A common sentiment among many entrepreneurs in the world of blockchain-based digital assets (such as cryptocurrency and other tokens) is that the SEC has been moving very slowly to provide guidance on the application of securities laws to digital assets and transactions involving them. Last summer, William Hinman, director of the SEC’s Division of Corporation Finance, gave a speech that cast a chill over the industry by, among other things, stating that most tokens appear to be securities. As a result, despite concluding that sometimes an asset that is a security when issued can later become a non-security (his examples being Bitcoin and Ether), it appeared that a great number of initial coin offerings, or “ICOs,” were illegal because, for one thing, they should have been registered with the SEC under the Securities Act of 1933. As Mr. Hinman stated, “The 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.” This was not surprising to many experienced securities lawyers, but it was disappointing and/or frightening to many entrepreneurs.
The speech was in fact not the first statement or action by the SEC or its staff on the issue. However, not long after it, multiple divisions of the SEC joined in a statement outlining certain transactions they viewed as illegal, highlighting certain types of enforcement action being pursued, and even suggesting one way that illegal ICOs might be later cleansed. In the meantime, the SEC has continued enforcement action but, until April 3, 2019, not provided much constructive guidance or even concrete hope for entrepreneurs seeking novel solutions involving issuances of digital assets. Registering a token offering (i.e., an IPO) is burdensome and expensive and, in any event, to date the SEC has not declared any Form S-1 registered token offering effective.
We now have more constructive guidance, even if it is not earth shaking. On April 3, the Staff of the Securities and Exchange Commission’s Strategic Hub for Innovation and Financial Technology (“FinHub”) published a framework (the “Framework”) for evaluating whether a digital asset is a “security” under federal law.
On the same day, the Staff of the Division of Corporation Finance published a no-action letter involving a proposed token offering, concluding that it would not recommend enforcement action with regard to the proposed offering, as there was no “security” involved.
The Framework’s analysis focuses on the U.S. Supreme Court's landmark 1946 decision in SEC v. W. J. Howey Co. and subsequent case law, where an “investment contract,” and therefore a “security,” has been found to exist when there is the investment of money (or other property having value) in a common enterprise with a reasonable expectation of profits to be derived primarily from the efforts of others. This so-called “Howey test” applies to any contract, arrangement or transaction, regardless of whether it has any of the characteristics of typical securities.
According to the Framework, “the focus of the Howey analysis is not only on the form and terms of the instrument itself (in this case, the digital asset) but also on the circumstances surrounding the digital asset and the manner in which it is offered, sold, or resold (which includes secondary market sales). Therefore, issuers and other persons and entities engaged in the marketing, offer, sale, resale, or distribution of any digital asset will need to analyze the relevant transactions to determine if the federal securities laws apply.”
If those laws do apply, then the issuer and others participating in the sale of the digital asset must (1) register the offering with the SEC, or (2) qualify for an exemption from such registration; otherwise, they have potentially committed a felony and subjected themselves to both civil and criminal liability.
The Application of Howey to Digital Assets
1. The Investment of Money/Valuable Property
As the Framework notes, “the first prong of the Howey test is typically satisfied in an offer and sale of a digital asset because the digital asset is purchased or otherwise acquired in exchange for value, whether in the form of real (or fiat) currency, another digital asset, or other type of consideration.”
2. In a Common Enterprise
As to the “common enterprise” element of the Howey test, the SEC Staff concluded that “[b]ased on our experiences to date, investments in digital assets have constituted investments in a common enterprise because the fortunes of digital asset purchasers have been linked to each other or to the success of the promoter’s efforts.”
3. With the Reasonable Expectation of Profits to Be Derived from the Efforts of Others
This is typically the most crucial part of a Howey analysis. When a promoter, sponsor, or other third party (or affiliated group of third parties) (each, an “Active Participant” or “AP”) provides essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts, then these two facets of the test are met. According to the Framework, the following characteristics are especially relevant.
a. Reasonable Expectation of Profits
Is there a reasonable expectation of profits (e.g., capital appreciation or participation in earnings resulting from the use of purchasers’ funds) by the purchaser of the digital asset? Price appreciation resulting solely from external market forces (such as general inflationary trends or the economy) is not considered “profit” under the Howey test.
