United States: SEC Releases Commentary Applying Howey Test To Digital Assets

On April 3, 2019, the U.S. Securities and Exchange Commission (SEC) took a first step toward providing greater clarity on the key question of how to evaluate whether transactions involving issuance or sales of digital tokens are sales of securities subject to U.S. securities laws and regulations.

The guidance came in two parts:

  • First, the SEC's Strategic Hub for Innovation and Financial Technology (FinHub) published the "Framework for 'Investment Contract' Analysis of Digital Assets" (Framework). In a public statement announcing its release, the SEC billed the Framework as an "analytical tool to help market participants assess whether the federal securities laws apply to the offer, sale, or resale of a particular digital asset." 1
  • That same day, the SEC's Division of Corporation Finance also issued a response to a no-action request submitted by TurnKey Jet, Inc., (TurnKey), a provider of air charter services. In the first SEC no-action letter addressing a blockchain-based project, the SEC indicated it would not pursue an enforcement action if TurnKey sold a digital token (TKJ) to its air charter-customers, under the circumstances outlined in TurnKey's letter.

Taken together, these publications provide much-needed guidance in an area of law and technology wrought with uncertainty. This post briefly addresses some of the takeaways from the publications.

Framework:

The Framework provides a list of factors that one should consider when determining whether the federal securities laws apply to digital tokens issued in an Initial Coin Offering (ICO). Its authors stressed that the Framework is not an authoritative rule, regulation, or statement of the SEC, but the document still offers a consolidated and comprehensive collection of issues to consider when analyzing the legal status of a digital token. The Framework reiterates the SEC's view that the question of whether a token is a security should be evaluated under the "Howey test" – a three-factor test formulated by the U.S. Supreme Court in a 1946 decision.2  In Howey, the Supreme Court held that an "investment contract," one type of a "security," exists when a purchaser makes an (1) investment of money (2) in a common enterprise (3) with a reasonable expectation of profits to be derived from the efforts of other persons.

The Framework only briefly touches the "investment of money" and "common enterprise" prongs of the Howey test, asserting that these elements are "typically" satisfied by the offer and sale of digital assets. What remains unstated is whether and to what extent the Howey test is satisfied when an acquiror of a digital asset contributes non-cash consideration, such as providing personal data or services.

Instead, the Framework focuses primarily on the third prong of the Howey test, which is met when a purchaser buys an asset with a "reasonable expectation of profits derived from the efforts of others." The Framework describes a range of factors that may be relevant to whether purchasers of a digital token have an "expectation of profits derived from the efforts of others," many of which were previously articulated by members of the SEC's staff. For example, the Framework reiterates that the third Howey prong is more likely met where tokens are sold before a platform or network is fully functional, where tokens are used as compensation, and where tokens are mass marketed, rather than targeted to expected users of a service or platform.

Still, several parts of the Framework provide new insight as to how the Howey analysis operates when applied to digital tokens. For example, the Framework notes that "[p]rice 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." This view may prove useful for issuers of tokens whose value fluctuates in relation to other assets or market forces, such as a token whose value is pegged to the market price of another asset. However, one should be cautious about other regulatory schemes that may apply in such instances, particularly CFTC oversight.

The Framework also identifies several characteristics that point toward a token being used for commercial activity and weigh against a finding that a token is a security. One such characteristic is a token that can only be used on the issuer's network and "generally can be held or transferred only in amounts that correspond to a purchaser's expected use."

The Framework authors cite, as an example, a hypothetical token issued by a fully developed online retailer that sells a non-transferrable digital asset to its customers for use in its network. Where the token can only be used, and can be immediately used, to purchase products from the retailer, the Framework concludes, "the digital asset would not be an investment contract."

TurnKey no-action letter:

The TurnKey no-action letter provides a real-world application of many of the factors articulated in the Framework.

TurnKey proposes to launch its own private blockchain network on which its customers can purchase tokens that can be redeemed for air charter services. The letter touts this new process as an improvement on the existing air charter business because it will allow immediate and transparent settlement for these expensive and time-sensitive transactions. In short, users who want to purchase air charter services will create an account with TurnKey, undergoing KYC/AML background checks. Once admitted, users can purchase TKJ tokens from TurnKey, which holds the funds collected from token sales in escrow for distribution to air-travel providers pursuant to a smart contract. Users wishing to charter a flight will then deliver TKJ to the carriers or brokers (or directly to TurnKey), and those parties can exchange their TKJ with TurnKey for the proceeds from the token sales. TKJ will not be transferrable outside the TurnKey ecosystem, and the TurnKey platform, network, and mobile app will be fully funded, apart from any token sale proceeds, and fully functional at the time of the first TKJ sale.

In its brief response, the SEC identified several factors as particularly important to its conclusion that TurnKey need not register TKJ as a security, including that the TurnKey platform will be fully developed and operational before and independent of any token sales, TKJ will not be transferrable outside of the TurnKey ecosystem, and TKJ will be pegged to a value of one USD per token and represent the right to receive services worth one USD.

The TurnKey no-action letter is a useful first step in defining a "safe harbor" exemption for certain token sales. However, many or most of the factors the SEC relied on to reach its conclusion in this case will not be present with other token issuers, meaning that the uncertain application of U.S. securities laws to most ICOs will continue.

Footnotes

1. U.S. Securities and Exchange Commission, Public Statement on "Framework for 'Investment Contract' Analysis of Digital Assets," (April 3, 2019).

2. SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (Howey)

This article is presented for informational purposes only and is not intended to constitute legal advice.

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