Late last week, William Hinman, Director of the SEC’s Division of Corporation Finance, speaking at a Yahoo Finance Summit, discussed whether a digital asset that was a security when it was originally issued could ever be resold in a manner that does not constitute the offer and sale of a security. See the text of the speech here. To the relief of many in the digital community, Hinman concluded that in cases “where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created,” the digital asset may, depending on the circumstances, cease to be a security.
Hinman applied this analysis to Bitcoin and Ether. With Bitcoin, he did not see a “central third party” whose efforts were a key determinant in the ongoing success of the enterprise. The network on which Bitcoin functions has been operational and decentralized for some time and perhaps always has been. For Ether, Hinman led off by “putting aside the fundraising that accompanied the creation of Ether,” suggesting that Ether may have been a security when it was first issued. But today, he explained, in light of the Ethereum network’s decentralized structure, sales of Ether today are not securities transactions. In the cases of both Bitcoin and Ether, Hinman noted that applying the disclosure regimen of the federal securities laws to trades of those digital assets in light of the current state of their networks would not add much value to purchasers. However, for “systems that rely on central actors whose efforts are a key to the success of the enterprise,” the securities laws serve to protect investors who purchase tokens or coins.
The SEC staff’s position on Bitcoin and Ether may have been welcome news to the digital asset community. However, much of Hinman’s speech was a thorough discussion of the SEC’s continuing position that most initial coin offerings, token-generating events or other issuances and sales of digital assets, regardless of their labels, are securities offerings that must be registered under the Securities Act of 1933 or for which an exemption from registration must be available.
Hinman’s speech confirms that the SEC staff still views the Howey investment contract analysis as the primary lens through which a digital asset’s status as a security should be analyzed. In SEC v. W.J. Howey Co., 328 U.S. 293 (1946), the U.S. Supreme Court held that an investment of money in a common enterprise with an expectation of profit from the efforts of others is an investment contract and therefore a “security” within the meaning of the Securities Act. However, in a footnote to the published speech, Hinman noted that, depending on the features of any given asset, it may also need to be evaluated under the general definition of a security in Section 2(a)(1) of the ’33 Act. This leaves open the possibility that the staff or the courts might use other theories to analyze digital assets in the future, particularly if courts do not accept Howey as the proper test for determining whether digital assets are securities.
Some have called for an entirely new approach to regulating digital assets, through either legislation or SEC rulemaking, that takes into account the unique nature and evolution of digital assets instead of relying on the Howey test, an approach adopted over 70 years ago that has been applied to assets such as interests in a citrus grove and whiskey warehouse receipts. There was no hint from Hinman that any rulemaking was underway to regulate digital assets specially. However, by acknowledging the dynamic nature of digital assets, including that an asset once issued as a security may cease to be a security, the SEC is signaling a willingness to be flexible in its application of the securities laws to emerging technologies, so long as that flexibility is consistent with the protection of investors.
Hinman invited promoters and their counsel to approach the SEC staff for interpretive guidance or no-action relief on the proper characterization of a proposed digital asset. In the meantime, he offered over a dozen factors to consider in analyzing whether a digital asset is an investment contract and therefore a security. The crux of these factors continues to be the existence of a sponsor or a promoter playing a significant role in the development and maintenance of the asset and its potential to increase in value; the manner in which the assets are offered and sold, including whether they are marketed to the general public instead of solely to potential users of a network; and whether information asymmetries exist between the promotors and potential purchasers.
In sum, Hinman’s speech reflected a reaffirmation of the staff’s position on ICOs as securities, while evidencing a flexible approach to the ongoing application of the federal securities laws to the secondary sale of digital assets.