The Staff then sets forth a long, detailed list of factors, observing that “the more the following characteristics are present, the more likely it is that there is a reasonable expectation of profit.” Those identified factors include, but are not limited to, whether:
- The digital asset gives the holder rights to share in the enterprise’s income or profits or to realize gain from capital appreciation of the digital asset;
- The digital asset is transferable or traded on or through a secondary market or platform, or is expected to be in the future;
- The digital asset is offered broadly to potential purchasers as compared to being targeted to expected users of the goods or services or those who have a need for the functionality of the network; and
- Purchasers would reasonably expect that an AP’s efforts to result in capital appreciation of the digital asset and therefore be able to provide a return on their purchase.
Included in the Staff’s comments is an analysis of factors relevant to whether a digital asset previously sold as a security should be reevaluated at the time of later offers or sales.
b. Reliance on the Efforts of Others
When an AP provides essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts, then this part of the test is met. Here, the inquiry focuses on two key issues:
- Does the purchaser reasonably expect to rely on the efforts of an AP?
- Are those efforts “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise,” as opposed to efforts that are more ministerial in nature?
Again, the Staff provides a detailed list of factors relevant to this branch of the analysis, stating that “although no one of the following characteristics is necessarily determinative, the stronger their presence, the more likely it is that a purchaser of a digital asset is relying on the ‘efforts of others.’” Those factors include, but are not limited to:
- An AP is responsible for performing or overseeing essential tasks or responsibilities, the development, improvement (or enhancement), operation, or promotion of the network.
- An AP creates or supports a market for, or the price of, the digital asset.
- An AP has a continuing managerial role in making decisions about or exercising judgment concerning the network or the characteristics or rights the digital asset represents.
The Staff also suggests a number of factors for determining whether a digital asset previously sold as a security should later be reevaluated with respect to the “efforts of others” test.
c. Other Relevant Considerations
When assessing whether there is a reasonable expectation of profit to be derived from the efforts of others, federal courts look to the economic reality of the transaction. In doing so, the courts also have considered whether the instrument is offered and sold for use or consumption by purchasers, and not for “investment” purposes.
Although no one of the following characteristics of use or consumption is necessarily determinative, according to the Framework the stronger their presence, the less likely the Howey test is met:
- The distributed ledger network and digital asset are fully developed and operational.
- Holders of the digital asset are immediately able to use it for its intended functionality on the network, particularly where there are built-in incentives to encourage such use.
- The digital asset’s creation and structure is designed and implemented to meet the needs of its users, rather than to feed speculation as to its value or development of its network. For example, the digital asset can only be used on the network and generally can be held or transferred only in amounts that correspond to a purchaser’s expected use.
- Prospects for appreciation in the value of the digital asset are limited. For example, the design of the digital asset provides that its value will 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.
- With respect to a digital asset referred to as a virtual currency, it can immediately be used to make payments in a wide variety of contexts, or acts as a substitute for real (or fiat) currency (the Staff providing a number of examples).
- Any economic benefit that may be derived from appreciation in the value of the digital asset is incidental to obtaining the right to use it for its intended functionality.
- The digital asset is marketed in a manner that emphasizes the functionality of the digital asset, and not the potential for the increase in market value of the digital asset.
- Potential purchasers have the ability to use the network and use (or have used) the digital asset for its intended functionality.
- Restrictions on the transferability of the digital asset are consistent with the asset’s use and not facilitating a speculative market.
- If the AP facilitates the creation of a secondary market, transfers of the digital asset may only be made by and among users of the platform.
Digital assets with these types of use or consumption characteristics are less likely to be investment contracts. Yet, according to the Framework, even in cases where a digital asset can be used to purchase goods or services on a network, where that network’s or digital asset’s functionality is being developed or improved, the securities laws may still apply if, among other factors, one or more of the following is present:
- The digital asset is offered or sold to purchasers at a discount to the value of the goods or services;
- The digital asset is offered or sold to purchasers in quantities that exceed reasonable use; and/or
- There are limited or no restrictions on reselling those digital assets, particularly where an AP is continuing in its efforts to increase the value of the digital assets or has facilitated a secondary market.
Turnkey Jet, Inc. ("TKJ") No-Action Letter
Contemporaneously with the release of the Framework, the Staff of the SEC’s Division of Corporation Finance issued a no-action letter regarding TKJ, an air charter service that proposed an offering of tokens that TKJ argued should not be considered securities. The SEC no-action letter confirmed to TKJ that the Staff would not recommend enforcement action if TKJ created and marketed a pre-payment program (the “Program”) whereby customers would purchase digital tokens for use solely in connection with the purchase of air charter services. The reasoning was consistent with prior no-action letters where the offerings did not involve digital assets.
