On April 3, 2019, the Staff of the Securities and Exchange Commission (the Staff) published its long-awaited guidance for analyzing whether a virtual currency is offered and sold as an investment contract and therefore is a security, titled “Framework for ‘Investment Contract’ Analysis of Digital Assets” (Framework). While, unsurprisingly, the Staff did not set forth a specific test, it did provide a long list of factors to consider when determining whether an initial coin offering (ICO) is a security.

On the positive side for those hoping to launch an ICO without registering as a security, the Framework leaves open the possibility of non-security ICOs and provides guidance as to what factors will be considered by the Staff. It also reaffirms that the Staff will continue to rely on the “investment contract” analysis first enunciated by the Supreme Court in SEC v. Howey, 328 U.S. 293 (1946), to determine whether an ICO constitutes a security. Additionally, following the suggestions set forth in Director Hinman’s speech on June 14, 2018, the November 16, 2018 Statement on Digital Asset Securities Issuance and Trading, and the March 7, 2019 letter written by Chairman Jay Clayton, it appears that the Staff agrees that “a digital asset previously sold as a security” could be “reevaluated at the time of later offers or sales.”

On the negative side, many of the factors that would lean in favor of determining that an ICO is a security are prevalent in the vast majority of ICOs. It remains to be seen how this guidance will impact possible SEC enforcement actions against past ICOs, but we anticipate that many of the factors set forth in the guidance will be paramount in SEC enforcement actions with regard to future ICOs.

Note that for purposes of this article, the terms “virtual currency”; “digital asset”; “token” and “cryptocurrency” will be used interchangeably. Similarly, while we have used the term “ICO,” that term is used interchangeably with a “token sale”; “token offering” or any other term commonly used to describe the launch or issuance of a new virtual currency.

1. The Staff Quickly Determines That Most ICOs Satisfy the First and Second Prong of the Howey Test

The Howey test, interpreted in the light of many subsequent cases, determines whether an investment will be considered a security. While there are various forms of securities, at issue in Howey and in the Framework is whether an investment constitutes an “investment contract” and therefore is a security. Under the Howey test, an “investment contract” exists when there is (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profits to be derived from the efforts of others. As noted in the Framework, and in a legion of decisional authority, whether an investment constitutes an “investment contract,” and therefore a security, “depends on the specific facts and circumstances.”

The Framework quickly passes on whether most ICOs would satisfy the first two prongs—(1) an investment of money into (2) into a common enterprise—stating that most ICOs meet those first two prongs.

2. The Staff Unloads 65 Overlapping Factors to Consider When Determining Whether an ICO Satisfies the Reasonable Expectation of Profits Deriving from the Efforts of Others Prong of the Howey Test

However, the Framework sets forth a long list of factors to determine whether an ICO meets the third prong—“reasonable expectation of profits derived from the efforts of others.” It states that “usually, the main issue in analyzing a digital asset under the Howey test is whether a purchaser has a reasonable expectation of profits (or other financial returns) derived from the efforts of others.” According to the Staff, “[w]hen a promoter, sponsor, or other third party (or affiliated group of third parties) (each, an Active Participant or AP) provides essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts, then this prong of the test is met.” Id. The inquiry, therefore, is an objective one, focused on the transaction itself and the manner in which the virtual currency is offered and sold.

But the SEC did not set forth a specific test. Instead, it lists no less than 65 factors (inclusive of sub-factors)—a number of which overlap—to consider when determining whether an ICO constitutes an investment contract. The application of these factors is not straightforward, and there is no indication as to whether certain factors weigh more heavily to the SEC than others. However, certain the factors should be highlighted when examining typical ICOs.

For example, to the extent APs are involved in distributing or promoting the virtual currency, according to the Staff, the following factors weigh in favor of an ICO being considered an investment contract:

• Determining who will receive additional digital assets and under what conditions.
• Purchasers reasonably would expect that an AP’s efforts will result in capital appreciation of the digital asset and therefore to be able to earn a return on their purchase.
• The availability of a market for the trading of the digital asset, particularly where the AP implicitly or explicitly promises to create or otherwise support a trading market for the digital asset.

