On April 3, the US Securities and Exchange Commission's (SEC) Strategic Hub for Innovation and Financial Technology (FinHub) published its "Framework for 'Investment Contract' Analysis of Digital Assets." The same day, the SEC's Division of Corporation Finance also issued its first "No Action" letter to a startup planning to sell digital assets.
The Framework describes the factors used by SEC Staff for assessing whether digital assets are "investment contracts" subject to federal securities laws; the No Action letter applies those factors. The Framework suggests that, over time, digital assets may evolve to a point where they are no longer securities.
While neither exhaustive nor binding, the Framework consolidates and expands upon principles previously articulated in SEC enforcement actions, press releases, and speeches. As such, it offers industry participants insights on the types of activities that can expose them to US federal securities regulation.
A careful reading of the Framework, however, suggests that the SEC's staff continues to view offer, sale, and distribution of most digital assets – especially those in early stages where purchaser funds are used to develop and launch the asset and its platform – as securities. The interpretive advice addressed in the No Action letter offers a rare exception to this general approach and thus is of limited value to market participants.
In the paragraphs that follow, we examine the Framework as well as the No Action letter and assess how these developments are likely to impact market participants.
I. Framework overview
The Framework is designed to serve as "an analytical tool to help market participants assess whether the federal securities laws apply to the offer, sale, or resale of a particular digital asset." It centers on the application of the Supreme Court's Howey test – the long-recognized standard for determining if an instrument or contract qualifies as an "investment instrument" and thus a security or whether a scheme or transaction (eg, the sale of a digital asset) qualifies as a sale of securities. The Howey Test requires (1) an investment of money; (2) in a common enterprise; (3) with an expectation of profits; (4) predominantly derived from, or in reliance on, the efforts of others. Federal securities laws require that all offers and sales of investment contracts and other securities be registered or qualify for an exemption from registration.
The Framework contains virtually no discussion of the first two prongs of the Howey test and claims – in a conclusory fashion – that those requirements are typically satisfied due to the nature of digital asset transactions. Instead, the Framework focuses on the third and fourth prongs, which are satisfied when the digital token issuers or third parties (eg, promotors or sponsors) – referred to in the Framework as "Active Participants" (APs) – provide "essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts."
In assessing whether the "reliance on the efforts of others" and "reasonable expectations of profits" requirements are satisfied, the SEC's staff will focus on the "economic reality" of digital asset transactions including the "terms of the offer, the plan of distribution, and the economic inducements" to encourage sales. If purchasers are believed to have relied on the efforts of others and reasonably expect profits, then the SEC staff will view the digital asset as a security.
a. Factors supporting "reliance on the efforts of others"
In analyzing whether a purchaser is relying on the efforts of others, the Framework asks whether (1) the purchaser reasonably expects to rely on the efforts of an AP; and (2) the AP's efforts are the "undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise." According to the Framework, the following factors – while neither determinative nor exhaustive – weigh in favor of a conclusion that a digital token purchaser is relying on the efforts of others, a necessary finding in determining whether a digital asset is a security. A common theme is AP control over key aspects of the digital asset:
- Network development/operation/promotion: The AP – rather than a "dispersed community of network users" – is responsible for the development, improvement, enhancement, operation, or promotion of the network for the digital asset, especially if the AP's efforts are "necessary for the network or digital asset to achieve or retain its intended purpose or functionality."As noted in the Framework, and as laid out in the No Action letter, the SEC's staff will evaluate the state of development and functionality of both the digital assets and associated network both when the offer and sale occur and over time as the assets and network mature. The less developed/functional the digital assets and network at the time of the offering or sale, the more likely purchasers are relying on the efforts of others. The Framework also notes that SEC's staff will also consider whether an AP, in its messaging to actual or prospective purchasers, has suggested that its future developmental efforts may help the digital asset grow in value.
- Market creation/support: The AP creates or supports a market for, or the price of, the digital asset. Examples include control of the creation and issuance of the digital assets as well as actions taken to support a market price of the digital asset (eg, by limiting supply or ensuring scarcity through buybacks and token burning).
- Governance, oversight, and control: The AP has 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." Also relevant is whether the AP is responsible for "exercising judgment concerning the network or the characteristics or rights the digital asset represents." Such decisions may include compensation to persons providing services to the network, arrangements for the trading of digital assets on secondary markets, and the use of funds raised from digital asset sales.