According to the requesting letter, the Program would utilize blockchain and smart contract technology to provide solutions for several air charter service payment problems. These solutions include:
- Reduction in transaction costs that financial institutions charge in payment settlement for air charter services,
- Increased efficiencies in the delivery of air charter services, such as rapid settlement of large transactions, and
- Decreased possibility of fraudulent transactions and potential chargebacks.
Each digital token would represent one U.S. dollar, and the proceeds of token sales would be escrowed with a FDIC-insured financial institution.
While the operation of the Program is complex, the basis for TKJ’s legal argument as stated in the requesting letter is straightforward: the Program should not be considered an “investment contract” within the meaning of Howey. While there is clearly an “investment” of money, there is no “common enterprise,” as consumers will not be involved in the operation of the Program. There is likewise no expectation of profit, because those who purchase tokens do so for only one purpose — to purchase air charter services. Their intention is not to provide a capital return or participation in any earnings of the Program (and carriers and brokers involved in the Program will likewise receive payment for their services only in tokens, each of which will have a fixed value of one U.S. dollar). In short, the same practical reason underlying the Supreme Court’s holding in United Housing Foundation, Inc. v. Forman, 421 U.S. 837 (1975), is present here. In United Housing, the plaintiff purchasers were simply purchasing an apartment in which to live, not an “investment.” Here, those who purchase the Program’s tokens are simply buying air charter services.
Second, the Program’s tokens are not “notes” within that term’s meaning in the definition of a federal “security,” as they represent open-account debts that have been expressly excluded from classification as “securities” under the Supreme Court’s holding in Reves v. Ernst & Young, 494 U.S. 56, 67 (1990).
In granting the requested no-action relief the SEC’s Staff highlighted several relevant factors:
“TKJ will not use any funds from Token sales to develop the TKJ Platform, Network, or App, and each of these will be fully developed and operational at the time any Tokens are sold;
TKJ will restrict transfers of Tokens to TKJ Wallets only, and not to wallets external to the Platform;
TKJ will sell 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;
If TKJ offers to repurchase Tokens, it will 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; and
The Token is marketed in a manner that emphasizes the functionality of the Token, and not the potential for the increase in the market value of the Token.”
Entrepreneurs inspired and encouraged by the guidance embodied in the Framework and the TKJ no-action letter will also need to consider state securities (“Blue Sky”) laws. While such laws include the term “investment contract” within their definition of a “security,” and the Howey test is widely followed by the state courts, a number of jurisdictions also adhere to what is known as the “risk capital” test. The risk capital test, initially adopted by the California Supreme Court in Silver Hills Country Club v. Sobieski, 55 Cal.2d 811 (1961), held that the term “security” also encompasses the capital advanced by members of a golf club in order to construct the course and facilities. See also the Securities Act of Washington, RCW 21.20.005.17(a):
(17)(a) "Security" means any . . . investment of money or other consideration in the risk capital of a venture with the expectation of some valuable benefit to the investor where the investor does not receive the right to exercise practical and actual control over the managerial decisions of the venture; * * *
It should also be noted that neither the Framework nor the no-action positions of the Staff represent “rules” or “regulations” of the SEC and the SEC itself has neither approved nor disapproved their contents. As a result, compliance with the conditions described in Staff pronouncements does not provide the protection from liability provided by Section 19(a) of the Securities Act of 1933, as amended, 15 U.S. Code § 77s(a), concerning compliance with the “rules and regulations” of the Commission.
 William Hinman, Digital Asset Transactions: When Howey Met Gary (Plastic), available at https://www.sec.gov/news/speech/speech-hinman-061418.
 See, e.g., Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (Exchange Act Rel. No. 81207) (July 25, 2017).
 SEC Staff’s “Statement on Digital Asset Securities Issuance and Trading,” https://www.sec.gov/news/public-statement/digital-asset-securites-issuuance-and-trading (Nov. 16, 2018).
 See https://www.sec.gov/news/public-statement/statement-Framework-investment-contract-analysis-digital-assets
 TurnKey Jet, Inc. (April 3, 2019) (see https://www.sec.gov/divisions/corpfin/cf-noaction/2019/turnkey-jet-040219-2a1.htm).