Are Digital Assets Securities? – Regulators Weigh In

by Orrick - Securities Litigation and Regulatory Enforcement Group
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Orrick - Securities Litigation and Regulatory Enforcement Group

Recently, two key officials of the Securities and Exchange Commission ("SEC") publicly expressed their views as to the status of digital assets under the federal securities laws. On June 6, SEC Chairman Jay Clayton spoke on CNBC and commented favorably regarding the potential applications of distributed ledger technology and responded to questions as to whether digital assets, such as Bitcoin, constituted securities under the federal securities laws.[1] He was definitive that Bitcoin is not a security, but more circumspect regarding the status of other cryptocurrencies. On June 14, William Hinman, Director of the Division of Corporation Finance, in prepared remarks struck a similar tone at the Yahoo Finance All Markets Summit and articulated an analytical framework for determining whether the federal securities laws should be applied to digital assets.[2]

Set forth below is a summary of a number of the key takeaways from their comments, bearing in mind that, as both emphasized, the determination whether a particular digital asset is a security is highly dependent upon the specific facts and circumstances presented. In addition, it is important to remember that these are not official pronouncements of the SEC, so any final rules, regulations or enforcement actions may or may not reflect these positions. However, we do think there are many helpful guideposts included in the remarks.

Selected Takeaways

  • Bitcoin should not be regulated as a security.
  • In its "present state" Ethereum is likely not a security.
  • Cryptocurrencies that operate as a replacement for sovereign currencies should not be regulated as securities.
  • Most Initial Coin Offerings ("ICOs") should be subject to the securities laws. Of particular importance is how digital assets are marketed and distributed to prospective purchasers. Director Hinman suggested that issuers consider whether the digital asset is marketed and distributed to potential users of the digital asset or to the general public.  
  • A key factor in determining whether a particular digital asset should be regulated as a security is whether, based upon the manner in which the asset is marketed, the "expectation of profits from the efforts of others" by a prospective purchaser outweighs the benefits the purchaser would reasonably expect to realize from using the asset to obtain the commensurate product or service. Clear representations by prospective purchasers of an intent to consume the digital asset, as opposed to investing in the digital asset, would evidence their motivation in purchasing the digital asset. A related material consideration is whether the issuer undertakes to create and support a secondary market for the digital asset, as opposed to independent actors setting the price for the digital asset on public markets.
  • Director Hinman observed that "information asymmetries" between the promoter of a digital asset and the prospective purchaser of such asset suggest that the offering and sale of the digital asset should be regulated as a securities transaction. Highly decentralized blockchain networks promote a decrease of material information asymmetries and reduce the ability to identify a central promoter or material third party to make meaningful disclosures to purchasers. The fact that the issuer of a digital asset may have a different economic stake presents a conflict of interest that may widen material information asymmetries between promoters and purchasers.   
  • Reliance upon central third parties to effect transactions contrasts with the decentralized nature of the Bitcoin blockchain network and suggests a greater need for the offer and sale of digital assets on a centrally managed platform to be regulated under the securities laws. In particular, Director Hinman stated that "if the network on which the token or coin is to function is sufficiently decentralized – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts, the assets may not represent an investment contract [i.e., a security]."
  • Purchaser reliance on third parties playing an essential central role in the creation, promotion, sale, development, maintenance, influence and governance of the digital asset and the platform on which the asset will function suggests that the activities of third parties and the operation of the platform should be subject to regulation as securities activities.
  • Director Hinman cautioned that the offer and sale of digital assets and secondary trading by regulated entities may otherwise implicate the federal securities laws, as well as the Commodity Exchange Act, the U.S. tax laws and money servicing laws. He also noted that other, non-exhaustive legal considerations might be implicated with respect to the following regulated entities and activities: broker-dealers, exchanges, funds, market manipulation, custody, valuation, margin purchases, anti-money laundering, and know-your-customer obligations.

Additional Takeaways on the Structure of Digital Asset Offerings and SAFTs

A phased approach to capital raising activities can support the position that not all stages of a financing program should be regulated as securities transactions. The first phase may be likened to a conventional venture debt or equity raise funding the building of a blockchain network and current operations. The second phase would commence only after the blockchain network is fully operational. During this phase, the issuer offers, sells and distributes a digital asset to participants who are primarily motivated by the benefits they anticipate they will realize from the functionality of the blockchain network and the product and/or service it provides. This framework supports the position that the first phase of the financing is distinct from the second, and whereas the first phase might be regulated as a securities transaction, the second phase need not be.

The foregoing considerations were addressed by Director Hinman in his comments regarding Simple Agreements for Future Tokens ("SAFTs") in which he stated: 

[T]he legal analysis must follow the economic realities of the particular facts of an offering, it may not be fruitful to debate a hypothetical structure in the abstract and nothing in these remarks is meant to opine on the legality or appropriateness of a SAFT. From the discussion in this speech, however, it is clear I believe a token once offered in a security offering can, depending on the circumstances, later be offered in a non-securities transaction. I expect that some, perhaps many, may not.[3]

Director Hinman directed listeners to consider Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc.[4] In Gary Plastic, a certificate of deposit ("CD"), though an exempt security under Section 2(a)(1) of the Securities Act of 1933, was nevertheless found to be subject to the securities laws when sold as part of a CD program offered by brokers promising liquidity and potential profit to retail investors.[5] Director Hinman's reference to the Gary Plastic case reorients the application of the SEC v. W.J. Howey Co.[6] analysis by focusing on the structure of the offer rather than the innate characteristics of the digital asset itself. The key determination in whether the underlying digital asset is classified as a security under a SAFT transaction is driven by the economic realities of the particular enterprise represented by the SAFT. Depending on the specific facts and circumstances, Director Hinman remarked that it may be possible to have a digital asset originally classified as a security, and over time, lose the characteristics of a security and be sold in a non-securities transaction.

What's Next?

These recent commentaries may prove to be a watershed moment in the evolution of the blockchain and digital asset industry.

Director Hinman struck a positive note, stating that: "We are happy to help promoters and their counsel work through these issues. We stand prepared to provide more formal interpretive or no-action guidance about the proper characterization of a digital asset in a proposed use."

 


[1] Interview by Bob Pisani with Jay Clayton, Chairman, Securities and Exchange Commission, in New York, N.Y. (Jun. 6, 2018).
[2] William Hinman, Director, Securities and Exchange Commission, Remarks at the Yahoo Finance All Markets Summit: Crypto (Jun. 14, 2018).
[3] Id.
[4] 756 F.2d 230 (2d Cir. 1985) (hereinafter "Gary Plastic").
[5] Id. at 240.
[6] 328 U.S. 293 (1946).

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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