- Financial interest/benefits: The AP has the ability to realize capital appreciation from the value of the digital asset. Considerations include whether the AP retains a stake or interest in the digital asset, distributes the digital asset as compensation to management, ties compensation to the price of the digital asset on the secondary markets, owns/controls the intellectual property rights of the network or digital asset, or monetizes the value of the digital asset, especially in instances where the digital asset has limited functionality.
b. Reasonable expectation of profits
The SEC staff will assess a number of factors to determine whether digital asset purchasers have a reasonable expectation of profits and is, therefore, a security. The Framework outlines both factors that support a finding of reasonable expectation of profits and factors that weigh against such a finding. Some of these factors dovetail with the "reliance on the efforts of others" analysis described above.
(i) Factors supporting reasonable expectations of profits
The following non-exhaustive list of factors weigh in favor of a finding that a digital asset purchaser has a reasonable expectation of profits; a common theme is the existence of value generating activity that exceeds the value provided to those who use the digital asset on its network:
- Capital appreciation and income/profit sharing: The digital asset gives purchasers the right to share in an enterprise's income/profits or to realize a gain from the asset's capital appreciation. The Framework suggests that virtually all forms of capital appreciation support this element of the Howey test.
- Secondary market trading: The digital asset can be traded or transferred on or through a secondary market or platform, or if such opportunities are expected in the future enabling digital asset holders to resell the asset and realize gains.
- Offer/purchase volume suggests investment intent: The quantities of digital assets offered or purchased are "significantly greater than any likely user would reasonably need" or there is little apparent correlation between digital asset trading or purchase quantities and "the amount of the underlying goods or services a typical consumer would purchase for use or consumption."
- Targeting non-users: The digital asset is offered to an audience beyond those who are likely to use the goods/services or have a need for the network's functionality and, therefore, presumably buying the digital asset with a view towards capital appreciation.
- Promotional/marketing activity suggesting a potential to profit: Promotional and marketing activities -- whether direct or indirect – that suggest a reasonable expectation of profits. Some of these activities are obvious, such as marketing the digital asset asan investment, stating that the solicited holders are investors or promoting "the availability of a market for the trading of the digital asset." Other examples overlap the "efforts of other analysis" and include promotion of "the expertise of an AP or its ability to build or grow the value of the network or digital asset," "use of the [sale] proceeds . . . to develop the network or digital asset," and "future (and not present) functionality of the network or digital asset, and the prospect that an AP will deliver that functionality."
(ii) Factors suggesting no reasonable expectation of profits
Factors that weigh against a finding that digital asset purchasers have a reasonable expectation of profits derived from the efforts of others focus on whether purchasers are buying the assets for consumptive use rather than as a speculative investment. These factors include:
- Functionality of the assets/network: The digital assets and associated network are fully developed/operational at the time of offer/sale, and purchasers are "immediately able to use [them] for [their] intended functionality." Evidence shows that the digital assets are designed and implemented to "meet the needs of its users" rather than "feed speculation as to its value or development of its network," and that the assets are "marketed in a manner that emphasizes the functionality of the digital asset, and not the potential for [its] increase in market value."
- Low likelihood of appreciation: The digital assets have limited prospects for appreciation. For instance, the digital assets are designed in a way that means that they will likely "remain constant or even degrade over time, and, therefore, a reasonable purchaser would not be expected to hold the digital asset for extended periods as an investment."
Notably, the Framework states that APs who help facilitate secondary market activity on a network do not push the digital asset sales further into the "investment contract" classification if the "transfers . . . may only be made by and among users of the platform."
II. "No Action" letter
The TurnKey Jet, Inc. No Action letter stated that the SEC's Division of Corporation Finance would not recommend an enforcement action if the private jet company proceeds with its plans to sell digital assets (tokens) without registering them as securities. The tokens are intended to facilitate air charter service reservations. The SEC's staff listed the following factors, all of which are consistent with the Framework, as important to its assessment:
- Fully developed/operational system: TurnKey Jet undertook to have a "fully developed and operational" platform/network/app "at the time any Tokens are sold," and "not use any funds from Token sales to develop" these technologies.