Certain characteristics of the virtual currency itself are listed as relevant factors, primarily whether the virtual currency can actually be used to purchase goods or services and the transferability of the virtual currency:

• With respect to a digital asset referred to as a virtual currency, it can immediately be used to make payments in a wide variety of contexts, or acts as a substitute for real (or fiat) currency [which would make the sale of such a virtual currency less likely to be considered an investment contract].
• The digital asset gives the holder rights to share in the enterprise’s income or profits or to realize gain from capital appreciation of the digital asset [which would make the sale of such a virtual currency more likely to be considered an investment contract].
• The digital asset is transferable or traded on or through a secondary market or platform, or is expected to be in the future [which would make the sale of such a virtual currency more likely to be considered an investment contract].
• The ready transferability of the digital asset is a key selling feature [which would make the sale of such a virtual currency more likely to be considered an investment contract].

Also, as one might expect, the manner in which the ICO is marketed plays a key role in determining whether it is an investment contract. Some of the factors pertaining to the marketing of an ICO that would lean in favor of determining that the ICO is an investment contract are:

• The digital asset is marketed in terms that indicate it is an investment or that the solicited holders are investors.
• The intended use of the proceeds from the sale of the digital asset is to develop the network or digital asset.
• The potential profitability of the operations of the network, or the potential appreciation in the value of the digital asset, is emphasized in marketing or other promotional materials.
• The availability of a market for the trading of the digital asset, particularly where the AP implicitly or explicitly promises to create or otherwise support a trading market for the digital asset.

In addition, the Framework appears to indicate that if APs receive virtual currency and can benefit from the increase in value of that virtual currency, that weighs in favor of the ICO being considered an investment contract:

• The AP has the ability to realize capital appreciation from the value of the digital asset. This can be demonstrated, for example, if the AP retains a stake or interest in the digital asset. In these instances, purchasers would reasonably expect the AP to undertake efforts to promote its own interests and enhance the value of the network or digital asset.
• The AP is able to benefit from its efforts as a result of holding the same class of digital assets as those being distributed to the public.
• The AP owns or controls ownership of intellectual property rights of the network or digital asset, directly or indirectly.
• The AP monetizes the value of the digital asset, especially where the digital asset has limited functionality.

These factors are somewhat concerning, given that most APs retain some of the virtual currency and related intellectual property, such that they would benefit if the virtual currency becomes popular and increases in value.

There are also a number of factors indicating that an ICO is more likely to be considered an investment contract if the APs are involved (and they usually are) in the development and improvement of the operation of a particular virtual currency:

• An AP is responsible for the development, improvement (or enhancement) operation, or promotion of the network, particularly if purchasers of the digital asset expect an AP to be performing or overseeing tasks that are necessary for the network or digital asset to achieve or retain its intended purpose or functionality.
• Where the network or the digital asset is still in development and the network or digital asset is not fully functional at the time of the offer or sale, purchasers would reasonably expect an AP to further develop the functionality of the network or digital asset (directly or indirectly). This particularly would be the case where an AP promises further developmental efforts in order for the digital asset to attain or grow in value.
• An AP creates or supports a market for, or the price of, the digital asset. This can include, for example, an AP that: (1) controls the creation and issuance of the digital asset; or (2) takes other actions to support a market price of the digital asset, such as by limiting supply or ensuring scarcity, through, for example, buybacks, “burning,” or other activities.
• An AP has a lead or central role in the direction of the ongoing development of the network or the digital asset. In particular, an AP plays a lead or central role in deciding governance issues, code updates, or how third parties participate in the validation of transactions that occur with respect to the digital asset.

The Staff also refers to a series of managerial responsibilities that many APs are tasked with as factors weighing in favor of an ICO being considered an investment contract:

• Determining whether and how to compensate persons providing services to the network or to the entity or entities charged with oversight of the network.
• Making or contributing to managerial level business decisions, such as how to deploy funds raised from sales of the digital asset.
• The AP distributes the digital asset as compensation to management or the AP’s compensation is tied to the price of the digital asset in the secondary market. To the extent these facts are present, the compensated individuals can be expected to take steps to build the value of the digital asset.

The list of factors the Staff identifies is long and inclusive. It is very likely that a vast majority of the ICOs launched in the past few years maintain at least some of the factors listed by the Staff weighing in favor of a determination that the ICO is an investment contract.

