Understanding the SEC’s Digital Asset Framework

Published in

DINNGO

6 min readJul 25, 2019

On April 3, 2019, the U.S. Securities and Exchange Commission (SEC) released a guidance, the Framework for “Investment Contract” Analysis of Digital Asset (Framework), in an effort to provide clarity for market participants to determine whether or not a digital asset is deemed to be an investment contract, and therefore a security.

On the same day, the SEC issued its first “no action letter” to TurnKey Jet, Inc. (TKJ), in which it gave assurance to TKJ that no enforcement action against TKJ will be recommended as long as TKJ adheres to a number of stipulations. As a result, TKJ will not be beholden to securities regulation from the SEC.

Despite this, it is important to note that while the Framework is designed to help identify whether a digital asset or company should be subject to federal securities laws, it is ‘not a rule, regulation, or statement of the Commission’ — in essence, the Framework is simply a clarification, rather than a regulation.

In the paragraphs that follow, we summarize the Framework and No-Action letter. To begin with the summary, we first have to understand the fundamental basis of the Framework — the Howey test, as the entire Framework articulates the application of the Howey test to digital assets.

What is the Howey test?

Howey test is the SEC’s favorite method to determine if an asset is a security. It is a Supreme Court ruling established in 1946 that lays out the criteria of whether an instrument qualifies as an investment contract and therefore security or whether a scheme or transaction qualifies as a sale of securities. The prongs of the Howey test are as follows:

(i) There is an investment of money (did you sell it for $$$??)
(ii) In a common enterprise (was there a central team developing it?)
(iii) Reasonable expectation of profits derived from the efforts of others (90% of the Framework talks about this)

When applying the test, all three prongs must be met for an instrument to be considered as security. If any one of the prongs is not met, the instrument fails the Howey test and therefore is not a security.

Framework overview

The Framework assumes that the first two criteria of the Howey test always apply to digital assets, so much so that the Framework virtually skips them and focuses only on the third prong, “reasonable expectation of profits derived from the efforts of others.”

In the assessment of the third prong, the Framework provides a lengthy outline: 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 the third prong is met. (If you have control issue over your ‘project’, the token is probably a security.) The Framework approaches this inquiry into two parts:

Reliance on the Efforts of Others

In analyzing whether a purchaser is relying on the efforts of others, there are two underlying questions:

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?

The Framework sets out a number of characteristics that supports “reliance of the efforts of others”. While not 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”. These characteristics center around the AP’s role in the network/digital asset. Relevant characteristics include:

Developing the functionality of the network/digital asset.
Controlling the creation and issuance of the digital asset.
Limiting supply or forcing scarcity of the digital asset to support its price, such as through buybacks or “burning”.
Promising purchasers further developmental efforts in order for the network/digital asset to attain growth in the value.
Promoting the network/digital asset.
Determining whether a digital asset will be traded on a secondary market or platform.
Playing a lead role in the confirmation of transactions on the network.
Deciding governance issues, code updates or the security of the network.
Owning the intellectual property right of the network/digital asset.

Reasonable Expectations of Profits

The Framework points out that if the digital asset price is solely, or mostly driven by external market forces, then it is usually not considered a reasonable expectation of profits.

Here, the Framework also lists a number of characteristics to evaluate whether there is a reasonable expectation of profits:

The digital asset gives the holder rights to share in the income or profits or to realize gain from capital appreciation of the digital asset.
The digital asset is transferable.
The digital asset is traded on a secondary market or is expected to be in the future.
The digital asset is offered broadly to purchasers beyond those who have a need for the functionality of the network or to use the goods/services
The amount of funds raised in excess of what may be needed to establish a functional network or digital asset.
The digital asset is marketed, directly or indirectly, as an investment.

What makes it LESS likely to be a security?

In the “Other Relevant Considerations” section, the Framework highlights circumstances in which digital assets might fail the Howey test and therefore fall outside the scope of securities laws. Digital assets with these types of use or consumption characteristics are less likely to be investment contracts. Such circumstances could include:

The network and digital asset are fully developed and operational at the time of sale.
The digital asset can be immediately used for its intended functionality.
The digital asset meets the needs of users rather than speculative value.
Prospects for appreciation in the value of the digital asset are limited.
Transfers of the digital asset in the secondary market are available only among users of the platform.
The AP must not market the digital asset to emphasize anything but its functionality.
The digital asset is not transferable outside the network.
The digital asset can be redeemed for goods or services.
Digital assets as virtual currencies can immediately be used to make payments in a wide variety of contexts or acts as a substitute for fiat currencies.

NO Action Letter

The TKJ no-action letter provides a clear example of when can you sell tokens without registration. TKJ is a small jet-leasing company that owns around 2–3 jets. They launched their own internal token platform to facilitate transactions between users, brokers of the flights and carriers. TKJ also has their own wallet. The no action letter is basically a go ahead from the SEC, but with certain conditions:

The tokens

will be fully developed and operational at the time of sale.
is usable for the services at the time of sale.
is not transferable outside of the network.
price must be fixed at $1.

And TKJ

will not use any funds from token sales for development.
can only buy back its tokens at a discount.
can only market the token in a manner that emphasizes the functionality, and not the potential for the increase in the market value of the token.

Clearly, all the conditions listed above are consistent with the Framework. The Framework and the No Action letter together represent a comprehensive statement of the SEC’s position.

Key points

The Framework articulates an illustrative list of factors that may suggest that purchasers are relying on the managerial efforts of others, including whether there is an expectation that other parties perform activities for the benefit of the digital asset or network.
The Framework outlines a list of factors that may suggest that a purchaser has a reasonable expectation of profits, including where the digital asset can be traded on the secondary market or is sold to purchasers who are not likely to use the asset for anything other than investment purposes.
The no-action letter includes a list of factors that largely focus on the ability to use a digital asset for consumer or commercial purposes to suggest that an instrument is less likely to be a security.

Coming soon in our next article, we will share our takes on the Framework, the securities compliance for blockchain projects and what to expect in the future.