- Immediate use/functionality: TurnKey Jet undertook that when sold, TKJ tokens "will be immediately usable for their intended functionality (purchasing air charter services)."
- Restrictions on token pricing, transfer, and repurchase: TurnKey Jet undertook to sell its TKJ Tokens "at a price of one USD per Token throughout the life of the Program, and each Token will represent a TKJ obligation to supply air charter services at a value of one USD per Token." In addition, TurnKey Jet agreed to "restrict transfers of Tokens to TKJ Wallets only, and not to wallets external to the Platform" and, in the event that the company repurchases tokens, to "only do so at a discount to the face value of the Tokens (one USD per Token) that the holder seeks to resell to TKJ, unless a court within the United States orders TKJ to liquidate the Tokens."
- Marketing limitations: TurnKey Jet agreed to market tokens "in a manner that emphasizes the functionality of the Token, and not the potential for the increase in the market value of the Token."
The TurnKey Jet model – like the "online retailer" model described in the Framework 1 – involves digital assets with utility only on a closed private network as opposed to the broader blockchain.
III. What do these developments mean?
The Framework and No Action letter represent the most comprehensive statement to date of the position of the SEC’s staff on the regulation of digital assets. They are a regulatory stake in the ground, warning market participants that going forward, they need to assess any potential sale of digital assets as outlined in the Framework to determine whether there is an offer or sale of a security.
While the SEC staff’s position recognizes that not all digital assets are securities requiring registration or an exemption from registration prior to sale, the instances where the sale of such assets will not be viewed by the staff as the sale of a security are extremely limited. Careful consideration of the Framework and No Action letter suggest that those who wish to sell digital assets falling outside of the narrow TurnKey Jet or online retailer model will need to register the asset prior to sale or sell the asset under a registration exemption, at least at the early stages of the launch of the digital asset and its network. While the Framework offers hope that over time, a digital asset may lose its characterization as a security through decentralization, when that occurs is a question that remains unanswered.
With that in mind, APs should recognize that the SEC is likely to view the offer, sale, or distribution of a digital asset as subject to securities regulation if:
- The asset itself is not fully functional
- The network on which the asset will operate is not fully functional
- The network is not fully decentralized
- The asset is marketed to purchasers who are not users
- The asset is marketed in a way that engenders an expectation of profits or
- The asset can be traded on secondary markets.
One unresolved question is how "functional" a digital asset – and its associated network – must be at the time of offer/sale in order to satisfy the "fully functional" standard. Functionality can evolve over time, and it is not clear when such changes shift a digital asset from insufficiently functional to acceptably functional for the purposes of SEC scrutiny.
Another unresolved question is when the purchase of a digital asset should be treated as an investment in a common enterprise – the second prong of the Howey test. The Framework oversimplifies this issue, substituting its "experience" for what is often a complicated analysis. Federal courts apply a number of different tests (eg, assessing vertical and horizontal commonality) when evaluating the existence of a common enterprise.
In addition to serving as a compilation of its past positions and guidance, the Framework serves as yet another warning shot at the industry: if you want to offer, sell, or distribute digital assets, you better talk to the SEC first and let them assist you in designing the sale and marketing of the digital asset. And, by the way, any possibility of capital appreciation supports the conclusion that purchasers had a reasonable expectation of profits.
Most importantly, the analysis in the Framework is not exhaustive and does not represent a "rule, regulation or statement of the [SEC]." The SEC has left the door wide open for additional pronouncements and regulation. Market participants will still proceed at their own peril to the extent they deviate from the TurnKey Jet No Action letter and the retailer example contained in the Framework. Expect more conversations with and more statements from the SEC Staff on these issues.
To learn more, please contact Deborah Meshulam, Ben Klein, Mark Radcliffe, Curtis Mo and Andrew Ledbetter.
An earlier version of this article appeared on Law360 on April 15, 2019.
1 According to the Framework, an online retailer with a fully operational business that develops a digital asset may be able to avoid securities regulation if:
- The 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 priced in that real currency.
- The retailer continues to market its products to its existing customer base, advertises its digital asset payment method as part of those efforts, and may “reward” customers with digital assets based on product purchases.
- Upon receipt of the digital asset, consumers immediately are able to purchase products on the network using the digital asset. 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.