On April 3, 2019, the Securities and Exchange Commission’s (SEC’s) Strategic Hub for Innovation and Financial Technology, a.k.a. the SEC FinHub, released its “Framework for ‘Investment Contract’ Analysis of Digital Assets,” (the “Framework”)1 providing further guidance on how the SEC will analyze whether a given digital asset2 is an investment contract and, therefore, a security under the federal securities laws. An “investment contract” is only one type of security, but as the Framework notes, both the SEC and federal courts typically use the “investment contract” analysis to determine whether a digital asset is subject to the federal securities laws.3
In the Framework, the SEC FinHub applies the Supreme Court’s analysis of “investment contract[s]” conducted in SEC v. Howey Co., 328 U.S. 293 (1946), to digital assets. Under this analysis, known as the Howey test, a transaction is an “investment contract” if (1) there is an investment of money (2) in a common enterprise (3) with a reasonable expectation of profits to be derived from the efforts of others. The Framework outlines how each prong of the Howey test applies to the sale or issuance of a digital asset.
An Investment of Money
The SEC FinHub notes that the “investment of money” prong is typically satisfied because the digital asset is offered or sold in exchange for something of value, be it fiat currency, another digital asset, or other consideration. The form that the value takes is immaterial.4 For example, an investor’s provision of services to the benefit of the issuer, such as the investor’s use, promotion, or marketing of the digital asset, where the issuer intends such actions to promote circulation and adoption of the digital asset, would count as value sufficient to qualify as an “investment of money” under the Framework.5 This means that digital asset issuers cannot avoid the application of the securities laws simply by distributing a digital asset through a “bounty program” or an “airdrop.”
In a Common Enterprise
With respect to the second prong, the SEC FinHub notes that, in evaluating digital assets, a common enterprise typically exists “because the fortunes of digital asset purchasers [are] linked to each other or to the success of the promoter’s efforts.”6
A Reasonable Expectation of Profits Derived from the Efforts of Others
Most of the ambiguity around whether a digital asset qualifies as an investment contract lies in the analysis of the third prong of the Howey test. For this Framework, the SEC FinHub notes that the inquiry conducted under this prong focuses on the “economic reality” of the transaction and the manner in which the digital asset is offered and sold to potential investors. The SEC FinHub separates the analysis under this prong into two subcategories: (1) whether a purchaser is relying on the efforts of others; and, (2) whether a reasonable expectation of profits exists.
When determining whether a purchaser relies on the efforts of others, the cornerstone of the SEC’s analysis rests with two key issues. First, whether the purchaser reasonably expects to rely on the efforts of others and second, whether those efforts are the “essential managerial efforts which affect the success or failure of the business.” In the Framework, the SEC FinHub lists the characteristics that, the “stronger their presence, the more likely it is that a purchaser of a digital asset is relying on the efforts of others.” These characteristics include whether some defined group or person other than the investor (an “Associated Person” or “AP”) has a lead or central role in deciding governance issues or code updates and whether the purchaser reasonably expects an AP to promote its own interests and enhance the value of the network or digital asset.
Furthermore, the SEC FinHub provides additional considerations for evaluating whether a digital asset previously sold as a security would, at a later offer or sale, meet this prong of the Howey test. At the time of a secondary sale, the SEC FinHub will consider, among other characteristics, whether the network on which the digital asset functions operates in such a manner that a purchaser would no longer expect an AP to perform essential managerial or entrepreneurial tasks. Here, it is important to understand the elastic nature of the “security” definition and the Howey test. A digital asset that, at the time of its original offering, met all the prongs of the Howey test could, at the time of secondary sale, cease to be a security because it no longer satisfies this part of the Howey test.
Next, the SEC FinHub explains how the SEC would evaluate whether a purchaser of a digital asset could have a reasonable expectation of profits. Again, the SEC FinHub provides characteristics that, the stronger their presence, the more likely it is that there is a reasonable expectation of profit. These characteristics include whether the digital asset gives its holder the right to a share in the enterprise’s income or profits and whether an AP offers the digital asset broadly or if it targets expected users of the goods or services or those purchasers who have a need for the functionality of the network on which the digital asset functions or operates.
The SEC FinHub also identifies certain characteristics that, if present, tend to show that the purchaser of the digital asset did not have a reasonable expectation of profits derived from the efforts of others. These characteristics generally center on whether the digital asset was offered or sold for a purchaser’s “use or consumption,” such as (1) whether the distributed ledger network or platform and digital asset are fully developed and operational; (2) whether holders of the digital asset are immediately able to use it for its intended purpose on the network; and (3) whether prospects for the digital asset’s appreciation are limited.
The Framework and the TurnKey Letter
The Framework in many respects represents a compilation of the SEC’s recent pronouncements in various speeches, cease and desist orders, administrative rulings, and investigative reports, and a letter to a member of Congress. The SEC paired the release of the Framework with the issuance of the SEC’s first no-action letter with respect to a digital asset sale, that of TurnKey Jet, Inc. (the “TurnKey Letter”). In the Turnkey Letter, the SEC’s Division of Corporation Finance stated that it would not recommend an enforcement action to the Commission against TurnKey Jet, Inc. (“TKJ”) for the offer and sale of its token, provided that certain facts were as set forth in TKJ’s inquiry to the SEC.
While the TurnKey Letter merely expresses the Division of Corporation Finance’s position on an enforcement action and does not establish any binding legal precedent, the Division did “particularly note” certain characteristics of the TKJ Token that the Division considered determinative in reaching its conclusion. Among other things, the Division noted that (1) TKJ would not use any funds from its token sale to further develop the TKJ platform, network, or app, as each would be fully developed at the time of the token sale; (2) the tokens would be immediately usable at the time sold; and (3) TKJ would restrict transfers of tokens to TKJ wallets only, and not to wallets external to the TKJ Platform.
Taken together, the Framework and the TurnKey Letter represent a critically important first step in clarifying for the market how the securities laws and regulations apply to the digital asset economy. However, they are just that—a first step. A great deal remains to be clarified, and companies are still well advised to seek competent legal counsel before issuing new digital assets.
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- The Framework “is not a rule, regulation, or statement of the Commission, and the Commission has neither approved nor disapproved its content. . . [It] does not replace or supersede existing case law, legal requirements, or statements or guidance from the Commission or Staff. Rather, [it] provides additional guidance in the areas that the Commission or Staff has previously addressed.” Framework at 11 n.1.
- Here, the Framework uses the term “digital asset” to signify an asset that is “issued and transferred using distributed ledger or blockchain technology, including, but not limited to, so-called ‘virtual currencies,’ ‘coins,’ and ‘tokens.’” Framework at 12 n.2.
- See Section 2(a)(1) of the Securities Act of 1933, 15 U.S.C. § 77b(a)(1), for the full definition of “security.”
- Framework at 2.
- Framework at 12 n. 9.
- Framework at 12 n. 11.