Through two publications on April 3, 2018, the Staff of the Securities and Exchange Commission provided greater clarity on the application of the federal securities laws to blockchain-based “digital assets.”1 While the Staff guidance does not markedly chart new territory, it advances interpretive guidance as to when a digital asset will be considered a “security.” Perhaps most importantly, the two publications signal a more helpful approach by the SEC and its Staff to digital asset industry participants seeking to navigate the federal securities laws.
First, the SEC’s Strategic Hub for Innovation and Financial Technology (FinHub) introduced an analytical framework (Framework) for evaluating whether digital assets qualify as investment contracts and, thus, securities under the federal securities laws.2 Second, the SEC’s Division of Corporation Finance issued a no-action letter3 under the Framework, marking the first instance in which the Staff has provided such relief in the context of digital assets. The Framework and no-action letter provide a structure for analyzing whether primary and secondary transactions in “tokens,” “coins” and other digital assets are subject to the federal securities laws.
In recent years, the Staff has actively monitored developments in the market for blockchain-based digital assets. Their focus has included whether such instruments, when offered and sold through initial coin offerings (ICOs), are “investment contracts” under SEC v. W.J. Howey Co.4 Digital assets qualifying as investment contracts meet the statutory definition of a security under both Section 2(a)(1) of the Securities Act of 1933 and Section 3(a)(10) of the Securities Exchange Act of 1934, and are therefore subject to various registration and disclosure obligations. These requirements include potential broker-dealer and exchange registration by persons offering and selling digital assets, as well as the platforms on which digital asset transactions take place.
In Howey, the U.S. Supreme Court found that an investment contract exists when there is (i) an investment of money (ii) in a common enterprise (iii) with the expectation of profits (iv) derived solely from the efforts of others. Howey and its progeny emphasize that the inquiry into an instrument’s status as a security requires prioritizing substance over form5 and focusing on underlying economic realities.6
The SEC provided its first assessment of whether digital assets are securities under the Howey test in July 2017 in its report on the Division of Enforcement’s investigation of The DAO and the offer and sale of DAO tokens (The DAO Report).7 Following The DAO Report, the SEC has primarily articulated its standard for evaluating the status of digital asset transactions as securities through enforcement actions8 and statements by SEC leadership.9 Efforts have aimed to: recognize variations among digital assets and related transactions; distinguish between so-called “utility tokens” (i.e., digital assets purchased for consumption purposes) and assets that meet long-established tests for determining securities status; and, to some extent, encourage innovation.
In a June 2018 speech, Division of Corporation Finance Director Bill Hinman asserted that “central to determining whether a security is being sold is how it is being sold and the reasonable expectations of purchasers” rather than a one-size-fits-all application of Howey.10 According to Director Hinman, “the analysis of whether something is a security is not static and does not strictly inhere to the instrument.” To this point, Director Hinman observed that “[t]he digital asset itself is simply code. But the way it is sold – as part of an investment; to non-users; by promoters to develop the enterprise – can be, and, in that context, most often is, a security – because it evidences an investment contract.” The approach advocated in Director Hinman’s remarks thus reflected a distinction recognized by the Second Circuit in Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc.11
On this view, Director Hinman further suggested that a sale of a digital asset may meet the elements of an investment contract under Howey at the time of its initial offering, but the same digital asset might eventually lose its status as a security “[i]f the network on which the token or coin is to function is sufficiently decentralized” because a third party’s efforts would no longer be as critical to the enterprise’s success. Accordingly, an inquiry into the security status of a digital asset transaction focuses in large part on the role of third parties in driving the expectation of a return on investment.
The Framework builds upon prior SEC and Staff guidance, and presents a detailed range of considerations that bear upon Howey’s application to digital asset transactions. The Framework represents the views of FinHub, which the SEC launched on October 18, 2018 to better facilitate the SEC’s engagement with the public and industry participants on FinTech topics. As such, the Framework is “not a rule, regulation, or statement of the Commission…”12 and, further, is “not binding on the Divisions or the Commission."13 The Staff invited market participants to submit questions on the guidance and with respect to particular transactions, through a request form made available on FinHub’s platform.14
The Framework focuses primarily on the “expectation of profits derived solely from the efforts of others” prong of the Howey test. The Staff articulated this analysis as a three-part test of relevant considerations, none of which is necessarily dispositive, but which, taken together, could make a digital asset transaction more or less likely to be considered an offer or sale of securities.
Reliance on the Efforts of Others
The Framework suggests that a digital asset transaction is more likely to meet the elements of the Howey test when a promoter, sponsor or other affiliated third party – referred to by the Staff as an “Active Participant” – provides “essential managerial efforts that affect the success of the enterprise” (such as when the Active Participant is responsible for the “development, improvement (or enhancement), operation, or promotion of the network” for the digital asset), or “creates or supports a market in, or the price of” the digital asset. The Framework emphasizes managerial or governance responsibilities that an Active Participant performs in making the enterprise a success and enhancing the value of the underlying digital asset. Importantly, the Framework also echoes the principle set forth in Director Hinman’s 2018 speech by noting that a digital asset previously sold as a security could subsequently be “reevaluated at the time of later offers or sales” when the circumstances surrounding an Active Participant’s involvement in the enterprise no longer support a finding of reliance on the efforts of others.
