SEC Hints What Crypto Assets Might be Securities (UPDATED 3)
On Wednesday, in a long-awaited move, a division at the U.S. Securities and Exchange Commission (SEC) released a framework for analyzing whether a digital asset is offered and sold as an investment contract, and, therefore, is a security.
(Updated on April 3, 17:04 UTC: two new sections - "Nothing new here" and "A no-action request" - have been added.
Updated on April 3, 18:26 UTC: two new paragraphs in the beginning of the "Nothing new here" section have been added.
Updated on April 4, 03:39 UTC: a new video with comments by a lawyer has been added to the "Nothing new here" section)
However, in an announcement, Bill Hinman, Director of Division of Corporation Finance at SEC, and Valerie Szczepanik, Senior Advisor for Digital Assets and Innovation at SEC, stressed that the framework 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."
"This framework represents Staff views and is not a rule, regulation, or statement of the Commission. The Commission has neither approved nor disapproved its content," they added.
According to them, the information contained in this framework may 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
The framework focuses on the Howey test that helps to determine whether an asset, including digital assets, is an "investment contract."
"Usually, the main issue in analyzing a digital asset under the Howey test is whether a purchaser has a reasonable expectation of profits (or other financial returns) derived from the efforts of others," according to the framework.
It goes further to explain:
"A purchaser may expect to realize a return through participating in distributions or through other methods of realizing appreciation on the asset, such as selling at a gain in a secondary market.
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.” The inquiry, therefore, is an objective one, focused on the transaction itself and the manner in which the digital asset is offered and sold."
The framework also listed the following characteristics that are important in evaluating a digital asset - "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 assets’ 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.
- Prospects for appreciation in the value of the digital asset are limited.
- 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.
- With respect to a digital asset that represents rights to a good or service, it currently can be redeemed within a developed network or platform to acquire or otherwise use those goods or services.
- 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.
However, the document added that 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, there may be securities transactions.
According to the framework, in this case, among other factors, 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.
"Nothing new here"
"This guidance not only confirms that cryptocurrencies like Bitcoin and Ethereum are not securities, it also goes a long way in helping entrepreneurs and technologists who have done the right thing know that they have done the right thing, and it should help those who want to build new networks know how the securities laws will be applied," Peter Van Valkenburgh, director of research at the Coin Center, a Washington based crypto-focused research and advocacy center, wrote in commentary on the framework.
According to him, the bottom line is that it is possible to fundraise by selling tokens in compliance with the securities laws and then have those tokens be clearly not securities when the promoter is no longer essential to the continued viability of the project.
Meanwhile, lawyer, blockchain enthusiast Preston Byrne tweeted that "there's really nothing new here."
"Any lawyer looking realistically at token sales will have given advice along these lines for years," he said.
Anyway. tl;dr, the SEC doc and the no-action letter are, legally speaking, nothingburgers. What these documents tell us is that the Commission understands the issues and is unlikely to be swayed by technobabble.— Preston Byrne (@prestonjbyrne) April 3, 2019
According to Philip Liu, co-founder and chief legal officer of Arca, a Los Angeles-based crypto investment management firm, "the SEC just says if you issue tokens based on blockchain for use as a mere exchange mechanism for existing goods and services, the tokens are not a security."
Andrew "Drew" Hinkes, co-founder and the General Counsel of investment firm Athena Blockchain, concluded that "it'll be another way for lawyers to analyze offerings and make arguments, but this doesn't create the checklist that so many have begged for- which makes sense."
"The SEC wants you to talk to get lawyers and to communicate with the SEC on Finhub," he said in a tweet.
In March, SEC Chairman Jay Clayton also clarified his position on crypto, however, not everyone was convinced back then.
Stephen Palley, a partner at U.S.-based corporate law firm Anderson Kill, discusses what the framework means for ICOs
A no-action request
Also, the Division of Corporation Finance issued a no-action request regarding TurnKey Jet (TKJ), a private aviation firm, concluding that tokens issued by the company are not securities.
According to the Division, these are the reasons why it will not recommend enforcement action to the Commission:
- 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;
- the Tokens will be immediately usable for their intended functionality (purchasing air charter services) at the time they 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.
Blockchain and finance deal lawyer Joshua Ashley Klayman commented:
In my view, the issuance of a no action letter is very meaningful for the industry...while necessarily limited in scope, at least it is a concrete example of an approach that would not result in enforcement.— Joshua Ashley Klayman (@josh_blockchain) April 3, 2019