism for distributing control of some blockchain networks. Yet the way they’ve been regulated has sown much confusion among projects that would like to decentralize while rewarding early stakeholders. The cause of the confusion was the SEC’s guidance regarding the potential application of federal securities laws to airdrops, which many rightly feared would be weaponized under the Biden administration. Fortunately, this approach was wrong as a matter of law and as a matter of policy. Notably, the projects that have used airdrops have had to choose to locate outside the United States and exclude consumers in the U.S. from receiving tokens — that’s bad for American innovation and bad for U.S. consumers.
Recently, the SEC has requested input from the public on how it should update its regulation of crypto, including airdrops. We submitted a formal reply (you can read it here), but we thought it would be worth summarizing our main points in this post. We propose five conditions that, when met, should mean that the airdrop or similar incentive-based reward distributions should be excluded from U.S. securities laws. This safe harbor would apply to tokens that don’t engender the risks of Section 5 of the Securities Act of 1933, which focuses on offering securities for sale without registration or exemption.
The what and why of airdrops
Crypto assets are often distributed to third parties through airdrops and other incentive-based rewards for free or a minimal contribution — such as historical engagement with or participation on the network.
Airdrops are not a “sale.” Rather, they’re critical in enabling blockchain projects to function but also enable them to achieve decentralization — dispersing control of the underlying blockchain or smart contract protocol and ensuring that the blockchain network can operate autonomously. When a blockchain network achieves decentralization, it provides substantial benefits such as promoting competition, safeguarding freedoms, rewarding stakeholders, reducing information asymmetries, and otherwise mitigating risks for market participants.
Crucially, because blockchain networks are capable of decentralization, they can function more like public infrastructure than proprietary software, enabling developers to bootstrap a wide variety of applications — decentralized social media networks, identity management protocols, and video games — onto a single network. It’s because of this decentralization that a blockchain project’s network token should not be subject to U.S. securities laws.
Similar to airdrops, projects also distribute network tokens to incentivize particular behavior from participants. Many blockchain networks rely on incentive-based reward programs for maintenance and security, which facilitate their autonomous operation. Proof-of-stake blockchains, for instance, programmatically distribute rewards to nodes that perform validation services, which are necessary for the system to function. These same incentive-based rewards can be used to drive network effects by encouraging user activity that is beneficial to the network and its users. The range of activities might include providing liquidity to a decentralized finance network, participating in decentralized governance, or posting to a decentralized social media network.
Which airdrops in the safe harbor?
Airdrops and incentive-based rewards are crucial for blockchain projects to distribute control and to facilitate autonomy of their networks. While these are just two critical aspects of decentralization, they better position these networks to pursue decentralization along other measures, including becoming permissionless, credibly neutral, non-custodial, and economically independent.
All of this is to say that airdrops and incentive-based rewards typically are preconditions for blockchain technologies to be deployed in practice on a widespread basis.
We propose a five-part approach to assess whether an exclusion would be appropriate for a given airdrop or incentive-based reward program. The safe harbor should require that:
- the distribution is of a network token
- the blockchain network with which the network token is intrinsically linked is functional
- the distribution is broad and equitable
- the distribution is effected for limited consideration, and
- transfer restrictions apply to certain related persons.
Only distributions meeting all of these requirements should be included in the safe harbor. Critically, that doesn’t mean that airdrops that don’t meet these conditions should be subject to federal securities laws; it just means that in those cases a facts and circumstances analysis is likely warranted, rather than a brightline safe harbor.
Network tokens: Network tokens primarily derive their value or are expected to primarily derive their value from blockchain networks, which are capable of decentralized operation — operation without human intervention or control. They stand in sharp contrast to company-backed tokens, which are controlled by a centralized entity like a company, person, or management team. This means that the trust dependencies of network tokens are inherently different from ordinary securities, whose value is dependent on systems or sources that are not capable of decentralized operation — centralized systems that require human intervention and control.
Functional: A functional network is one that enables participants to transact through the updating of the state of the network, including by transmitting and storing value, taking part in staking or other method of securing the blockchain network, participating in services provided by or an application running on the blockchain network, or partaking in a decentralized governance system. In assessing whether a blockchain network is functional, regulators should require that it exhibit basic operational capacity and is capable of fulfilling its essential purposes absent the intervention of individual actors.
Broad and equitable distribution: Any participant in a blockchain network should be capable of accessing an airdrops or incentive-based reward program. Network token distributions that are limited to a narrow group can, instead, serve to reify and enrich insiders.
Limited consideration: A defining feature of airdrops is that they are distributed for free or de minimis consideration, which distinguishes them from traditional sales. Likewise, distributions of network tokens via incentive-based reward programs are not made in exchange for monetary consideration. These forms of crypto asset distribution do not pose the same risks as traditional sales, nor should they be subject to the Howey test.
Transfer restrictions: Transfer restrictions, or “lockups,” prevent holders from selling for a predetermined amount of time. In essence, insiders agree for a given period not to sell, contract to sell, or otherwise transfer or dispose of any crypto asset that it holds. A sufficiently long token lockup (say, one year) can ensure that insiders are effectively restricted from using any asymmetric information and capitalizing on the volatility that may come with an airdrop, protecting consumers and investors. During this restriction window, the network may mature and become decentralized. Once the transfer restrictions have expired, the network token will be more seasoned and its price more effectively stabilized by market forces.
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For more detail, read our complete response on airdrops to the SEC’s request for information.
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Miles Jennings is Head of Policy & General Counsel for a16z crypto, where he advises the firm and its portfolio companies on decentralization, DAOs, governance, NFTs, and state and federal securities laws.
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