Reasonable Expectation of Profits
The Framework suggests that a digital asset transaction is more likely to provide purchasers a reasonable expectation of profits, and therefore meet the elements of the Howey test, when the transaction gives holders of the asset either the right to share in the enterprise’s income or profits (e.g., in the form of dividends) or the right to enjoy gains from the capital appreciation of the underlying digital asset. Beyond this, however, other factors may also shape whether a digital asset transaction provides a reasonable expectation of profit. These include: how broadly the digital asset is offered (in contrast to targeted offerings for expected users of underlying goods or services or network functionality); the extent of the correlation between the price of the digital asset and any goods or services for which the digital asset is to be redeemed; the transferability of the asset in secondary markets; whether funds from the offering are to be expended to develop or enhance functionality of the network or asset; and whether the digital asset is marketed in terms of future enhancements in either the value or functionality of the digital asset or network.
Other Relevant Considerations
The Framework also suggests that a digital asset transaction is less likely to be considered a security if it displays certain key characteristics. For example, a fully developed and operational network and digital asset is less likely to be considered a security than a network or digital asset that is still in development or not yet operational. Similarly, restrictions on transferability and limited prospects for appreciation in the digital asset’s value also weigh in favor of non-security status. Significantly, emphasis on the functionality of the digital asset, with respect to both its structure and the manner in which it is offered, would also make a security determination less likely.
Notably, the factors identified in the Framework are not exhaustive, and there is no threshold number of factors a digital asset must satisfy in order to be considered a security; rather, the more security-like attributes that apply to an offer and sale of a digital asset, the more likely the digital asset will be characterized as a security.
Consistent with the Framework, the Division of Corporation Finance’s no-action letter to Turnkey Jet, Inc. (TKJ Letter) stated that the Division would not recommend enforcement to the SEC against a company proposing to offer and sell certain pre-paid “tokens” without registration under the Securities Act and the Exchange Act.15 The TKJ Letter concerned a provider of interstate air charter services that sought to resolve payment settlement inefficiencies by issuing their tokens to be used in conjunction with a blockchain-based settlement platform.
In granting this no-action relief, the Division of Corporation Finance noted the following factors, which highlight the consumption or utility purposes of the tokens:
The company would not use any funds from token sales to develop the proposed platform, network or application, each of which would be fully developed and operational at the time any tokens are sold;
The tokens would be usable for their intended functionality immediately upon their sale;
The company would restrict transfers of tokens to wallets used to hold tokens on the company’s network and not permit transfers to external wallets;
The company would sell tokens at a price of $1 per token throughout the life of the program, and each token would represent a company obligation to supply air charter services at a value of $1 per token;
Any repurchase by the company of tokens would be priced at a discount to the face value of the tokens, unless a court ordered the company to liquidate the tokens; and
The tokens would be marketed in a manner emphasizing the functionality of the tokens, and not the potential for an increase in the market value of the tokens.
The Framework and the TKJ Letter provide a useful roadmap for analyzing ICOs and other digital asset transactions under the federal securities laws. Although the determination of how Howey applies to a given digital asset transaction remains dependent on the facts and circumstances surrounding the transaction in question, the SEC appears to be working towards a comprehensive view of this new and growing class of assets.
1) Bill Hinman, Director of Division of Corporation Finance, and Valerie Szczepanik, Senior Advisor for Digital Assets and Innovation, Statement on “Framework For ‘Investment Contract’ Analysis of Digital Assets” (Apr. 3, 2019).
2) Strategic Hub for Innovation and Financial Technology, Framework For “Investment Contract” Analysis of Digital Assets (Apr. 3, 2019).
3) Turnkey Jet, Inc. (pub. avail., Apr. 3, 2019).
4) 328 U.S. 293 (1946).
5) Tcherepnin v. Knight, 389 U.S. 332, 336 (1967).
6) United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 849 (1975).
7) Division of Enforcement, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (July 25, 2017).
8) See, e.g., In the Matter of Munchee Inc., Securities Act Release No. 10445 (Dec. 11, 2017).
9) See, e.g., Chairman Jay Clayton, Statement on Cryptocurrencies and Initial Coin Offerings (Dec. 11 2017) (“Tokens and offerings that incorporate features and marketing efforts that emphasize the potential for profits based on the entrepreneurial or managerial efforts of others continue to contain the hallmarks of a security under U.S. law”).
10) Bill Hinman, Digital Asset Transactions: When Howey Met Gary (Plastic) (June 14, 2018).
11) 756 F.2d 230 (2d Cir. 1985) (a certificate of deposit ordinarily exempt from being treated as a security could nevertheless be considered part of an investment contract when it was sold through a program promising retail investors liquidity and profits from interest rate changes).
12) Supra, note 2.
13) Supra, note 1. This distinction has been a recent point of emphasis in the discourse surrounding regulatory activity. See, e.g., Presidential Executive Order on Core Principles for Regulating the United States Financial System, (Feb. 3, 2017)(directing the Secretary of the Treasury to evaluate “existing laws, treaties, regulations, guidance, reporting and recordkeeping requirements, and other Government policies.”); see also Chairman Jay Clayton, Statement Regarding Staff Views (Dec. 11, 2017) (“The Commission’s longstanding position is that all staff statements are nonbinding and create no enforceable legal rights or obligations of the Commission or other parties…. As we carry out our market oversight functions, I believe we at the Commission should keep this important distinction in mind.”).
14) Id. The request form is available at https://www.sec.gov/finhub-form#no-back.
15) Supra, note 3.