Last week, William Hinman, the Director of the Division of Corporate Finance of the Securities and Exchange Commission, said that the cryptoasset Ether is not a security. It may have once been a security, but not today. As a result, transactions involving Ether are not securities transactions.
Moreover, in a speech before the Yahoo Finance All Markets Summit in San Francisco, Mr. Hinman additionally indicated that he could envision that certain utility tokens might also not be securities. He said that such a conclusion might be appropriate “where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created.”
Typically, the term “utility token” references a digital token that has express functionality authorizing a holder to access or purchase assets based on a specific blockchain technology.
According to Mr. Hinman, when promoters raise money to build networks on which digital assets will operate and investors purchase such tokens with the expectation of selling their tokens in the secondary market, an investment contract likely exists – which is a type of security under applicable law – requiring registration for the digital token to be issued and sold to the public, or a valid exemption. In these cases, investors are passive, marketing is not ordinarily targeted solely to token users, and the likelihood of success of the underlying system is uncertain. In such cases, said Mr. Hinman, “[t]he purchaser usually has no choice but to rely on the efforts of the promoter to build the network and make the enterprise a success.” These characteristics, intimated Mr. Hinman, satisfy the tests of the Supreme Court’s 1946 SEC v. Howey decision, and make the cryptoasset a security.
According to the Supreme Court, an investment contract constitutes (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived solely from the entrepreneurial or managerial efforts of others.(Click here for a discussion of the Howey tests in the article “SEC Declines to Prosecute Issuer of Digital Tokens That It Deems Securities Not Issued in Accordance with US Securities Laws” in the July 26, 2017 edition of Between Bridges. Click here to access the Howey decision.)
However, a token that might have been a security at one point in time may cease being a security over time, said Mr. Hinman. This could happen when “the network on which the token or coin is to function is sufficiently decentralized – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts.” According to Mr. Hinman this is what happened to Ether which initially was distributed through fundraising and now has a “decentralized structure.”
In evaluating whether a digital token is likely a security, Mr. Hinman set forth 13 considerations, including:
- Is there a single person or small group that is behind the sale of the digital asset and who play a “significant role” in the development and maintenance of the token and its potential increase in worth?
- Does this person or group have a stake or other interest in the digital token and are they incentivized to cause an increase in value of the digital asset? Do purchasers anticipate such an effort and increase in value?
- Do the customer protection provisions of applicable law make sense, including disclosure obligations of a person or entity that plays a key role in the system?
- Do persons or entities other than the promoters exercise governance rights?
- Is token creation tied to the needs of users or for speculation?
- Is the token marketed and distributed to the general public?
- Is the system underlying the token fully functioning or in the early stages of development?
The Canadian Securities Administrators also issued guidance regarding when digital tokens are subject to securities laws and not utility tokens. CSA’s analysis generally followed Mr. Hinman’s analytic approach. According to CSA, “[i]n analyzing whether an offering of tokens involves an investment contract, businesses and professional advisors should assess not only the technical characteristics of the token itself, but the economic realities of the offering as a whole, with a focus on substance over form.”
Unlike Mr. Hinman who solely proposed considerations to evaluate, CSA provided 14 fact patterns derived from actual episodes it has considered, and provided its conclusions as to whether the relevant digital token had characteristics of a security or not.
In one example where the number of tokens was limited and the expectation that access to new tokens in the future would also be limited, CSA concluded that “initial purchasers may have an expectation of profit as increased demand with limited or reduced supply should lead to an increase in price.” This would suggest the digital token is a security.
Contrariwise, CSA concluded that where digital tokens have a fixed value that does not “automatically” increase over time or change “based on non-commercial factors,” there is likely a lesser expectation of profit by a digital holder. This would seem to suggest the cryptoasset is more likely not a security.
In his presentation, Mr. Hinman also reconfirmed that Bitcoin is not a security.
My View: Mr. Hinman’s detailed analysis of digital tokens and recognition that the characteristics of a digital token (such as Ether) may change over time – likely resulting in a different legal categorization – were overdue but very much welcomed. Moreover, his and CSA’s articulation of specific considerations in evaluating tokens is very helpful. (Click here to access other possible considerations in the PowerPoint download to the webinar “Beyond Bitcoin” by Katten Muchin Rosenman LLP and hosted by FIA on May 17, 2018.) However, at the fringes, it still is unclear when market appreciation might be considered derived from a promoter’s hype as opposed to investor sentiment. It is still troubling to me that, applying the SEC's broad view of Howey, smart kids who purchased and held, as collectibles, Beanie Babies promoted by Ty Inc. years ago, and later eagerly resold the Beanies Babies on eBay for a profit, potentially could have been considered to have been transacting in securities.
Ripple will be the next challenging digital asset for the SEC to provide its views on. Because of its powerful central governance, ongoing offering, and restricted consensus protocol, the SEC could very well see it more like a security than not. However, like Ether, Ripple is going through an evolution to become more decentralized, and XRP – the Ripple digital token – is designed and operates more like a payment mechanism than anything else. The large number of XRP outstanding also makes it more likely that the digital token will not appreciate markedly, although the promoters’ decision last year to make available no more than one billion XRP tokens monthly may augment its appeal as a speculative play. This is a digital asset on the cusp, but it still appears more likely not a security to me.
The issue of whether Ripple is a security is front and center in a purported class action lawsuit filed in a California state court last month, as well as a more recent case filed on June 5. (Click here for background regarding the first legal action in the article, “Class Action Lawsuit Filed Against Ripple Labs for Unregistered Sales of Securities” in the May 6, 2018 edition of Bridging the Week. Click here for a copy of the complaint in the second action.)
Legal Weeds: There is no unanimity among countries as to when digital tokens may be securities. The government of Gibraltar, for example, issued a proposal for the regulation of digital token sales, secondary digital token market platforms, and investment services relating to non-security and non-virtual currency digital tokens during March 2018, that expressed a narrow view of what constitutes a security token. According to Gibraltar Finance, most digital tokens are not securities because they are not structured as such – meaning they afford no equity interest or right to distributions (e.g., of profits or in the event of a firm’s insolvency). They more often represent “the advance sale of products that entitle holders to access future networks or consume financial services” – and thus represent “commercial products,” or have the characteristics of virtual currencies. (Click here for further information regarding Gibraltar’s views in the article “Gibraltar Suggests Many ICO-Issued Digital Tokens Are Commercial Products, Not Securities” in the March 18, 2018 edition of Bridging the Week.)
This is very different from the view of the SEC which claims that the expectation of profit can be derived by the anticipation of capital appreciation through secondary trading of the relevant digital asset.
In February 2018, the Swiss Financial Market Supervisory Authority (FINMA) provided its insight into the nature of different types of digital tokens – which it termed “payment tokens (e.g., virtual currencies),” “utility tokens” and “asset tokens (e.g., securities tokens).” FINMA defined utility tokens as tokens “intended to provide access digitally to an application or service by means of a blockchain-based infrastructure.” The regulator indicated it would not consider utility tokens as securities if the tokens’ “sole purpose” was to confer digital access rights at the time of issue. However, if a utility token could additionally or only have an investment purpose at the time of issue, it would be treated as an asset token too. (Click here for further background in the article “SEC Sues Bitcoin-Denominated Trading Platform for Operating an Unlicensed Securities Exchange; Principal Criminally Charge” in the February 25, 2018 edition of Bridging the Week.)