The U.S. Securities and Exchange Commission (SEC) issued the “Framework for ‘Investment Contract’ Analysis of Digital Assets” on April 3, 2019. The framework provides much-anticipated guidance for market participants to gauge whether a digital asset, defined as “an asset that is issued and transferred using distributed ledger or blockchain technology,” should be considered a security and subject to U.S. securities laws. The framework is useful for entities considering an Initial Coin Offering (ICO) or investors participating in the offer, sale, or distribution of a digital asset.
When does a digital asset become an investment contract? The SEC’s framework draws on the “Howey test,” after the U.S. Supreme Court’s 1946 case SEC v. W.J. Howey Co., for guidance. The test, when applied to digital assets, provides four important requirements for potential ICO issuers and token holders: (1) monetary investment, (2) in a common enterprise, with (3) reasonable expectation of profits, (4) derived from the efforts of others. The framework focuses in large part on the fourth requirement. Specifically, the SEC appears to confirm prior remarks that truly decentralized digital assets like Bitcoin are not investment contracts subject to U.S. securities laws. In applying the fourth consideration of Howey, the purchaser of a digital asset relies on the efforts of others when there are “essential tasks or responsibilities performed and expected to be performed by” a promoter, sponsor, or related third party of the digital asset, “rather than an unaffiliated, dispersed community of network users,” as exists in the case of Bitcoin.
When read alongside the SEC’s ICO-related enforcement actions, the framework indicates that in most circumstances ICOs are securities issuances that rely on the efforts of others. Most ICOs should therefore be registered, at least until such point when the network relevant to the ICO is in fact decentralized — not satisfying the fourth requirement of the Howey test — and operating as intended. Given this, potential ICO issuers should heed the provisions of the guidance and determine whether the right processes and controls are in place for registration of the ICO.
In addition to the form and terms of digital assets, the SEC also applies the Howey test to the circumstances in which digital assets circulate throughout the market. Transaction activities include, but are not limited to, offering, selling, distributing, holding, storing, and offering management or advice. The SEC is careful to point out that while the Howey test serves as a powerful litmus test for current and prospective market participants, “no one factor is necessarily dispositive as to whether or not an investment contract exists.” Instead, multiple factors and considerations should apply.
The SEC issued the framework on the heels of a no-action letter from the Division of Corporation Finance to TurnKey Jet, Inc., in which the Division did not recommend enforcement action against TurnKey Jet for not registering digital assets — in this case tokenized cards redeemable for air travel — as securities. While a narrowly defined use case, the no-action letter represents the first application of the SEC’s new framework for digital assets.
The SEC concludes the framework with the following reminder — the framework works best as regulatory scaffolding, not a definitive set of rules, regulations, or statements of the Commission. Best viewed as a living document, the authors emphasize their reliance on relevant legal precedents and the continued evolution of the digital asset market. The SEC’s guidance will continue to evolve in kind, and the new framework and no-action letter are important steps in this process.