The SEC provides additional guidance for analyzing whether a digital asset is a security.
On April 3, 2019, the U.S. Securities and Exchange Commission’s Strategic Hub for Innovation and Financial Technology (the SEC) released a framework (the Framework) for assessing whether a blockchain-issued token or digital asset (each, a Token) constitutes an investment contract. An investment contract is an enumerated type of security subject to US federal securities laws. The Framework does not have the force of law, but rather, provides additional guidance on the factors to consider when applying the Howey test to Tokens. For background regarding the Howey test, please see Latham’s Client Alert. Latham’s read of the Framework suggests two key takeaways. First, it provides added insight into how existing Tokens may be reevaluated over time and may cease to be subject to federal securities laws. Second, it offers the clearest guidance to date that Tokens that are designed and marketed as purely “virtual currency” should not be considered securities.
The Classification of Tokens Previously Sold in Securities Offerings May Be Reevaluated at the Time of Future Offerings or Sales
The Framework reaffirms a proposition introduced in June 2018 by SEC Director Hinman. He noted in a speech that Tokens once offered as a security may in the future no longer be subject to the securities laws, if, for example, the Token’s network became “sufficiently decentralized.” At that time, Latham noted in a Client Alert that:
In the case of nascent platforms and networks, digital tokens sold in an offering by promoters to “develop the enterprise” will most often constitute securities because the entrepreneurial efforts of the enterprise’s promoters will be the primary source of value creation in the token … But, if the network on which the token functions is sufficiently decentralized – that is, “where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts” – there is less of a public policy need to correct the informational asymmetries the securities laws aim to prevent.
Building on Director Hinman’s initial comments, the Framework focuses the sufficient decentralization discussion on the third prong of the Howey test – whether an investor reasonably expects to derive profits from the efforts of others. The Framework suggests considering the extent to which managerial efforts continue to be important to the value of the Token and the success of the enterprise. In addition, the Framework notes that “price appreciation resulting solely from external market forces … impacting the supply and demand for an underlying asset generally is not considered ‘profit’ under the Howey test.” Thus, a Token would not necessarily be deemed a security if its price rose incidentally “to obtaining the right to use it for its intended functionality.” Other considerations in relation to the expectation of profits may turn on whether the Token’s value or trade volume correlates to the value of the goods or services for which it can be exchanged.
Tokens Used as a Currency Are Less Likely to Constitute Securities Under the Howey Test
The Framework highlights that Tokens designed and marketed as virtual currencies (i.e. those immediately usable for payments in many contexts) are less likely to be considered securities under the Howey test if:
- The Token can be used to pay for goods or services without first having to convert it to fiat currency or another Token.
- The Token operates as a retrievable store of value that can be exchanged for something of value later on.
These principles are applied in the SEC’s no-action letter (the Letter), which was released on the same day as the Framework. The Letter stated that TurnKey Jet Inc.’s (TurnKey’s) proposed Token, designed to pay for charter flights, would not constitute a security. While the market buzzed about the Letter being a first-of-its-kind for Token offerings, the SEC’s conclusion that Turnkey’s Token is not a security followed directly from prior guidance that found that prepaid redeemable credits, such as gift certificates, are not securities (see e.g., Release No. 44-1523, dated February 3, 1976; Release No. 44-4505, dated August 9, 1976). The Framework similarly indicated that “digital assets to be used by consumers to purchase products only on [a] retailer’s network” are not securities. Of course, Tokens characterized as virtual currency may yet constitute securities under the SEC view, regardless of their design, if they are marketed as investments or if the functionality of the network on which they are useable is under development or being improved. The SEC notes in the Framework that this may also be the case where purchasers can buy the Token at a discount to the value of the goods or services for which it may be redeemed, if such Tokens may be freely resold, and if the amount of Tokens offered or sold exceed “reasonable use.”