Why 'Pass-Through' Economics Don't Pass Legal Muster

The SEC's framework for an 'investment contract' is a three-pronged trap for token distributions.\n- Money Invested: User stakes capital (e.g., ETH, stablecoins).\n- Common Enterprise: Protocol's success is tied to collective effort.\n- Expectation of Profit from Others: Pass-through rewards are pure yield, creating a clear profit motive derived from the work of developers and other users.

Shift from passive yield to active contribution. Legally defensible rewards must be compensation for verifiable work, not a financial return.\n- Fee-for-Service: Pay users for providing a resource (e.g., bandwidth for Akash, storage for Filecoin).\n- Bounties & Grants: Discrete payments for completing specific tasks or building integrations.\n- Loyalty/Utility Points: Non-financial incentives that accrue value through protocol utility, not a promise of future profit.

Contrast the regulatory outcomes of two major airdrop models.\n- Uniswap (UNI): Distributed as a 'governance token' for past usage. No ongoing yield mechanism. Result: No SEC action to date.\n- LBR (Lybra Finance): Promised and delivered ongoing staking APY in its native token. Result: Deemed a security, forced to shut down US operations and buy back tokens. The key differentiator was the explicit promise of future yield.

CTOs often assume sufficient decentralization immunizes a token. This is a dangerous miscalculation.\n- Legal Threshold is High: The SEC's view of decentralization is far stricter than the crypto community's. Ethereum only escaped after its transition to Proof-of-Stake, which the SEC reluctantly accepted.\n- Control is Key: If a core development team or foundation controls >20% of supply or can materially influence development, the 'common enterprise' prong is likely satisfied. Pass-through economics centralizes the profit expectation on that team.

Beyond securities law, pass-through models create intractable operational burdens.\n- Taxable Event Per Epoch: Each micro-reward is a new income event for the user, creating a logistical nightmare for reporting.\n- Protocol Liability: If classified as a security, the protocol may be liable for withholding taxes on global users.\n- Balance Sheet Poison: Native tokens paid as expenses must be marked-to-market, creating massive earnings volatility for the issuing entity.

The endgame is building sustainable value without creating a security. Learn from successful models.\n- Protocol-Owned Liquidity (POL): Fees accrue to a treasury-controlled pool (e.g., Olympus DAO model), funding development without user-facing yield.\n- Burn Mechanisms: Use protocol revenue to buy and burn a non-security asset (e.g., EIP-1559 burning ETH). This increases scarcity for all holders without a profit promise.\n- Fee Switches for Governance: Allow token holders to vote to activate a fee on protocol usage, with proceeds directed to POL or burns—this ties value to utility, not passive yield.

LBRY argued its LBC token was a utility for accessing a decentralized file-sharing network. The court ruled it was a security because its primary use was speculative investment, not platform access. The 'pass-through' of governance rights did not negate the investment contract.

• Key Precedent: Utility must be the primary use case at launch, not a theoretical future feature.
• Failed Defense: Tokenomics designed to incentivize holding (e.g., staking rewards) were cited as evidence of investment expectation.

Terra argued UST and LUNA were decentralized algorithmic stablecoins, not securities. The court dismissed this, focusing on Terraform Labs' central managerial efforts to promote the ecosystem and maintain the peg. The 'pass-through' of protocol fees to stakers was seen as a profit-sharing mechanism.

• Key Precedent: Developer marketing and active ecosystem management can establish a 'common enterprise,' even for algorithmic systems.
• Failed Defense: Claims of technical decentralization did not offset the central promotional role of the founding entity.

Despite Uniswap Labs' careful separation from the UNI token and protocol, the SEC's Wells Notice signals scrutiny of the entire economic stack. The 'pass-through' of fee switches to token holders is a direct profit-sharing mechanism that regulators view as a security hallmark, regardless of technical decentralization.

• Key Precedent: Even a legally separated foundation and a fully deployed protocol can be targeted based on tokenholder economics.
• Active Risk: The $1.7B+ UNI treasury and proposed fee mechanism create a clear link between token ownership and expected profits from the enterprise.

Promising token price appreciation via protocol fees or buybacks is a direct path to a security classification. The SEC's core argument against projects like Uniswap (UNI) and SushiSwap (SUSHI) hinges on this expectation of profit.

• Key Risk: Linking token value to revenue creates an 'investment contract' under Howey.
• Builder Action: Decouple token utility from direct fee distribution. Use it for governance or access, not as a profit-sharing coupon.

Emulate Filecoin (storage) or Ethereum (gas). The token's primary, non-speculative function must be undeniable.

• Key Benefit: Creates a defensible 'consumptive use' argument, weakening the 'investment' premise.
• Builder Action: Design the token as a required input for a core, non-financial service. Its value should stem from operational demand, not investor speculation.

Founder and VC hype trains marketing token price potential are exhibit A for the SEC. This satisfies the 'efforts of others' prong of Howey.

• Key Risk: Public statements by the team can implicate the entire project, as seen with Ripple (XRP).
• Builder Action: Enforce strict communication policies. Focus messaging on technology and utility, never on investment returns or price.

A sufficiently decentralized network, where no single entity controls development or promotion, can exit security status. This is the Ethereum precedent.

• Key Benefit: Transforms the asset from an investment contract into a commodity-like resource.
• Builder Action: Architect for credible neutrality from day one. Cede protocol upgrades to on-chain governance and foster independent developer ecosystems.

Free tokens aren't free from scrutiny. The SEC views retroactive airdrops to early users as a form of investment solicitation, rewarding past contributions to the network.

• Key Risk: Creates an implied promise of future value for ecosystem support, as argued in cases against Coinbase and others.
• Builder Action: If you airdrop, avoid tying it directly to prior financial contribution or specific, rewardable actions. Frame it as a pure user acquisition tool for a functional network.

Stop optimizing for 'tokenomics' and start building a machine that needs a token to run. This is the first-principles shift.

• Key Benefit: Aligns incentives with long-term protocol health and legal durability, not short-term speculation.
• Builder Action: Ask: 'Does this feature make the protocol more useful, or just the token more valuable?' Kill any feature that only serves the latter.