The SEC’s Digital Asset Guidance: A Regulatory “Genesis Block”?
On April 3, 2019, the United States Securities and Exchange Commission (“SEC” or the “Commission”) released two separate statements that provide important insight into the Commission’s views of the digital asset space: a “Framework for ‘Investment Contract’ Analysis of Digital Assets” (the “Framework”) from the Strategic Hub for Innovation and Financial Technology (“FinHub”) and a no-action response from the Commission’s Division of Corporation Finance to a requesting letter submitted by TurnKey Jet, Inc. (“TKJ”) relating to the proposed offer and sale of a blockchain-based digital token (the “TKJ Letter”). Although the Framework and the positions taken in the TKJ Letter build on many prior statements made by the SEC, its Commissioners, and its Staff, taken together, these two actions represent the most detailed look yet at the Commission’s thinking on this critical topic. So where does this leave us?
Here’s what you need to know:
The TKJ Letter is Limited by its Facts. Going back at least to a speech given by Director of the Division of Corporation Finance, William Hinman, in June 2018, the SEC has promised that they would be providing guidance to the market in the form of “no-action” relief. For the first time, we see the fruits of this effort. Why is no-action relief so important for the market? Although no-action positions are not formally binding on the Commission or on private parties, they do provide the market with fact patterns in which the Staff is comfortable that a sale of a security did not take place. This allows practitioners to reason from both the “negative” guidance (factors that would result in a digital asset being deemed a security) as well as “positive” guidance (analogizing to facts from applicable no-action letters). However, perhaps unsurprisingly, the facts set out in the TKJ Letter look quite a bit different from those applicable to a typical token sale. In particular:
- The seller in the TKJ Letter is developing a private blockchain platform (as opposed to using an existing “public” network, like Ethereum) and committed in the letter not to use any funds from the token sales to develop the platform, which they state will be fully operational at the time the tokens are sold.
- The tokens are not part of a decentralized project and there is not a limited supply of tokens. Instead, the seller will offer the tokens at a fixed price throughout the life of the program. Rather than being a functional part of a decentralized system, the tokens simply represent an obligation of the seller to supply air charter services (the seller’s pre-existing business).
- The seller will restrict transfers of the tokens to wallets they have created and approved, and transfers to wallets external to the platform will not be permitted. The TKJ platform is not intended to be decentralized and there will be an unlimited supply of tokens available for sale. Transferability of the tokens under these circumstances is not necessary for the platform to function as intended, whereas in decentralized systems with a fixed supply of tokens available to network participants, transferability is critical to facilitate the exchange of value necessary to incentivize participants to perform the functions necessary for the network to operate.
- The price of the tokens will be pegged to the U.S. Dollar. Further, while the seller may offer to repurchase tokens, it will only do so at a discount to the “face value” of the tokens (unless a court within the United States orders the seller to liquidate the tokens). In decentralized platforms, there is no entity to repurchase the issued tokens, nor is there a known fixed price — the token price is whatever a willing buyer and seller agree on.
- Similar to most current thinking in the market for token sales, the seller undertakes to market the tokens only in a manner that emphasizes the functionality of the token, and not the potential for the increase in its market value.
The Framework is Guidance, not Commission Action. The Framework explicitly expresses the views of only the FinHub Staff and not of the Commission itself. As a statement issued by the Staff, the Framework did not receive any formal approval by the Commission (a time-consuming and more involved process) and does not create a binding precedent or a regulatory “safe harbor” of any type. Rather, the Framework reflects Staff guidance intended to assist market participants in evaluating the legal status of certain digital assets. Although we would be surprised if the Commission wound up taking a position significantly different from what is set out in the Framework, things can change quickly in this area and market participants are on notice that the positions set out in the Framework may evolve or be supplanted altogether.
Practical Application of Framework Factors. The Framework sets forth a detailed list of factors to consider when conducting an analysis of the “expectation of profits” and “efforts of others” elements of the Howey test in the context of a sale of digital assets. The factors are laid out in more detail in the Framework than they had been in any previous guidance from the Staff, which provides the market with some helpful color. However, the factors presented in the Framework are deliberately not weighted, which makes using them to make a determinative assessment of whether a particular token or transaction is, or is not, a “security“ very challenging. Any such conclusion necessarily requires a facts and circumstances-specific consideration of the mix of factors present and an estimate of the appropriate weight to assign each such factor. Until we have a significant number of no-action letters to generalize from, counsel will likely find it hard to provide definitive, reliable advice about the status of tokens without first engaging with the Staff of the SEC.
