Yesterday, a senior U.S. Securities and Exchange Commission (SEC) official announced that Ethereum will not be regulated as a security – at least not in its “present state.”
The statement was part of a broader speech made by SEC Director of Corporate Finance William Hinman on June 13, 2018 at the Yahoo! Finance All Markets Summit: Crypto in San Francisco. In addition to signaling that Ethereum is not currently on the SEC’s target list, Hinman used the opportunity to provide some long-awaited guidance on the SEC’s view of when a coin offering is and is not likely to be a security.
Hinman first explained his view of what he “often” sees in coin offerings: promoters raising funds to build the network on which the coin will operate, the success of which will generate a return for investors who sell their coins on the secondary market once the value has increased. Under this model, according to Hinman, “the economic substance is the same as a conventional securities offering” because the purchaser usually has no choice but to rely on the coin’s promoter to build the enterprise and make it successful. “At that stage,” Hinman explains, “the purchase of a token looks a lot like a bet on the success of the enterprise and not the purchase of something used to exchange for goods or services on the network.” And in keeping with the SEC’s consistent messaging that form will be disregarded for substance, Hinman emphasized that labeling a security offering as a “utility token” is no more availing than the defendants’ attempt in SEC v. Howey, 328 U.S. 293 (1946) to claim that investment contracts in an orange grove were merely real estate transactions.
In Howey, a hotel operator sold interests in an orange grove to its guests and claimed it was selling real estate, not securities. However, the transactions included a service contract for the defendant to grow and harvest the oranges, with the profits going to the investors. While the investors could have done the cultivation work themselves, most did not. They were passive and relied on the efforts of the defendant to turn a profit from the orange grove. Hinman noted yesterday that, “as in Howey – where interests in the groves were sold to hotel guests, not farmers – tokens and coins typically are sold to a wide audience rather than to persons who are likely to use them on the network.” Those purchasers, like the Howey investors, are passive, relying on the coin’s promoters to create a successful application that will yield a return.
Thus, strictly speaking, the token or coin by itself is not a security; just as the orange groves in Howey were not securities. The central questions are how is the asset being sold and what are the purchasers’ reasonable expectations. If a coin that can be exchanged for cloud storage on the promoter’s network is sold to a targeted group of purchasers who are likely to actually use the coin to purchase cloud storage, there is a good argument it is not. But where that coin is marketed and sold to a wide audience of “non-users” as part of an investment offering to fund the promoter’s development of the cloud storage enterprise in the first place, Hinman noted that sale “can be, and, in that context, most often is, a security – because it evidences an investment contract.”
In those circumstances, the success of the investment depends on the promoter’s abilities and efforts. And, it is in those circumstances that the SEC requires accurate disclosures of material information concerning the promoter (its background, financing, plans, financial stake, etc.) and the risks to potential investors to eliminate information asymmetry and permit investors to make an informed decision.
But, as Hinman explained, those same hallmarks of a digital asset investment contract also inform when a coin offering would not be viewed as a security. Where a coin’s network is already “sufficiently decentralized” such that purchasers “would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts,” the assets may not represent an investment contract. Hinman notes that in such a scenario where a network is “truly decentralized,” the “efforts of the third party are no longer a key factor for determining the enterprise’s success,” the “material information asymmetries recede,” and “the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful.”
Such rationale set the stage for Hinman’s statement yesterday about Ethereum: “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.” The same focus on decentralization surrounded SEC Chairman Clayton’s recent statement in a June 6 CNBC interview that Bitcoin also is not a security.
Hinman’s remarks about Ethereum are a welcomed clarification following the recent debate on the matter. In April, the New York Times reported that former financial regulator Gary Gensler believed there was a “strong case” that Ethereum is a “noncompliant securit[y].” And in May, the Wall Street Journal reported that some regulators thought Ethereum’s 2014 initial offering was likely an illegal sale and that the coin is now in a regulatory “gray zone.”
But the decentralized nature of Ethereum as well as the fact that Ether coins are given out via mining – or, to use a Howey analogy, the fact the oranges are now harvesting themselves – has apparently moved the world’s leading altcoin out of the gray zone and into the clear.
At his conclusion, Mr. Hinman provided a non-exhaustive list of questions to consider when seeking guidance on whether a coin offering is a security. Regarding whether the expectation of profit is driven by a third party or group of coordinated actors, consider:
- Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value?
- Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?
- Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?
- Are purchasers “investing,” that is seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?
- Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?
And, regarding whether the circumstances and structure of a coin offering are likely to evince an investment contract, consider:
- Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?
- Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading?
- Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent?
- Are the tokens distributed in ways to meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?
- Is the asset marketed and distributed to potential users or the general public?
- Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?
- Is the application fully functioning or in early stages of development?
Hinman’s statements are by no means a set of bright line rules, but they are a significant leap forward from the SEC’s prior commentary about when a coin offering may need to be registered. Hinman also made clear that the SEC is prepared to provide more formal guidance – whether through interpretations or non-action letter – about the proper characterization of a token or a coin in a proposed use situation.