Long awaited guidance from the US Securities and Exchange Commission (SEC) on application of the Howey test to digital assets came on April 3 in the form of a Framework for “Investment Contract” Analysis of Digital Assets (“Framework”) and a No-Action Letter regarding TurnKey Jet, Inc. (the “TurnKey No-Action Letter”). These two documents are best understood as part of a trilogy with the June 2018 Hinman speech.
The Framework offers the clearest indication yet of the SEC staff’s thinking on the Howey test, with the TurnKey No-Action Letter and the Hinman speech providing examples of where a digital asset fails to meet a necessary element of the test. For purposes of clarity, it helps to think of the Howey test as having four elements: (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) derived from the efforts of others.
The first two prongs are essentially throwaways inasmuch as the Framework devotes only three sentences to them in total. SEC staff note that these prongs are “typically satisfied” in evaluating digital assets. On the other hand, the Framework pays significant attention to the third and fourth elements.
Starting with the “efforts of others” element, the Framework introduces the concept of an “Active Participant” (AP) as a promoter, sponsor, or other third-party (or affiliated group of third-parties) that provides essential managerial efforts that affect the success of the enterprise. The Framework then gives examples of when the actions of the AP are likely to indicate that a purchaser of a digital asset is relying on the efforts of others. In prior cases, the SEC has focused on whether a network is fully functional or still in development, and whether it has achieved the requisite level of decentralization. On this latter point, the Framework confirms that decentralization is to be viewed from a governance and managerial standpoint. The staff is interested in whether the AP has a “central role” in the maintenance and ongoing development of the network. It also may be worth noting that the Framework characterizes this element as “reliance on the efforts of others” in contrast to the DAO report and the Hinman speech, which use the phrase “derived from the managerial efforts of others.” There is no explanation given for this shift in phrasing.
The Framework’s analysis of the “reasonable expectation of profits” element further introduces many new characteristics that may not have historically been viewed as evidence that a purchaser has a reasonable expectation of profits. These include whether the digital asset is transferrable or likely to be so in the future; whether there is correlation between the purchase price of the digital asset and the value of goods or services for which it can be exchanged; or whether the AP is able to benefit as a result of holding the digital asset.
However, the clearest understanding of the staff’s thinking on this element comes from the TurnKey No-Action Letter in which the SEC Division of Corporation Finance staff found a purchaser of tokens sold by TurnKey Jet, Inc. (TKJ and TKJ Tokens) would not have a reasonable expectation of profits. In this case, the token is essentially a dollar-denominated stablecoin that can be used solely to purchase air travel priced in USD, and where any redemptions by the issuer would be at a discount (i.e., less than one USD). The TKJ Token is a means for users and providers of air travel services to avoid various transaction costs and delays associated with credit cards and wire transfers. TKJ Tokens are not likely to appeal to many entrepreneurs who seek the benefits of open-source software development and community networking, such as speed to execution, diverse development activities, sharing of expenditures among multiple network participants, fostering alternative network uses and commercial providers, and diversity of viewpoints in network governance. (See additional insight from Steptoe on the TurnKey No-Action Letter here.)
Fortunately, an investment contract must meet all four elements of the Howey test, and thus most entrepreneurs will focus on whether the purchaser of a token is relying on “the efforts of others.” It was this element upon which Director William Hinman in his June 2018 speech concluded that Ether was not a security. Many of the factors cited in his speech have been incorporated into the Framework, but they are now better understood because they are placed directly in the context of each element of the Howey test, and because there is a greater understanding of what is meant by when a “network on which [a token] is to function is sufficiently decentralized.” These factors include:
- Whether or not the efforts of an AP, including any successor AP, continue to be important to the value of an investment in the digital asset;
- Whether the network on which the digital asset is to function operates in such a manner that purchasers would no longer reasonably expect an AP to carry out essential managerial or entrepreneurial efforts; and
- Whether the efforts of an AP are no longer affecting the enterprise’s success.
While expectations were flying high that the Framework and TurnKey No-Action Letter would answer all outstanding questions concerning token issuances, we believe the Framework and TurnKey No-Action Letter – read together with the Hinman speech – are a positive step forward to providing a clearer flightpath to compliance.