On April 3, the SEC issued a letter which assures investors in a company that issues a digital token for the purposes of raising capital that it will not take an enforcement action against the company. The letter was accompanied by a published framework by the SEC for analyzing whether a digital asset is offered and sold as an investment contract, and, therefore, is a security.
The communications are loose guidance but show the world that the SEC understands the issues facing regulation over the digital assets industry. While additional guidance will likely come in the form of future legal decisions, non-lawyers like myself are excited to see anything from the SEC on digital assets.
The Howey Test: What Makes an Asset a Security?
Like any other asset, digital assets should be analyzed to determine whether they have any characteristic of a product that meets the definition of a “security” under the federal securities laws. The term “security” includes an investment contract as well as other instruments such as stocks, bonds and transferrable shares. The recent framework explores specifically whether a digital asset qualifies as an investment contract, discussing the Howey Test and how it applies to digital assets. The Howey Test has been used to analyze whether stocks and other conventional investments fall under the category of securities.
Each analysis using the Howey Test is highly dependent on the facts and circumstances of the underlying digital asset. Under the Howey Test, the SEC states that “an investment contract exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to derive from the efforts of others.” In its framework, the SEC proceeds to address all of the elements of the Howey Test. The first two elements are fairly straightforward. Did you sell tokens for money? Was there a central team developing the tokens network?
Reasonable Expectation of Profits
The SEC notes that in most of the cases it has reviewed, the answer is yes to these first two elements. The third element, “reasonable expectation of profits derived from the efforts of others,” is a bit more complicated. The SEC provided numerous comments on this element by breaking it down into two pieces: the reliance on the efforts of others, and the reasonable expectation of profits.
We can simplify the “efforts of others” to a simple question: Is the purchaser relying on others to make the tokens more valuable? “Others” can be defined as a promoter, sponsor or other third party (or affiliated group of third parties). The SEC points out that a decentralized network that has a core team doing the bulk of the development, improvement, operation or promotion of the network should be careful, as this would make it more likely they are relying on the “efforts of others.” These comments tell us that the SEC is aware that decentralized networks exist, but if there is a team promoting the network through sales and marketing campaigns, then it isn’t decentralized enough to pass this test. Unfortunately, the reasonable expectation of profits isn’t as easily simplified.
The SEC notes, “Profits can be, among other things, capital appreciation resulting from the development of the initial investment or business enterprise or a participation in earnings resulting from the use of purchasers’ funds. Price appreciation resulting solely from external market forces (such as general inflationary trends or the economy) impacting the supply and demand for an underlying asset generally is not considered ‘profit’ under the Howey Test.” The SEC points to several characteristics that, if present, make it more likely that a reasonable expectation of profit exists. The general question here is, what is influencing the token’s price?
The SEC addresses another important question facing the industry before concluding on the framework. What if a token sale occurred in the past that was a security offering, but now the token is able to be re-evaluated in its current form today and it isn’t a security? The SEC lays out several factors to consider on this topic. This is interesting when we look at a digital asset like Ethereum. Today it is a decentralized network like Bitcoin, and it most likely would not qualify as a security. When the network launched in 2015, however, one could argue it would have been seen as a security. Again this shows the SEC is doing its homework to understand this new industry and to realize the networks can evolve beyond the token sale phase.
The SEC also provides us with some examples of when it might be less likely that a token should be considered a security. Are both the network and the token fully functional and decentralized at the time of sale? Can the token purchasers immediately use the token for its intended purpose? Are prospects for appreciation in the value of the digital asset limited? The SEC lists several more items that should be considered when reviewing a token offering.
This framework gives us valuable commentary from the SEC and a basket of cautionary items to consider if you are launching a token. You can review the full framework from the SEC here. If you are considering this route, consult with an advisor who understands the industry—they will be asking these questions before the SEC comes knocking.