Last month, SEC officials began to place additional definition around the raging debate over whether digital assets, including tokens, are securities, in a June 14 speech by William Hinman, the SEC’s Director of the Division of Corporate Finance. Until that speech, much commentary had focused on the repeat statements by SEC officials that digital assets distributed in initial coin offerings (ICOs) are almost always securities in the SEC’s view, with the possible exception of widely disseminated cryptocurrencies like Bitcoin. Hinman’s remarks set out the view that, in their initial phases, tokens are more likely to qualify as securities under the Supreme Court’s Howey test, but in limited circumstances may, over time, shed enough of the characteristics of securities to lose that designation. Under the rubric Hinman laid out, the new hallmark of success for a token project may become the point at which a project’s tokens are so widely used that they function without any centralized efforts and lose their securities status. This post lays out some of the background and considerations under this new framework.
Hinman Lays Out a Framework
In his June 14 speech, Hinman addressed a hotly debated issue in the cryptocurrency world: which tokens, if any, are securities and which aren’t? His remarks started by covering well-trod territory explaining why cryptocurrencies issued in ICOs are generally securities, but, later in his remarks, added important comments that could shift the ground beneath current thinking.
At the outset, and consistent with past comments from Hinman and other SEC staff, Hinman stated that most, if not all, sales of digital assets in ICOs he has seen satisfy Howey’s “investment contract” test and should be treated as securities. In reaching this conclusion, Hinman explained that token promoters tend to tout their ability to create an innovative application of blockchain technology; that investors are passive; that marketing efforts are rarely targeted to token users; and that, although the business model is still uncertain, purchasers usually must rely on the efforts of the promoter to build the network and make the enterprise a success. “At that stage,” Hinman said, “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.”
The ground-shift came in Hinman’s next explanation: that tokens that start out as securities, can later change their characteristics such that they no longer would be securities. He explained, “[i]f 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—the assets may not represent an investment contract. Moreover, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede.” In other words, issuers may structure their token platforms in a manner that initially requires significant setup and investment, but, if the network and tokens eventually become self-sustaining, the tokens can lose their status as securities.
Having drawn this distinction between more and less mature projects, Hinman then laid out a variety of questions relevant to the analysis of which side of the line a particular project (or a particular project at a particular time) would fall:
- 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 was careful to note that this list of factors was not exclusive, however, and to state that not every factor would need to be present to find that a token was not a security. Indeed, while laying out these factors, Hinman reiterated that the north star of the analysis is the economic substance of the transaction. In Hinman’s words:
Again, we would look to the economic substance of the transaction, but promoters and their counsels should consider these, and other, possible features. This list is not intended to be exhaustive and by no means do I believe each and every one of these factors needs to be present to establish a case that a token is not being offered as a security. This list is meant to prompt thinking by promoters and their counsel, and start the dialogue with the staff—it is not meant to be a list of all necessary factors in a legal analysis.
Based on this framework, Hinman concluded that applying the disclosure regime of the federal securities laws to current transactions in Bitcoin and Ether would add little value because the networks are decentralized and there is no third party whose efforts are a key determining factor in the enterprises. But each project will require its own analysis to determine whether it bears sufficient indicia to not be deemed a security by the SEC.
Clayton Confirms Hinman’s Framework
It appears that Hinman’s view is not a one-off. Testifying before the Committee on Financial Services of the U.S. House of Representatives, SEC Chairman Jay Clayton referred to Hinman’s June 14, 2018 remarks saying, “[o]ur Corporation Finance Division Director recently further outlined the approach staff takes to evaluate whether a digital asset is a security.” Clayton’s reference suggests that Hinman’s framework is not merely his personal view, but rather an approach taken by the staff as a whole.
Hinman’s and Clayton’s remarks create somewhat more certainty about an approach to regulatory compliance for a group of issuers that has been in regulatory limbo. A class of companies and token holders—mostly related to digital assets issued back at a time when the crypto community was of a view that a “utility token” would not be treated as a security—was caught between a rock and a hard place as it became evident that the SEC Chairman and staff had a broader view of which tokens constituted securities (i.e., most tokens issued in ICOs) than most in the crypto community had originally believed. These issuers who had already conducted ICOs based on the idea that their tokens were not securities were left with few and poor options to develop their platform and transact in their tokens without running into potential securities law violations. Common questions in the community included whether, when, and how the SEC would create a way forward for these companies and digital assets.
Now we know a little more. For platforms designed to run independently after a certain point—or that can be adapted to do so—tokens that the SEC would previously consider securities may transition and become non-securities tokens. The factors laid out by Hinman establish a useful baseline for predicting where the SEC will draw the line, with project participants on notice that they will need to comply with securities laws until platforms are “sufficiently decentralized.”
But numerous issues still remain. The concept of being “sufficiently decentralized” has not yet been tested, and some reports draw into question just how decentralized certain cryptocurrency ecosystems truly are. Recently, for instance, reports indicated that the zCash Foundation paid money to a developer to prevent a fork of the protocol. Likewise, earlier this year, a report prepared by researchers at Cornell indicated that neither Ether nor Bitcoin was as decentralized as initially thought. This issue will likely be tested in the months and years to come. Further, projects may need to add new disclosures around the transition from securities tokens to non-securities tokens, including that the protections of the securities law may, at some point, cease to apply. And, in addition, some commentators have surmised that this new framework may breathe new life into the movement for the use of Simple Agreement for Future Tokens (SAFTs); however, no SEC official has formally endorsed SAFTs and Hinman’s prepared remarks expressly disavowed any view on whether any particular SAFT passed muster, noting that each case is reviewed on its particular economic substance and advising those with questions to contact the SEC.
In all, these and other questions will continue to be debated. And, as the market develops its understanding of the mix of factors that will safely render a token a non-security, any potential distributor of tokens should work closely with counsel to ensure its tokens comply with applicable legal requirements.