Recent guidance from the SEC’s Strategic Hub for Innovation and Financial Technology (FinHub) and Division of Corporate Finance have shed light on the SEC’s view toward initial coin offerings (ICOs) by applying a classic framework to a new-age issue.
On April 3, 2019, FinHub issued guidance9 titled “Framework for ‘Investment Contract’ Analysis of Digital Assets.” Though it does not constitute a rule, regulation, or statement of the SEC, the Framework provides a step-by-step method for analyzing whether a digital asset is a security falling under the Commission’s regulatory reach.
FinHub’s guidance discusses the foundational decision of SEC v. W.J. Howey Co. in the context of offerings of digital assets, such as crypto-coins or tokens. The Howey test and its progeny have found that securities exist when there is (1) the investment of money (2) in a common enterprise with (3) a reasonable expectation of profits to be derived from the efforts of others. FinHub’s stance is that cryptocurrency and ICOs that meet the Howey test are securities.
In FinHub’s view, the analysis often hinges on the third prong, and the purchase and sale typically involve an investment of money in a common venture. Therefore, the question is whether purchasers of a digital asset rely on the efforts of others, such as promoters, sponsors, or other third parties (or affiliated groups of third parties), with the expectation of realizing profits on their investments. In deciding this issue, the Framework asks whether purchasers “reasonably expect” to rely on the efforts of others and whether these efforts are essential to the success of the enterprise, rather than “ministerial.” In addition, FinHub states that when a digital asset is marketed as an investment or transferable on secondary platforms, among other characteristics, it is more likely to create an expectation of profits for purchasers.
Also on April 3, 2019, the SEC’s Division of Corporate Finance issued a no-action letter response10 stating that it would not recommend an enforcement action against start-up charter air travel company Turnkey Jet, Inc. (TJK) in connection with its ICO.
In its no-action letter request11 to the Commission, TJK applied the Howey test to its proposed ICO. The company conceded that although the sale of its coins arguably constitutes an investment of money in a common venture, there is no expectation of profits to be derived from the efforts of others because “[c]onsumers will have no right to share in any income generated by the operation of [TJK] (or any other affiliated entity).” Purchasers of the company’s digital token are not entitled to “dividends, rebates, rewards, interest or other distributions.” Rather, the tokens are exchangeable for the company’s air charter services.
The Division of Corporate Finance highlighted several factors impacting its decision that the TJK’s tokens are not securities. It noted that:
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The funds from token sales will not be used to build the company’s platform and infrastructure, which will be complete at the time of the ICO;
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The tokens are functional and exchangeable for services at the time of the ICO;
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Tokens are exchangeable only with other users on the company’s platform;
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Tokens will sell at a price of $1 throughout the life of the program and can only be used for flight services;
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Any repurchases of tokens by the company will be at a discount; and
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The token is not marketed as having profit potential.
Though each transaction of digital assets must be analyzed on its own facts, FinHub’s guidance and the Division of Corporate Finance’s no-action letter response provide clarity on certain issues that influence whether digital assets are securities. Importantly, issuers and brokers of crypto coins should be on alert for ICOs where purchasers have a reasonable expectation of profits to be derived from the efforts of others.
9: https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets#_edn1
10: https://www.sec.gov/divisions/corpfin/cf-noaction/2019/turnkey-jet-040219-2a1.htm
11: https://www.sec.gov/divisions/corpfin/cf-noaction/2019/turnkey-jet-040219-2a1-incoming.pdf
