SEC Provides Framework to Determine if Digital Assets are Securities
The Situation: The Director of the U.S. Securities and Exchange Commission's Division of Corporate Finance, William Hinman, has weighed in on when digital assets will be characterized as securities.
The Result: In reinforcing the core principles set forth in the SEC's recent ICO enforcement actions, Mr. Hinman described important nuances involved in the application of the landmark Howey test, highlighted that the application of the Howey test may yield a different result in light of changing circumstances over time, and affirmed that current sales of Bitcoin and Ether are not securities transactions.
Looking Ahead: While market participants seeking to determine whether transactions in a particular digital asset involve the sale of a security continue to face a challenging facts-and-circumstances based analysis, Mr. Hinman's remarks provide important insights into certain of the factors that the SEC views as critical to the analysis.
Although the SEC has consistently noted that whether or not a particular digital asset transaction should be characterized as a securities transaction will depend on the characteristics and use of that particular asset, market participants have highlighted the potential chilling effect of a lack of certainty regarding the outcome of the securities law analysis when applied to particular digital assets. Against this backdrop, William Hinman, the SEC's Director of the Division of Corporation Finance, addressed the Yahoo Finance All Markets Summit: Crypto on June 14, 2018.
Key Factors in the Application of the Howey Test
At the outset, Mr. Hinman's remarks reinforce the core principles set forth in the SEC's recent statements and enforcement actions relating to initial coin offerings, or ICOs—the U.S. Supreme Court's landmark decision in SEC v. Howey continues to apply, requiring a facts-and-circumstances analysis as to whether a particular transaction involves an investment of money in a common enterprise and with the expectation of profits that are expected to arise substantially from the efforts of a third party. Nevertheless, Mr. Hinman's statements provide useful insights into certain factors that may arise in a particular application of the Howey test, which the SEC staff would likely view as critical to the determination of whether a digital asset transaction constitutes a securities transaction:
Decentralization. Focusing on information asymmetries between investors and promoters as a key impetus of the Securities Act of 1933, Mr. Hinman articulated that sufficient decentralization of a network may lead such information asymmetries to recede, as investors no longer reasonably expect a third party to carry out managerial or entrepreneurial efforts with respect to the network. Over time, therefore, there may be sufficient decentralization of networks and systems such that regulating digital assets that function on these systems as securities may not be required. In this regard, Mr. Hinman affirmed that current offers and sales of Bitcoin and Ether are not securities transactions.
Expectations of Profit. Mr. Hinman also expounded on the expectation-of-profit prong of the Howey test to emphasize the importance to the Howey analysis of evaluating the manner in which a digital asset is sold and the expectations of the purchases in the transaction. Because the Supreme Court has acknowledged that the purchase of an asset for consumption only is likely not a security, it is important to ask the key question: is a particular digital asset "marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?" In this regard, an instrument marketed and sold to the general public rather than to specific users of a network may weigh heavily on the expectation-of-profits prong of the Howey analysis.
While market participants seeking to determine whether transactions in a particular digital asset involve the sale of a security continue to face a challenging facts-and-circumstances based analysis, Mr. Hinman's remarks provide important insights into certain of the factors that the SEC views as critical to the analysis. However, the factors identified in Mr. Hinman's remarks are only illustrative, and the application of the Howey analysis to particular facts and circumstances is a challenging and uncertain endeavor. Until further regulatory clarity develops, market participants should discuss their particular circumstances with securities counsel.
Mr. Hinman affirmed the SEC's willingness to assist in making this determination and encouraged market participants to engage with SEC staff: "We are happy to help promoters and their counsel work through these issues. We stand prepared to provide more formal interpretive or no-action guidance about the proper characterization of a digital asset in a proposed use." We expect that pioneering market participants will take up Mr. Hinman's invitation to engage with the SEC staff in effort to crystallize, and formalize, the SEC staff's approach to the characterization of digital asset transactions.
Additional Questions to Contemplate
Mr. Hinman concluded his remarks by providing the additional questions set forth below to contemplate while analyzing the factors listed above. While the following questions do not comprise an exhaustive list of necessary factors, the questions are intended to prompt discussion and thinking by promoters and their counsel and to initiate the conversation with SEC staff.
Does the Third Party Drive the Expectation of a Return?
- Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value?
- Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?
- Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?
- Are purchasers "investing"—that is, seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?
- Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?
- Do persons or entities other than the promoter exercise governance rights or meaningful influence?
What is the Function of the Asset?
- 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?
Four Key Takeaways
- The U.S. Supreme Court's landmark decision in SEC v. Howey continues to apply to initial coin offerings.
- William Hinman, Director of the U.S. Securities and Exchange Commission's Division of Corporate Finance, has affirmed that current offers and sales of Bitcoin and Ether are not securities transactions.
- An instrument marketed and sold to the general public rather than to specific users of a network may weigh heavily on the expectation-of-profits prong of the Howey analysis.
- Proactive market participants are likely to reach out to the SEC staff to seek formal interpretive or no-action guidance in order to understand the SEC staff's thinking with regard to digital asset transactions.
For further information, please contact your principal Firm representative or the lawyers listed below. General email messages may be sent using our "Contact Us" form, which can be found at www.jonesday.com/contactus/.
Stephen J. Obie
New York / Washington
+1.212.326.3773 / +1.202.879.5442
Harold K. Gordon
Peter E. Devlin
Mark W. Rasmussen
Aanand A. Mehta, an associate in the Cleveland Office, assisted in the preparation of this Commentary.
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