William Hinman, Director, Division of Corporate Finance, provided significant guidance on the applicability of U.S. Federal Securities Laws to Initial Coin Offerings (ICOs) and the sale of digital tokens. His presentation was made on Thursday, June 14, 2018 at the Yahoo Finance All Market Summit: Crypto in San Francisco.
Click here to read the full presentation.
Director Hinman confirmed in detail that the SEC will continue to apply the “Howey Test” in determining whether the sale of “tokens” amount to the issuance of a security:
“[The Howey Test] requires an investment of money in a common enterprise with an expectation of profit derived from the efforts of others. And it is important to reflect on the facts of Howey. A hotel operator sold interests in a citrus grove to its guests and claimed it was selling real estate, not securities. While the transaction was recorded as a real estate sale, it also included a service contract to cultivate and harvest the oranges. The purchasers could have arranged to service the grove themselves but, in fact, most were passive, relying on the efforts of Howey-in-the-Hills Service, Inc. for a return. In articulating the test for an investment contract, the Supreme Court stressed: “Form [is] disregarded for substance and the emphasis [is] placed upon economic reality.” So the purported real estate purchase was found to be an investment contract – an investment in orange groves was in these circumstances an investment in a security.
Just as in the Howey case, tokens and coins are often touted as assets that have a use in their own right, coupled with a promise that the assets will be cultivated in a way that will cause them to grow in value, to be sold later at a profit. And, as in Howey – where interests in the groves were sold to hotel guests, not farmers – tokens and coins typically are sold to a wide audience rather than to persons who are likely to use them on the network.”
Much press is being made that Director Hinman, in this speech, stated that the decentralized nature of tokens like Bitcoin and Ether (which are no longer reliant on the efforts or others for profit), are not securities (nor were the Orange groves in Howey). Director Hinman pointed out, however, that, as in Howey, any assets can become a security if packaged and sold as an investment contract:
“I would like to emphasize that the analysis of whether something is a security is not static and does not strictly inhere to the instrument. Even digital assets with utility that function solely as a means of exchange in a decentralized network could be packaged and sold as an investment strategy that can be a security. If a promoter were to place Bitcoin in a fund or trust and sell interests, it would create a new security. Similarly, investment contracts can be made out of virtually any asset (including virtual assets), provided the investor is reasonably expecting profits from the promoter’s efforts.”
In advising clients in the issuance of digital tokens, it has been unknown what facts the SEC would focus on in determining if such tokens meet the Howey test for being a security (especially in an environment where the Chairman of the SEC, John Clayton, has recently stated that “Every ICO I have seen is a security”). Director Hinman, however, stated that this does not need to be the case and listed a set of factors (while not exhaustive), that begin to provide guidance to those who wish to create and sell “tokens” without the onerous compliance required by securities laws:
“What are some of the factors to consider in assessing whether a digital asset is offered as an investment contract and is thus a security? Primarily, consider whether a third party – be it a person, entity or coordinated group of actors – drives the expectation of a return. That question will always depend on the particular facts and circumstances, and this list is illustrative, not exhaustive:
- 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?
Additionally, Director Hinman provided additional guidance on how to sell tokens “more like a consumer item and less like a security”:
“Again, we would look to the economic substance of the transaction, but promoters and their counsels should consider these, and other, possible features. This list is not intended to be exhaustive and by no means do I believe each and every one of these factors needs to be present to establish a case that a token is not being offered as a security. This list is meant to prompt thinking by promoters and their counsel, and start the dialogue with the staff – it is not meant to be a list of all necessary factors in a legal analysis.
- 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?”
Digital tokens are changing day to day and the contributions that such tokens can make to society will be immense. The analysis of what constitutes a security is “not static” and we will no doubt hear more in the future.
Michael Best has an integrated team that works with clients in the cryptocurrency, ICO, and blockchain space. We assist in securities, investment, Bitcoin and other cryptocurrencies, intellectual property, privacy and security, blockchain implementation, and other matters in this space.