Since the introduction of digital assets, including digital “coins” or “tokens,” market participants have been left to speculate if they should fall under the purview of federal securities laws. U.S. Securities and Exchange Commission (SEC) Chairman Jay Clayton and Director of the Division of Corporate Finance William Hinman had previously provided significant guidance on the applicability of federal securities laws to Initial Coin Offerings (ICOs) and the sale of digital tokens (see our January 2018 blog post available here and our June 2018 blog post available here), but up to now the SEC had not officially released its position. On April 3rd, the regulator released much anticipated guidance that ends any speculation and confirms advice Michael Best provided to clients to date (see, for example, our analysis of the application of federal securities laws to digital assets in this Utah Bar Journal article).
Whether or not federal securities laws are applicable depends on whether an offering involves a “security.” Federal securities laws provide an extensive list of items classified as a “security.” One of such items is the broad term “investment contract.” In SEC v. W.J. Howey Co., 328 U.S. 293 (1946), the Court articulated the so-called “Howey test” to determine if an investment is considered an “investment contract.” The elements of the Howey test are: (i) an investment of value, (ii) in a common enterprise, (iii) with an expectation of profit, (iv) that are derived from the efforts of others. If all four elements are met, then such investment would be classified as an investment contract, and thus triggering federal securities laws.
The SEC’s guidance contemplates ICOs and whether such offerings involve securities under federal securities laws. The guidance breaks down each element of the Howey test and how such element would apply to digital assets. The guidance explains that when the Howey test is applied to digital assets, the first and second criteria (an investment of value, in a common enterprise) are often met. As a result, the guidance focuses more on the considerations for determining if an offering of a digital asset meets the third and fourth criteria (an expectation of profit, derived from the efforts of others). The guidance also identifies some of the factors market participants should consider in determining whether and when a digital asset may no longer be a security.
The same day the guidance was published on the SEC’s website, the Division of Corporation Finance released a No Action Letter that stated it would not recommend enforcement against TurnKey Jet, Inc. for its use of digital tokens to facilitate the purchase of private jet flights. The SEC’s determination was based on TurnKey Jet’s argument that its digital tokens are not sold with the expectation of profit, because buyers would be unlikely to resell them for a financial gain, and thus would fail the third prong of the Howey test. TurnKey Jet’s tokens can be analogized to trading stamps redeemable for cash or meal tickets.