Over the last few years, airdrops have become much more common in the crypto space. Airdrops are often used to market or promote a crypto startup or platform. But like with so many other things in the space, their legal status remains murky. In this post, I do a deep dive on the legality of airdrops.
What are airdrops?
Airdrops involve sending tokens or coins to a wallet without receiving monetary payment. You might see a lot of terms thrown around, like standard airdrops (where anyone who registers is eligible to receive an airdrop), bounty airdrops (where a person who completes a task like posting on social media or joining a platform), or holder airdrops (where existing coin or token holders receive an airdrop).
At the end of the day, the common feature of each of these kinds of airdrops is that the recipient does not pay money to get them. This distinction is critical for determining whether airdrops are legal.
Are airdrops securities?
For issuers dropping tokens into the wallets of US persons, the most important legal question is whether their coin or token is a security. The test that the Securities and Exchange Commission (SEC) and courts use to make this determination is known as the Howey Test from the U.S. Supreme Court case SEC v. W.J. Howey Co., 328 U.S. 293 (1946). We did a deeper dive into the Howey Test in the context of SEC v. Ripple here, which I strongly suggest you read.
The Howey Test asks whether something is an investment contract, which is a type of security. To be an investment contract (and by extension a security), the following four prongs must be satisfied:
- An investment of money or other consideration
- In a common enterprise
- With the expectation of profits
- Derived solely from the efforts of others.
Now you may be thinking that free airdrops cannot possibly satisfy the first prong, so the analysis ends there. Well, in the eyes of the SEC, that’s wrong.
In 2018, the SEC issued an order in an administrative proceeding known as In re Tomahawk Exploration LLC, in which it concluded that a bounty program constituted an offer of securities. Critically, the SEC stated:
The lack of monetary consideration for “free” shares does not mean there was not a sale or offer for sale for purposes of Section 5 of the Securities Act. Rather, a “gift” of a security is a “sale” within the meaning of the Securities Act when the donor receives some real benefit.
In other words, if the issuer of a coin or token receives a non-monetary benefit, that could satisfy the “money or other consideration” prong of the Howey Test. And indeed, the SEC concluded that “Tomahawk received value in exchange for the bounty distributions, in the form of online marketing including the promotion of the ICO on blogs and other online forums. Tomahawk also received value in the creation of a public trading market for its securities.”
It seems pretty clear then that bounty airdrops would meet this prong. But what about standard or holder airdrops where the recipient does not have to do a specific task to get the token or coin? It seems, based on Tomahawk, that the SEC would still conclude that the issuer received a benefit, in that the issuance of the coin or token would create a secondary market and would likely cause more people to register (for standard airdrops) or purchase coins or tokens (for holder airdrops).
I won’t go through the other factors here, but if you’re interested in them, you can take a look at this Framework for “Investment Contract” Analysis of Digital Assets created by the Strategic Hub for Innovation and Financial Technology of the SEC. The framework goes through each element of the Howey Test and notes in a footnote (citing Tomahawk) that:
Further, the lack of monetary consideration for digital assets, such as those distributed via a so-called “air drop,” does not mean that the investment of money prong is not satisfied; therefore, an airdrop may constitute a sale or distribution of securities. In a so-called “airdrop,” a digital asset is distributed to holders of another digital asset, typically to promote its circulation.
Can airdrops be legal?
Considering that the SEC will probably consider any airdrop to be a “security,” the question becomes whether they are legal. Under federal securities law, a security cannot be offered for sale unless it is registered or is subject to a registration exemption. I’m going to go out on a limb here and say that most airdrop tokens or coins are not registered.
For issuances that are not registered, the issuer must find a federal registration exemption. And, unless federal law preempts state law, the issuer must also comply with state laws. This is where things get complicated, and really depend on the facts of an airdrop issuance. There is not a clean, one-size-fits-all exemption here.
Crowdfunding exemptions require transactions to occur via an SEC-registered intermediary, which just isn’t the case with most airdrops. General solicitations are permitted, but only to accredited investors where an issuer takes reasonable steps to verify accredited investor status – which just isn’t going to happen with most airdrop issuances. Private placements can’t use general solicitation. Limited offering exemptions may be the closest applicable exemption, but they do not preempt state law so an issuer would have to conceivably comply with state law requirements (which vary substantially) in every state.
The point here is that most airdrop issuers are going to face a hurdle trying to find an exemption that fits. And without an exemption, the issuer would need to register their securities to avoid potentially serious penalties.
Are there any other considerations?
Let’s just assume that an airdrop issuer clears all the hurdles mentioned above. Are there other legal issues to consider? The answer is “yes,” of course.
First off, issuers of securities are restricted from a host of conduct. This includes a prohibition on fraud in connection with the purchase and sale of securities. This kind of fraud requires a showing of “scienter,” which is a fancy word for intentionality. If an individual affiliated with an issuer makes material misrepresentations, that “scienter” can be “imputed” to the issuer entity.
To see how seriously the SEC takes allegations of fraud, look no further than the Tomahawk order. The SEC focused a substantial portion of the order alleging that the issuer made false and misleading statements in connection with the issuance. The SEC concluded that there was evidence of scienter and imputed it to the entity.
Second, there will likely be some tax ramifications for recipients of airdrops – even though they are technically “free” of monetary consideration.
There are other factors that airdrop issuers must consider, but these are two of the bigger ones (in addition to clearing the registration v. exemption hurdle).
It seems like almost every day our web3 team fields questions about the legality of some kind of emerging technology or practice. This is an area of the law where the technology and business practices move much faster than the regulators. There is not always a clear answer, and sometimes the best answer is “maybe” or “it depends” or “we need to wait and see what the SEC does.”
Here though, it looks like the SEC has already made up its mind on airdrops. That said, things change quickly in this space, so stay tuned to our blog for more updates.
