The publication of the SEC Framework relating to digital assets on Wednesday resulted in something of a debate on social media, after the US Securities and Exchange Commission (SEC) published its guidance on tokens and ICOs with a simple link on Twitter.
— SEC_News (@SEC_News) 3 April 2019
The Framework for “Investment Contract” Analysis of Digital Assets introduction began:
If you are considering an Initial Coin Offering, sometimes referred to as an “ICO,” or otherwise engaging in the offer, sale, or distribution of a digital asset, you need to consider whether the U.S. federal securities laws apply.
Without reproducing the entire intro, one point that was noted on social media was reference to The U.S. Supreme Court’s 1946 Howey case and subsequent case law.
The framework goes on to say that, under the Howey Test, an “investment contract” exists “when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others”.
It was the Howey Test and what this meant for the regulation of digital currency that occupied the minds of many tweeters.
The Howey Test
In May 2018, the news was full of discussions as to whether the Howey Test could be applied to cryptocurrencies. The test establishes whether an asset constitutes an investment contract and can therefore classed as a security. In the case of crypto, if it is classed as a security, it can be subject to Securities and Exchange Commission (SEC) regulation, thereby affecting the deregulated and decentralized ethos of cryptocurrences and potentially affecting crypto projects.
The four criteria an asset must meet to be classed as a security are:
- It is an investment of money
- There is an expectation of profits from that investment
- The money invested is in a common enterprise
- Any profit comes from the promoter of a third party.
The SEC framework states that, whether a particular digital asset at the time of its offer or sale satisfies the Howey Test depends on the specific facts and circumstances – and the framework addresses each element of the Howey Test as follows:
A. The Investment of Money
The first prong of the Howey test is typically satisfied in an offer and sale of a digital asset because the digital asset is purchased or otherwise acquired in exchange for value, whether in the form of real (or fiat) currency, another digital asset, or other type of consideration.
B. Common Enterprise
Courts generally have analyzed a “common enterprise” as a distinct element of an investment contract. In evaluating digital assets, we have found that a “common enterprise” typically exists.
C. Reasonable Expectation of Profits Derived from Efforts of Others
Usually, the main issue in analyzing a digital asset under the Howey Test is whether a purchaser has a reasonable expectation of profits (or other financial returns) derived from the efforts of others. A purchaser may expect to realize a return through participating in 3 distributions or through other methods of realizing appreciation on the asset, such as selling at a gain in a secondary market. When a promoter, sponsor, or other third party (or affiliated group of third parties) (each, an “Active Participant” or “AP”) provides essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts, then this prong of the test is met.
The entire document can be read at SEC.
But while the framework was still hot off the press, the crypto community on Twitter was also warming up in response.
Twitter response to SEC Framework
Katharine Wu @katherineykwu set the ball rolling on Twitter with her initial tweet:
🚨 THIS IS HUGE: the SEC just released an official statement on “Framework for ‘Investment Contract’ Analysis of Digital Assets” analyzing whether a digital asset is a security or not
READING NOW WILL POST ANALYSIS HERE STAY TUNED
— Katherine Wu (@katherineykwu) 3 April 2019
— Nathaniel Whittemore (@nlw) 4 April 2019
🚨Heard the SEC dropped guidance on tokens & ICOs and want to know WTF is what? 👇
And of course….
— Nathaniel Whittemore (@nlw) 4 April 2019
🔥😑💀 this SEC guidance on Howey Test re: ICOs basically kills crypto funds *and* airdrops in one swoop
“the asset is offered and purchased in quantities significantly greater than any user would reasonably need, or so small to make use of the asset in the network impractical”
— Meltem Demirors (@Melt_Dem) 3 April 2019
— Patrick Berarducci (@PatBerarducci) 3 April 2019
After digesting the contents of the SEC framework, Katherine Wu – of the founding team at Mesari Crypto – was actually moved to blog about it. One of her conclusions on the framework is:
“Unfortunately, there are still so many questions left unanswered and I suspect will leave both startups as well as legal practitioners with immense headaches. For example – the framework gives a broad ‘active participant’ definition when analyzing under the third prong of the Howey Test. Taken liberally, that definition could really impact and even hinder the process in which a token project/start-up can decentralize itself.”
If you cannot wade through the entire SEC Framework at this present time, Katherine recommends you read “…at least the following pages: page 9, which details the factors that would make something less likely to be a security; page 6 + 7 for characteristics that would make token holders ‘expect profits’, and page 3 + 4 +5 for all of the AP activities”.
To no one’s surprise, I had more feelings about this (another 3,000 words worth of feelings, actually!!), so I wrote a blog post last night. If you’d like a deeper dive beyond this tweet thread of the SEC’s framework + no action letter, give this a read!https://t.co/bEpBjg5CHy
— Katherine Wu (@katherineykwu) 4 April 2019
SEC Framework Conclusion
The conclusion of the framework quite simply advises market participants to consider certain stated factors in “assessing whether a digital asset is offered or sold as an investment contract and, therefore, is a security”.
It also “identifies some of the factors to be considered in determining whether and when a digital asset may no longer be a security”, although these factors “are not intended to be exhaustive in evaluating whether a digital asset is an investment contract or any other type of security”.
But for such a long-awaited document, the SEC framework appears to raise as many questions as it sets out to answer among the crypto and legal community – and the factors discussed regarding whether a digital asset is a security are not set in stone, according to SEC:
These factors are not intended to be exhaustive in evaluating whether a digital asset is an investment contract or any other type of security, and no single factor is determinative; rather, we are providing them to assist those engaging in the offer, sale, or distribution of a digital asset, and their counsel, as they consider these issues. We encourage market participants to seek the advice of securities counsel and engage with the Staff through www.sec.gov/finhub.
SEC image licensed via Shutterstock.