3. Subsequent Sales of Virtual Currency Can be Reassessed

Interestingly, the Staff appears to countenance the possibility that a virtual currency launched in an ICO could be “reevaluated at the time of later offers or sales” even if it originally would have considered an investment contract. In determining whether there should be such a “reevaluation,” the Staff will consider additional factors as they relate to efforts of others and separate factors as they relate to the “reasonable expectation of profits.” The Staff provided the following factors to consider in determining whether a reevaluation is appropriate: (1) whether purchasers no longer reasonably expect that continued development efforts of an AP is a key factor in determining the value; (2) the value of the virtual currency comes to have a direct and stable correlation to the value of the good or service being exchanged; (3) the volume of trading corresponds to the demand for the good or service being exchanged; (4) whether holders can use the virtual currency for its intended functionality, such as to acquire goods and services; (5) whether the economic benefit of the virtual currency is incidental to obtaining the right to use it for its intended functionality; and (6) no AP has access to material, non-public information or could otherwise be deemed to hold material inside information about the digital asset. This is of particular importance to ICOs that have been launched in the last few years. According to the Framework, even if the initial ICO should have been registered as a security, the Staff leaves open the possibility that subsequent sales of that virtual currency will not be considered an investment contract.

4. The Staff Provides an Example and a “No Action” Letter Indicating that Retail-Only ICOs Are Not Securities

The Staff also provides some helpful examples of ICOs that would not constitute securities. As one example, the Staff refers to the case of an online retailer with a fully developed operating business where that retailer “creates a digital asset to be used by consumers to purchase products only on the retailer’s network, offers the digital asset for sale in exchange for real currency, and the digital asset is redeemable for products commensurately price in that real currency.” Importantly, the “digital assets are not transferable; rather, consumers can only use them to purchase products from the retailer or sell them back to the retailer at a discount to the original purchase price.” According to the Staff, such “digital asset[s] would not be an investment contract.” However, the Staff does list some limitations to the retailer example, stating that even in the retailer scenario the sale of virtual currency may constitute an investment contract if the virtual currency is offered or sold at a discount to the value of the good or service, sold in quantities that exceed reasonable use on the retailer’s platform and there are no restrictions on reselling the virtual currency, “particularly where an AP is continuing its efforts to increase the value of the digital assets or has facilitated a secondary market.”

Similarly, together with the Framework, the Staff issued a “no action” letter to a company called TurnKey Jet, Inc. (TKJ). TKJ sought to offer a virtual currency directly tethered to the US dollar, where each TKJ token is worth one USD. TKJ tokens can only be used to purchase air charter services, can only be used within the TKJ marketplace and cannot be transferred to external wallets. Also, if a user wants to convert its TKJ token into USD, it can only do so at a discount to the face value of the TKJ (less than $1 per TKJ token). In addition, TKJ agreed to not use any of the funds from the sale of TKJ tokens to develop the TKJ platform, network or apps. Under those circumstances, the Staff stated that it “will not recommend enforcement action to the Commission, if, in reliance on [TKJ’s] opinion as counsel that [TKJ tokens] are not securities, TKJ offers and sells [TKJ tokens] without registration under the Securities Act and the Exchange Act.”

Viewing the example in the Framework and the TKJ no action letter, it appears that the Staff has become comfortable with the concept that if virtual currency is only used to purchase goods or services on an existing platform and cannot be sold for a profit, then such a sale of virtual currency is not an investment contract. It remains to be seen how this retail-only ICO concept will be adopted in the marketplace. We anticipate that APs and others in the virtual currency marketplace will test the boundaries of this retail-only concept. We also anticipate that APs will be looking at the TKJ no action letter as a model of sorts on how to conduct an ICO without concern for securities registration issues.

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While we have listed a number of prominent factors above, the Framework lists many more. Despite listing 65 overlapping factors to consider, the Staff still takes the position that the Framework specifies only “some of the factors market participants should consider in assessing whether a digital asset is offered or sold as an investment contract and, therefore, is a security.” While the ICO marketplace has been seeking guidance from the SEC, the Framework may not be viewed as greatly clarifying which ICOs constitute securities and which do not. However, the Framework does give an insight as to how the Staff views ICO structures and will likely guide both enforcement actions and future ICOs. We anticipate that additional guidance, enforcement actions or decisional authority will further clarify the regulatory requirements for ICOs.