Why Governance Tokens Inevitably Drift Toward Security Status

The Howey Test's core is the 'expectation of profits from the efforts of others.' As a protocol's treasury grows to $100M+ TVL and fees generate $1M+ daily revenue, tokenholders vote on distributions, directly linking governance to profit. This transforms the token from a tool into an investment contract.

• Key Consequence: Airdrops to 'active users' are deemed securities distributions by the SEC (see Uniswap UNI).
• Key Consequence: Staking rewards for governance participation are reclassified as dividend-like payments.

Decentralization is a spectrum, not a binary. Most 'governance' tokens launch with a core team controlling >30% of supply and a multi-sig for upgrades. The SEC argues token value is derived from this core team's ongoing development efforts, not from decentralized utility.

• Key Consequence: Legal memos pre-launch are obsolete post-mainnet, as continued development by the founding entity reinforces the 'efforts of others' argument.
• Key Consequence: The MakerDAO MKR model, where tokenholders directly control a $8B+ treasury, is the ultimate stress test for this definition.

Deep liquidity on centralized exchanges (Coinbase, Binance) is necessary for user adoption but is Exhibit A for the SEC. Listing requires a legal opinion that the asset is not a security. Trading volume and price charts become public evidence of speculative investment intent.

• Key Consequence: The $SOL lawsuit precedent: The SEC cited Solana Foundation's promotion and CEX listings as evidence of creating a market for investment.
• Key Consequence: Protocols like Compound COMP or Aave AAVE cannot decouple their governance utility from their highly liquid, speculative secondary markets.

Governance votes directly control revenue distribution and tokenomics, creating a direct financial incentive. This is the primary vector for security classification.

• Fee Switch Votes: Token holders vote to divert protocol fees to themselves (e.g., Uniswap, SushiSwap).
• Token Buybacks & Burns: Governance directs treasury funds to manipulate token supply and price.
• Staking Rewards: Yield is funded by protocol revenue, not just inflation, creating an income stream.

VCs and early investors market tokens with explicit profit narratives, creating a paper trail of 'investment contract' evidence. The SEC's cases against Ripple and Coinbase highlight this.

• Pre-Launch Sales: SAFTs and private sales are pure capital raises for future development.
• Roadmap Promises: Projections of ecosystem growth and token utility imply appreciation.
• Exchange Listings: Active facilitation of secondary trading markets fulfills the 'common enterprise' criterion.

Most token holders delegate voting power, proving they are passive investors, not active protocol participants. This undermines the 'consumptive use' defense and strengthens the security claim.

• Delegation Rates: >80% of UNI, >90% of MKR is typically delegated.
• Airdrop Farmers: Majority of recipients immediately sell, demonstrating speculative intent.
• Liquidity Mining: 'Yield' is the primary draw, not governance rights.

Legal actions establish that functionality determines status. The SEC's Wells Notice to Uniswap Labs and the Ripple ruling on institutional sales create a clear playbook for enforcement.

• Howey Test Focus: Regulators analyze actual use, not whitepaper promises.
• Institutional vs. Retail: Direct sales to VCs are treated as securities, creating a bifurcated market.
• Remediation Cost: $200M+ in legal fees and settlements is the baseline for fighting classification.

To avoid security status, governance must be decoupled from financial value accrual. This means votes should control non-monetary parameters only.

• Parameter Tweaks: Adjusting slashing conditions, oracle sets, or upgrade timelocks.
• Grants & Ecosystem Funds: Directing capital away from token holders and toward builders.
• Pure Consumptive Use: Tokens as required fuel for protocol operations (e.g., gas, storage).

The market prices governance tokens almost exclusively on cash flow potential, not voting power. This creates an irreconcilable conflict between community incentives and legal compliance.

• Price Correlation: Token value tracks protocol revenue, not governance participation.
• The Merge Fallacy: Attempts to separate 'governance' and 'utility' tokens (e.g., veTokenomics) fail; value still derives from fee control.
• Investor Demand: The market wants yield-bearing assets, not administrative rights.

The SEC's Howey Test evaluates investment contracts, not code. Your token's legal status is determined by user expectation, not your whitepaper.

• Expectation of Profit: If holders buy primarily for price appreciation, you're in dangerous territory.
• Common Enterprise: A protocol's treasury and fee distribution create a de facto common enterprise.
• Efforts of Others: Delegated voting and core developer teams satisfy this prong trivially.

Tying token value directly to protocol cash flows is the fastest path to a security designation. This includes staking for rewards, fee-sharing, or buyback-and-burn mechanics.

• Case Study: Uniswap: UNI's "fee switch" debate highlights this tension; activating it could trigger regulatory action.
• The Alternative: Focus governance on non-financial parameters (e.g., listing new pools, adjusting weights) to decouple token value from profits.
• Reality Check: Most DeFi protocols with >$100M TVL have already crossed this line.

A truly decentralized protocol, where no single entity is essential for success, is the sole credible argument against security status. This is a high bar.

• Developer Exit: The core team must be dispensable. See Bitcoin and Ethereum as benchmarks.
• Governance Capture: If a VC fund or founding team holds >20% of votes, decentralization is a fiction.
• Operational Independence: The protocol must run without the founding entity's infrastructure or administrative keys.

Free distribution doesn't inoculate you. The secondary market creates immediate profit expectation, and your protocol's actions post-airdrop define the asset.

• Secondary Market Reality: Tokens traded on Coinbase or Binance are treated as investment vehicles by default.
• Post-Airdrop Promises: Announcing future utility or features after the drop can be construed as fostering profit expectation.
• Legal Precedent: The SEC vs. Ripple case centered on institutional sales, but Judge Torres' ruling on programmatic sales is narrow and unstable.

"Utility" like voting on treasury grants or parameter tweaks is often financial in outcome. Regulators see through semantic games.

• Treasury Governance: Voting on $50M+ treasury allocations is a financial management activity.
• Parameter Voting: Adjusting fees or incentives directly impacts tokenomics and holder profits.
• The Illusion: Most governance in Compound, Aave, or MakerDAO is fundamentally economic, not technical.

Accept that a successful, valuable governance token will be treated as a security. Your strategic choice is to either prepare for that reality or radically restructure.

• Option A: Compliance: Plan for registration, KYC for governors, and operating within regulated frameworks. See Ondo Finance.
• Option B: Radical Restructuring: Eliminate all profit linkage, sunset the token, or move to a non-tokenized governance model (e.g., soulbound).
• The Default Path: Ignorance leads to the path of Ripple, Coinbase, and endless legal discovery.