Broad in Scope. The breadth of the scope of the Framework should not be underestimated. By its terms, the Framework applies to almost any activity relating to a digital asset. The Framework does not distinguish between initial sales of digital assets and subsequent secondary transactions in digital assets. Taken literally, this means that anyone interacting in almost any way with a “digital token” may be engaging in a regulated securities transaction.
Framework Specific to Investment Contract Analysis. The Framework only applies to the interpretation of the term “investment contract“. An investment contract is just one of the specifically enumerated instruments within the definition of “security” in the Securities Act of 1933. Certain tokens (such as some “stable coins”) may be considered by the Commission to be securities because they meet the requirements of one of the other instruments in the definition of “security” (such as “collateral trust certificate”).
Disclosure and Information Asymmetries. The importance of disclosure of “information relating to the essential managerial efforts that affect the success of the enterprise“ is emphasized in the Framework. However, it is not at all clear what “enterprise“ the Framework is referring to in the context of a decentralizing blockchain network. This lack of clarity is exacerbated by the Staff’s position, noted in footnote 10 of the Framework, that they do not believe that the requirement that there be a “common enterprise“ is a distinct element of the Howey test (despite the direct use of that term by the Supreme Court in the Howey decision).
The Active Participant. The Framework introduces a new concept into the Howey analysis — the Active Participant (“AP”). According to the Framework, someone who “provides the essential managerial efforts that affect the success of the enterprise” is an Active Participant. This can be a “promoter, sponsor, or other third party (or affiliated group of third parties)”. The Framework later indicates that a “successor” AP can also provide essential managerial efforts for purposes of the Howey analysis.
- The term “Active Participant“ has some precedential value in the context of securities law issues. Specifically, in disputes alleging securities law violations related to general partnership interests, courts generally presume that the interests in question are not “securities” so long as the holders are considered to be active participants in the entity and have access to relevant information about the entity (unlike what is typically the case with limited partners in limited partnerships). However, this presumption can be overcome under certain circumstances by the aggrieved investor establishing that a general partnership interest holder is not an “active participant” in the entity. The standard used to make these determinations may be applicable in this context to determine whether the “efforts of others” prong of the Howey test is satisfied.
- A factor in determining if a token once sold as a security is no longer a security is whether an AP or successor AP continues to be “important” to the value of the network or the token. The Framework assumes that the role of providing the essential managerial efforts can shift from one AP to another and the inquiry looks at the circumstances at the time of a particular transaction. It thus seems possible under the Framework that at the time of a secondary transaction in digital asset, a third party or affiliated group of third parties, with whom the token holder looking to transact has no legal relationship, may nevertheless be deemed to be providing “essential managerial efforts”, subjecting the transaction to ongoing compliance with the securities laws.
- This is unlikely in a centralized system, because a change of control from one AP to a “successor AP” will likely happen in a legally formal way (e.g., a merger).
- In a decentralized system however, it may be possible (if you can even have “essential managerial efforts” in a decentralized system) for a party that was not involved in developing the platform, did not sell the token, or that does not have any legal relationship with other token holders to be an AP under the Framework’s definition.
- One question that arises as a result is whether a successor AP might be deemed to have assumed a fiduciary duty to token holders as a result of their status. Also unclear is whether transactions in a token can go from securities transactions to non-securities transactions and back again, depending on how control of the network is viewed. This in turn will impact the analysis of whether the platform may be deemed to be acting as a broker-dealer in facilitating transactions in the digital asset.
Mutability. The concept of mutability introduced in the Hinman Speech is reaffirmed by the Framework. The Framework suggests that a digital asset sold in a securities transaction can later be sold in a non-securities transaction. Even more, the Framework puts forward the idea that the very nature of an asset can transform, from being a security to no longer being a security, although no legal precedent is cited for this new idea. However, upon closer consideration, the concept of mutability would be problematic to apply in practice. The Framework does not clarify who would determine when transactions in digital assets would no longer be deemed securities transactions or how interested parties would be able to agree consistently as to whether or at what exact moment in time such a transformation occurs (a determination critical for tax, accounting, risk capital and commercial law purposes, among others). Given the broad scope of the Active Participant definition and the possibility that successor APs can play a role in the analysis, a digital asset once sold as a non-security could also later be sold as a security on these theories, further complicating an already difficult and murky concept.
