On June 14, William Hinman, Director of the Division of Corporation Finance of the SEC, delivered a speech at the Yahoo Finance All Markets Summit in San Francisco, in which he laid out the analysis applied by the SEC staff in assessing whether a digital asset constitutes a security. The speech, which has been published on the SEC's website, 1 provides two sets of non-exhaustive factors (discussed below) to use in assessing the status of a given asset as a security. However, the speech emphasizes that the SEC will continue to focus on the economic substance of transactions to determine when the securities laws are applicable, and where those transactions involve raising capital from investors to fund a venture, the securities laws generally will apply.
Without addressing any other digital asset specifically, Hinman separately confirmed that current offers and sales of ether and bitcoin are not securities transactions. In reaching this conclusion, Hinman focused on the operational and decentralized nature of the underlying networks on which these two digital assets exist.
The Securities and Exchange Commission (the "SEC") has been following and monitoring the development of initial coin offerings ("ICOs") and digital assets closely, giving particular attention to the issue of whether digital assets are securities under the U.S. federal securities laws.2 To further this effort, Valerie A. Szczepanik was appointed earlier this month to serve as Associate Director of the Division of Corporation Finance and Senior Advisor for Digital Assets and Innovation for Mr. Hinman, as director of the Division.3
Hinman's speech at the Yahoo Finance All Markets Summit included observations and comments on the nature of digital assets and digital asset transactions generally, mirroring prior SEC statements that have suggested that a digital asset may, in certain circumstances, not be viewed as a security.4 Hinman began by stating that the analysis should "focus not on the digital asset itself, but on the circumstances surrounding the digital asset and the manner in which it is sold."
Hinman emphasized several core principles to keep in mind when assessing whether a particular digital asset transaction implicates the securities laws, in each case focusing on the analysis in Howey5-- specifically, whether the value received for the digital asset is invested in a common enterprise with an expectation of profit derived from the efforts of others. Acknowledging that, in many cases, the digital asset itself may not be a security, Hinman noted that when the asset is sold in a way that causes investors to have a reasonable expectation of profits based on the efforts of others, the sale involves an investment contract within the meaning of Howey. When the network on which the digital asset functions becomes sufficiently decentralized that this expectation no longer exists, the same asset may no longer be treated as a security. Citing the Gary Plastic6 case, as well as Howey, as examples, Hinman noted that even an instrument that is not itself a security may become subject to securities regulations depending on how and why it is sold.
Applying this conceptual framework to bitcoin and ether, two of the most prominent virtual currencies in current use, Hinman observed:
[W]hen I look at Bitcoin today, I do not see a central third party whose efforts are a key determining factor in the enterprise. The network on which Bitcoin functions is operational and appears to have been decentralized for some time, perhaps from inception. Applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value. And putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions. And, as with Bitcoin, applying the disclosure regime of the federal securities laws to current transactions in Ether would seem to add little value.7
Hinman provided two sets of factors to consider in assessing whether a digital asset transaction will be subject to the securities laws. In previewing the factors, Hinman noted that the primary issue is "whether a third party . . . drives the expectation of a return" and whether the digital asset functions "more like a consumer item and less like a security." The factors he proposed to assess these two tests are set forth in full in an appendix to this memorandum.
Hinman's remarks concluded by encouraging promoters of digital assets and their counsel to engage in dialogue with the SEC, noting that the Division of Corporation Finance stands prepared to provide more formal interpretive or no-action guidance about the proper characterization of a digital asset in a proposed use.8 In addition, the speech noted that other divisions at the SEC will guide market participants through other related issues, including those relating to broker-dealers, exchanges, market manipulation, custody and valuation.