The Securities and Exchange Commission (SEC) recently published long-awaited guidance on digital securities (primarily based on blockchain technology). The SEC’s Strategic Hub for Innovation and Financial Technology (FinHub) intends the guidance to provide a framework for helping businesses determine whether a digital asset is a security.
“The Framework for “Investment Contract” Analysis of Digital Assets is not intended to be an exhaustive overview of the law, but rather, 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,” Bill Hinman, director of the Division of Corporation Finance, and Valerie Szczepanik, senior advisor for Digital Assets and Innovation said in a public statement.
Digital Assets Plagued by Regulatory Uncertainty
While blockchain and distributed ledger technology grew rapidly in recent years, it hit a snag with regulatory pushback and legal concern for the “issuers”, which some attribute to a rapid decline of coin or token offerings, the laws governing digital assets such as coins/tokens have been slow to evolve.
As discussed in prior articles, the term “security” can include an “investment contract,” as well as other instruments such as stocks, bonds, and transferable shares. As a result, prior to the new framework for digital assets, the SEC, courts and businesses were largely relying upon informal guidance, derived from the “investment contract” analysis, which came to be known as the “Howey Test” from 1946 contract.
In SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946), the Court defined “investment contract” as a contract, transaction or scheme in which (i) a person invests money in a common enterprise; (ii) with a reasonable expectation of profits; (iii) to be derived from the entrepreneurial or managerial efforts of others. As explained by the Court, this definition embodies a “flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”
In prior guidance and enforcement actions involving the offer and sale of coin/tokens, the SEC had made it clear a digital asset may fall within the definition of a security under the U.S. federal securities laws, depending on what rights it purports to convey and how it is offered and sold. The federal securities laws generally require all offers and sales of securities, including those involving a digital asset, to either be registered under its provisions or to qualify for an exemption from registration.
SEC’s Digital Asset Framework
The SEC’s Framework for “Investment Contract” Analysis of Digital Assets provides a framework for analyzing whether a digital asset is an investment contract and whether offers and sales of a digital asset are securities transactions. To do so, FinHub addresses the elements of the Howey test and discusses how it applies to digital assets. So while the framework is not breaking new ground, it does provide greater insight on how the SEC conducts its analysis.
As the framework highlights, 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. In addition, courts have also found that a “common enterprise” typically exists, which satisfies the second prong of the test.
The third prong — whether a purchaser has a reasonable expectation of profits (or other financial returns) derived from the efforts of others — is usually determinative and requires the most analysis. As the SEC explains:
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 this prong of the test is met. Relevant to this inquiry is the “economic reality” of the transaction and “what character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect.”
To aid in this analysis, the SEC lists characteristics that make it more likely that a purchaser of a digital asset is relying on the “efforts of others.” While too numerous to include in this article, they include where an AP has a lead or central role in the direction of the ongoing development of the network or the digital asset and where 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 SEC’s framework also details characteristics that make it more likely that there is a reasonable expectation of profit. They include the following: 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; and there is little apparent correlation between the purchase/offering price of the digital asset and the market price of the particular goods or services that can be acquired in exchange for the digital asset.
The SEC has already issued a No-Action Letter in connection with this analytical framework.
Key Takeaway for Businesses Involved in Digital Assets
In its guidance, the SEC makes it clear that “[m]arket participants may engage in activities that require registration of transactions and persons or entities involved in [digital asset] transactions.” Even if no registration is required, activities involving digital assets that are securities may still be subject to the SEC's regulation and oversight. According to the SEC, the information contained in the new digital assets framework is intended to apply to entities conducting the following activities related to digital assets:
- offering, selling, or distributing
- marketing or promoting
- buying, selling, or trading
- facilitating exchanges
- holding or storing
- offering financial services such as management or advice
- other professional services
Finally, it is important to emphasize that the framework represents Staff views and is not a rule, regulation, or statement of the Commission. In addition, the framework was not approved by the Commission and is not binding on it. This area is still one in flux and can change at any time. For detailed advice, we encourage businesses and investors to consult with an experienced securities attorney.
If you have any questions, please contact us
If you have any questions or if you would like to discuss the matter further, please contact me, Jeff Cassin, or the Scarinci Hollenbeck attorney with whom you work, at 201-806-3364.