Airdrops Out? Footnote 9 of the Framework re-visits the contentious issues of “airdrops” (token giveaways) and “bounties” (tokens earned through providing marketing support to the issuer or other useful services). Although this too will be determined on a case-by-case basis, the Framework makes clear that both techniques would not in any way prevent the Commission from the finding that a token that was “airdropped” or given away in a bounty program was an “investment contract” and thus a “security” when the facts otherwise warrant it.
Lack of References to the term “Decentralized”. The Framework makes only one, relatively light-touch, reference to the concept of a “decentralized” network. This in itself is somewhat notable, particularly given the prominence of the concept of “decentralization” and the use of the sufficiently decentralized standard in the Hinman Speech. This is a step forward in our view as “decentralization” is not itself a legal concept and securities lawyers have almost no relevant case law to fall back on when attempting to determine what this might mean in practice.
Secondary Markets for Tokens? The Staff has been very sensitive to secondary market trading of digital assets — generally, secondary market trading has been seen as a strong indication that a token should be considered a “security”. The Framework provides some new guidance that opens the door to secondary market transactions in digital assets that are not securities under certain circumstances. It is still clearly problematic if one or more APs are deemed to exist for a given network and that AP (or APs) determine “whether and where” the digital asset will trade. This suggests, by negative implication, that users (not affiliated with the AP) can take it on themselves to create a secondary market for tokens or trade tokens on a secondary market and that this does not necessarily weigh heavily in the analyses of “expectation of profits” or “efforts of others”.
- The purchase of a digital asset may be an “investment” but, rather than treating the token as if it were a security issued by a particular legal entity, the digital asset would often be better understood as an investment in the success of the network. The Framework provides that a digital asset that is considered a security must be marketed along with all material disclosure about the AP upon whom the investor relies to provide “essential managerial efforts”. A token-based blockchain network however may not have a party whose managerial efforts are “essential”, or who is capable of providing the required disclosure to investors. Under the Framework it seems that, in these circumstances, an “investment” in the success of the network would not be considered a securities transaction, even if the value of the digital asset later appreciates significantly.
- Developers of networks that are intended to be decentralized should conduct an analysis of their network and any related token to assess whether any participant in the network might be deemed an “Active Participant” for purposes of the investment contract analysis. Carefully structuring the development of a network or transactions relating to the creation of the network or dissemination of a network token may help avoid unintended Active Participants in the network.
- Given the potential breadth of application of the Framework’s factors, the SEC may want to consider a “safe harbor“ for transactions in tokens by persons not directly or indirectly involved in the initial issuance or distribution of a given token who, in good faith, are not aware of any action taken by the SEC to question whether the token may be considered a “security” for purposes of federal securities law.
 See William Hinman, Digital Asset Transactions: When Howey Met Gary (Plastic), Remarks at the Yahoo Finance All Markets Summit: Crypto (June 14, 2018), available at https://www.sec.gov/news/speech/speech-hinman-061418 (the “Hinman Speech”).
 As has been often repeated, the Howey Test holds that an instrument qualifies as an “investment contract” and therefore a regulated “security” under the Securities Act of 1933 if there is an “investment of money in a common enterprise with the reasonable expectations of profits from others.” SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
 We have the same issue as we did with the factors set forth in a speech by William Hinman, which were also intentionally not weighted. See Hinman Speech.
 The Commission’s announcement of the Framework states that it may apply to entities conducting any of the following activities related to digital assets: (i) offering, selling, or distributing; (ii) marketing or promoting; (iii) buying, selling, or trading; (iv) facilitating exchanges; (v) holding or storing; (vi) offering financial services such as management or advice; and (vii) other professional services.
 The Fifth Circuit in Williamson v. Tucker set forth the test under which general partnership interests might be considered “investment contracts.” 645 F.2d 404 (5th Cir.), cert denied, 454 U.S. 897 (1981).