The U.S. SEC suggests a framework for analysing whether digital assets are “investment contracts” (and thus considered securities under the U.S. federal securities laws)
This is Howey Do it: The view from the SEC’s FinHub
U.S. regulation of digital assets that are issued and transferred using distributed ledger technology remains in flux. Active participants must consider whether these assets are subject to characterization as securities. The term “security” is broadly defined and interpreted in the U.S. federal securities laws to include an “investment contract.” While investment contract is not a statutorily defined term, it was most notably interpreted in the U.S. Supreme Court’s Howey case.
The Strategic Hub for Innovation and Financial Technology (FinHub) of the U.S. Securities and Exchange Commission (SEC) recently provided a Framework to apply the factors identified in that case to digital assets for purposes of assessing whether those assets are investment contracts, and thus securities.
The Investment of Money
The first and most easily applied Howey test - the investment of money - is satisfied any time fiat currency or any other item of value is exchanged for a digital asset.
FinHub believes that investments in digital assets typically are investment in a “common enterprise” (the second Howey test) because the fortunes of purchasers are linked to each other and/or to the success of the promoter’s efforts.
Reasonable Expectation of Profits
FinHub describes several characteristics, including the following, of a digital asset that suggest that the Howey test of "reasonable expectation of profits" is satisfied:
- Holders share in an enterprise’s income or profits and/or realize gain from capital appreciation of a digital asset
- The digital asset is, or will be soon, traded on or through a secondary market
- The digital asset is offered broadly rather than limited to expected users of the goods or services
- There is a weak, if any, correlation between the purchase price and the market price of goods/services that can be acquired in exchange for a digital asset
- There is a weak, if any, correlation between the quantities of traded digital assets and the amount of underlying goods or services a typical consumer would use for consumption
- The proceeds from an offering of a digital asset exceed the funding needed to establish a functional network or digital asset
- A digital asset is marketed akin to a security (e.g., holders are investors, the asset is an investment)
Derived from the Efforts of Others
FinHub describes several characteristics, including the following, of a digital asset that suggest that the Howey test of "reliance on the efforts of others" is satisfied:
- Purchasers expect that an offerer of digital assets, rather than a dispersed network of unafilliated users, is and will remain responsible for the development, enhancement, operation and promotion of the various elements that comprise a digital asset’s network, enterprise, platform and/or application
- An offerer creates or supports a market for the price of a digital asset, such as by limiting supply through buybacks or “burning”
- An offerer has a continuing managerial role with respect to the network or the rights that a digital asset represents, such as determining how to compensate persons providing services to the network, where the digital assets will trade, how additional digital assets will be distributed, and how to deploy funds raised from sales of digital assets
As a supplement to the Howey tests, the Framework identifies other factors that will make a digital asset less likely to be characterized as a security, including:
- The ledger and digital asset are fully developed and operational
- The digital asset can be immediately used widely to make payments as a substitute for fiat currency
- The digital asset can be immediately redeemed to acquire or otherwise use goods or services
- A secondary market exists only for the transfer between and among users of a platform, not speculators
Concerns over ICO boom
It is probably worth noting that the reason so many digital assets (i.e., tokens and cryptocurrencies) were issued is that they could initially finance the development of a decentralized network and then be used as a currency for buyers and sellers of services or products on that network.
The problem which arose during the ICO boom related to the fact that because the networks were not developed at the time of the ICO, the purchasers of the digital assets were speculating on their future value and, in the SEC’s view, were therefore buying unregistered securities.
Chilling effect of SEC’s approach
Since a digital asset is a security, an issuer needed to either register with the SEC, or make sure that sales were made only to “accredited investors” in private placements.
Because neither of these options are particularly attractive to start-up businesses (registration with the SEC is expensive and time-consuming, and brings with it significant and on-going compliance obligations, while a digital asset which can only be freely traded amongst accredited investors has limited liquidity) the SEC’s approach had a chilling effect on new issuance of digital assets in 2018 and into 2019.
Framework strikes a balance
The Framework seems to strike a much-needed balance between the needs of start-up entrepreneurs and the prudential and supervisory goals of the SEC. Under the Framework, a new business could issue digital assets to fund the development of a decentralized network, but these digital assets will be treated as securities and therefore must be sold in a registered offering or under an available exemption.
Assuming the network becomes fully developed and operational and is sufficiently “decentralized”, these same digital assets will cease to be securities and can become utility tokens.
What happens next?
FinHub does not claim that the Framework contains an exhaustive list of factors to be considered. This is partly to preserve future regulatory discretion but also a result of the difficulty of applying 20th century definitions to 21st century technology.
And the Framework does not purport to analyse other potentially applicable U.S. regulations, such as whether digital assets, particular virtual currencies, are commodities under the U.S. Commodity Exchange Act.
In sum, the Framework is a useful tool, not the end of the analysis, or even the beginning of the end, but rather barely the end of the beginning.