On April 3, 2019, the Division of Corporation Finance of the Securities and Exchange Commission (“SEC” or the “Commission”), through its Strategic Hub for Innovation and Financial Technology (“FinHub”), issued a white paper titled “Framework for ‘Investment Contract’ Analysis of Digital Assets” (the “Framework”). On the same day, FinHub issued the first no-action letter recommending no enforcement action for a token offering. To see the Framework and the no-action letter, click here and here. The Framework is likely to disappoint those looking either for bright-line standards that would allow developers to be confident the digital assets they sell are not securities or for a new regulatory approach that would treat fewer token offerings as securities offerings.
The Framework
The Framework is a detailed analysis of digital assets using the investment contract analysis from SEC v. W.J. Howey Co., 328 U.S. 293 (1946). Under the Howey test, an investment contract, and therefore a security, exists when there is (i) an investment of money (ii) in a common enterprise (iii) with a reasonable expectation of profits derived from the efforts of others. Commission staff members previously have presented this analysis regarding digital assets, most notably in the 2017 DAO Report and in Division of Corporation Finance Director William Hinman’s June 2018 speech. The Framework, however, is a more detailed discussion of the Howey test, with particular application to the offer and sale of digital assets for blockchain projects, networks and apps.
The Framework notes, without much discussion, that the first two prongs of the Howey test – an investment of money in a common enterprise – typically exist with offerings of digital assets. The Framework primarily analyzes the third prong of the Howey test – a reasonable expectation of profits derived from the efforts of others. As a threshold matter, the Framework introduces the notion of an “active participant” or “AP,” which is a promoter, sponsor or other third party that can be the provider of the “essential managerial efforts that affect the success of the enterprise” under Howey. The staff’s broad definition of AP seems to give the staff the ability to take the position that unconventional forms of managing or governing a network can satisfy the “managerial efforts of others” element of Howey.
The Framework lists 11 nonexclusive factors to use in evaluating whether a purchaser of digital assets is relying on the efforts of others. It lists 16 factors to use in evaluating whether a purchaser has a reasonable expectation of profits. In each case, the Framework notes that the more the listed factors are present, the more likely the applicable Howey element is met. Perhaps as important, the Framework notes that the courts have looked to the economic reality of the transaction and whether the instrument is offered and sold for use or consumption. The Framework lists 11 characteristics of use or consumption; the stronger their presence, the less likely the digital asset is a security. As with many multifactor legal analyses, the Framework notes that the factors are not intended to be exhaustive and no single factor is determinative.
The No-Action Letter
In a no-action letter issued on the same day the Framework was published, TurnKey Jet, Inc. (“TurnKey”) proposed to develop a token membership program and offer and sell blockchain-based tokens redeemable for air charter services. In light of the representations made by TurnKey in its request letter, the determination that the tokens were not securities was unremarkable. These included the following:
- The funds from the token sales would not be used to develop a platform, network or apps (a “project”), and the project would be fully developed when the tokens are sold.
- At the time of sale, the tokens could be used for the intended functionality – charter air services.
- Tokens could be transferred only within the project’s wallet and not on external platforms or exchanges.
- The tokens would be sold for $1.00 for the life of the program, and one token would represent a right to services worth $1.00.
- If TurnKey offered to repurchase tokens, it would do so at a discount to the face value of $1.00.
- The token would be marketed in a manner that emphasizes the functionality of the token and not the potential for an increase in value.
In light of TurnKey’s representations, it does not appear that it would have been difficult for the staff to conclude that the TurnKey tokens were not securities. Therefore, the TurnKey letter does not provide much comfort to others seeking to confirm that their tokens are not securities. The TurnKey letter, which merely confirms that it is possible to structure a token that is not a security, is a sort of bookend to the DAO Report cited above, which merely confirms that a token can be a security. In both cases, those conclusions were apparent to most practitioners paying attention, and they have not shed much light on the large gray area in between.
Summary
Taken together, the Framework and the TurnKey no-action letter confirm the staff’s prior position – developers seeking to raise capital through a token offering in order to finance the buildout of a network or project are likely to be selling a security. This will certainly be the case if the potential for appreciation or trading on a third-party platform is a significant feature of the token. While the Framework provides numerous factors to consider, unless and until the staff weighs in on specific, more nuanced applications of the Howey test to digital assets or provides additional guidance, we believe market participants and practitioners will continue to face difficult judgment calls when they apply the Howey test to digital assets.
In the Framework, the staff reiterates its willingness to consult with market participants through the FinHub portal to assist them in determining whether a particular digital asset is a security. Given the many factors involved in assessing that issue, we expect consultation with the SEC staff as to the securities law status of a particular proposed token offering to become the norm.
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