Amid increasing enforcement activity with respect to cryptocurrencies, coins and tokens, the SEC recently issued guidance intended to provide clarity to the markets. The SEC’s FinHub published a framework to help clarify when digital assets may fall under the purview of the U.S. securities laws. Concurrently, the SEC’s Division of Corporation Finance issued a no-action letter that provides an indication of when it would not recommend enforcement action in the offer and sale of certain digital assets.
Digital asset framework
FinHub’s new framework for digital assets revisits the classic test established by the U.S. Supreme Court in SEC v. W.J. Howey Co., 328 U.S. 293 (1946), for determining when an investment contract constitutes a security. The Howey test provides that an investment contract exists when there is (1) the investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived from the efforts of others.
The SEC indicated that the first two factors are generally satisfied in the offer and sale of a digital asset. There is an “investment of money” if the digital asset is purchased in exchange for value, whether in the form of a real or fiat currency, or another type of consideration. Second, without much analysis, the SEC stated that a “common enterprise” typically exists with digital assets. Accordingly, the framework focuses on the latter two requirements of the Howey test, namely, whether there is a reasonable expectation of profits to be derived from the efforts of others.
The framework indicates the following factors are particularly relevant when determining whether those two prongs of the Howey test are met with respect to digital assets:
- Reliance on the efforts of others: Although no single characteristic is determinative, these factors may indicate reliance.
- An active participant (AP) associated with the digital asset is responsible for the development, improvement, operation or promotion of the network.
- The AP, rather than an unaffiliated, dispersed community of network users, performs essential tasks.
- The AP creates or supports a market for, or the price of, the digital asset.
- The AP has a central role in the direction of the network or digital asset’s ongoing development, namely with respect to governance, code updates or the participation of third parties in transactions.
- The AP has a continuing managerial role with regard to the network or the characteristics of the digital asset.
- Purchasers reasonably expect the AP to undertake efforts to promote its own interests and enhance the value of the network or digital asset.
- Reasonable expectation of profits: The framework also suggests factors that, if present, would increase the likelihood that the purchaser of the digital asset acquired the asset with a reasonable expectation of profits.
- The digital asset gives the holder rights to share in the enterprise’s income or profits, or to realize gain from the appreciation of the digital asset.
- The digital asset is transferable or traded on a secondary market or platform.
- Purchasers expect that an AP’s efforts will result in appreciation of the digital asset and they will be able to earn a return on their purchase.
- The digital asset is offered to a broad range of potential purchasers, rather than being targeted to expected users of the goods or services or to those who have a need for the network’s particular function.
- There is little correlation between the purchase/offering price of the digital asset and the market price of the particular goods or services to be acquired in exchange for the digital asset.
- There is little correlation between quantities the digital asset typically trades in and the amount of the underlying goods or services a typical consumer would purchase for use or consumption.
- The AP has raised an amount of funds exceeding that which may be needed to establish a functional network or digital asset.
- The AP is able to benefit from its efforts as a result of holding the same class of digital assets as those being distributed to the public.
- The AP continues to use funds from proceeds or operations to enhance the network or digital asset’s functionality or value.
- The digital asset is marketed, directly or indirectly, using certain claims such as ready transferability, future functionality or potential profitability.
The framework also delves into an analysis of factors one should consider when determining whether to reevaluate the classification of a digital asset previously sold as a security and outlines a number of other considerations that influence the Howey analysis, some of which were considered in the Division of Corporation Finance’s response to a no-action request described below.
In keeping with the new framework, the Division of Corporation Finance issued a response to a no-action request regarding TurnKey Jet (TKJ) Inc. As background, TKJ was seeking to sell digital assets (called TKJ Tokens) to customers who could exchange them for prepaid, on-demand air charter services. The ultimate business objective was to facilitate air charter service reservations. In its response, the Division indicated that it will not recommend enforcement action to the SEC against TurnKey Jet if its digital assets are offered or sold without registration under the Securities Act and the Exchange Act. In reaching its decision, the Division noted that:
- TKJ will not use any funds from token sales to develop its platform, network or application, all of which will be fully operational when the tokens are sold.
- The tokens will be immediately usable for their intended purpose (purchasing air charter services) at the time they are sold.
- TKJ will restrict transfers of tokens to wallets on its internal platform only.
- TKJ will sell tokens at a unit price of $1 throughout the life of the program, and each token will represent a TKJ obligation to supply air charter services at the same value.
- If TKJ offers to repurchase tokens, it will only do so at a discount to the face value of the tokens that the holder seeks to resell to TKJ, unless a U.S. court orders it to liquidate the tokens.
- The token is marketed in a way that emphasizes its functionality rather than the potential for the increase in its market value.
The SEC’s FinHub framework confirms what many in the industry already assumed, namely, that the reasonable expectation of profits derived from the efforts of others constitute the two most important Howey factors in determining whether a digital asset constitutes a security. In addition, the TKJ no-action letter, while not likely to be applicable to many issuers of digital assets, does provide guidance as to how certain digital assets may be offered and sold as instruments that are not subject to the U.S. securities laws. Any firm unsure about its legal obligations pertaining to digital assets should obtain professional advice to ensure compliance with applicable securities law.