On April 3, 2019, the Strategic Hub for Innovation and Financial Technology – known as “FinHub” – of the U.S. Securities and Exchange Commission (the “SEC”) published a “Framework for ‘Investment Contract’ Analysis of Digital Assets” (the “Guideline”) to provide additional guidance to market participants in determining whether a “digital asset” meets the definition of an “investment contract”, and thus, is a “security” under U.S. federal securities laws. A “digital asset” is defined in the Guideline as “an asset that is issued and transferred using distributed ledger or blockchain technology, including, but not limited to, so-called ‘virtual currencies’, ‘coins’ and ‘tokens’”.
The Guideline is not a rule, regulation or statement of the SEC, nor is it an exhaustive treatment of the legal and regulatory issues relevant to conducting an analysis of whether a digital asset is an investment contract, and thus, a security under U.S. federal securities laws. FinHub expects that the analysis concerning digital assets as securities in the U.S. may evolve over time as the digital asset market matures.
The U.S. Supreme Court in SEC v. Howey1 and subsequent case law have found that an investment contract (and therefore a security) exists when there is (1) an investment of money (2) in a common enterprise with (3) a reasonable expectation of profits (4) to be derived from the efforts of others. The “Howey test” applies to any contract, scheme or transaction, regardless of whether it has any of the characteristics of typical securities. The test focuses not only on the form and terms of an instrument (in this case, a digital asset) but also on the circumstances surrounding the digital asset and the manner in which it is offered, sold or resold. The Guideline confirms that that the level of decentralization present in a token network continues to be a key element in the regulatory analysis.
The Guideline builds upon SEC Director William Hinman`s widely followed speech on token offerings at the Yahoo Financial Summit in June, 2018 and provides a framework for analyzing whether a digital asset has the characteristics of an investment contract in the U.S. and focuses on the third and fourth elements of the “Howey test”.
The Third Element: “Reasonable Expectation of Profits”
The Guideline sets out a list of non-exhaustive characteristics relevant in an analysis of whether the third element of the “Howey test” – a reasonable expectation of profits – is satisfied. The more these characteristics are present, the more likely it is that there is a “reasonable expectation of profits”. These characteristics include:
- 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;
- the digital asset is offered broadly to potential purchasers instead of being targeted to expected users of the goods or services or those who have a need for the functionality of the network;
- purchasers of the digital asset would expect that the efforts of a promoter, sponsor or other third party (or affiliated group of third parties) (each, an “Active Participant” or “AP”) will result in capital appreciation of the digital asset; 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 Fourth Element: Reliance on the Efforts of Others
The Guideline also sets out a list of non-exhaustive characteristics relevant in an analysis of whether the fourth element of the “Howey test” – a reliance of the efforts of others – is satisfied. Although the presence of any one characteristic is not necessarily determinative, the stronger the presence of these characteristics, the more likely it is that a purchaser of a digital asset is relying on the “efforts of others”. These characteristics include:
- the AP is responsible for developing, improving, operating or promoting the network, particularly if purchasers of the digital asset expect the AP to perform or oversee tasks that are necessary for the network or digital asset to achieve or retain its intended purpose or functionality;
- there are essential tasks or responsibilities performed or expected to be performed by the AP, rather than by an unaffiliated, dispersed community of network users (commonly known as a “decentralized” network);
- the AP has a lead or central role in the direction of the ongoing development of the network or the digital asset, particularly in deciding governance issues, code updates or how third parties participate in the validation of transactions that occur with respect to the digital asset; and
- the AP has a continuing managerial role in decision-making concerning the network or the characteristics or the rights of the digital asset.
The Guideline in Action: TurnKey’s SEC No-Action Letter
When an entity or individual is unsure whether a certain action may violate U.S. federal securities law, a “no-action” letter may be requested from the relevant regulating division of the SEC.
On April 2, 2019, TurnKey Jet, Inc. (“TurnKey”), which provides interstate air charter services as a licensed U.S. air carrier and air taxi operator, submitted a request for a no-action letter (the “Request”) to the Division of Corporation Finance of the SEC (the “Division”)2 . TurnKey proposed to offer and sell its digital assets through a private blockchain network. TurnKey proposed to sell its digital assets at a price of U.S.$1.00 per digital asset throughout the life of its digital asset program. Purchasers of TurnKey’s digital assets could redeem the digital assets for air charter services. TurnKey would require purchasers to sign an agreement in which purchasers represented, warranted and acknowledged, among other things, that they are not acquiring the digital assets as an investment and they have no expectation of economic benefit or profit from the digital assets.
On April 3, 2019, the Division stated in response to the Request that, based on the facts presented in the Request and in reliance on the opinion of TurnKey’s counsel set out in the Request that after applying the “Howey test” TurnKey’s digital assets are not an investment contract nor are they a security on any other basis, it will not recommend enforcement action to the SEC if TurnKey offers and sells its digital assets without registration under U.S. federal securities laws. In reaching this position, the Division noted, among other things, that:
- TurnKey would not use any funds from its digital asset sales to develop its platform or network and its platform and network will be fully developed and operational at the time any of its digital assets are sold;
- the digital assets will be immediately usable for their intended functionality (purchasing air charter services) at the time they are sold;
- TurnKey will sell its digital assets at a price of U.S.$1.00 per digital asset throughout the life of its digital asset program, and each digital asset will represent a TurnKey obligation to supply air charter services at a value of U.S.$1.00 per digital asset;
- if TurnKey offers to repurchase its digital assets, it will only do so at a discount to the U.S.$1.00 face value of the digital assets, unless a court within the U.S. orders otherwise; and
- TurnKey’s digital assets are marketed in a manner that emphasizes the functionality of the digital assets, and not the potential for the increase in their market value.
The Guideline sets out certain considerations that can assist issuers and other market participants in determining if a digital asset is an investment contract, and consequently, a security under U.S. federal securities laws. The Guideline and the TurnKey “no action” letter provide that not every digital asset will be a security in the U.S. However, digital asset issuers and their legal counsel in the U.S. and in Canada will need to carefully analyze the characteristics of a digital asset and the manner in which it is offered, sold or resold in order to determine if it is a security in their jurisdiction.