The Securities and Exchange Commission earlier this month issued detailed guidance to companies that want to sell digital tokens, providing clarity on the application of federal securities laws to digital assets.
The SEC’s Strategic Hub for Innovation and Financial Technology, or FinHub, on April 3 published a framework for analyzing whether a digital asset has the characteristics of a specific type of security, known as an investment contract.
The agency has taken the position that digital tokens should be evaluated under the Howey Test, a three-prong test established by a 1946 Supreme Court decision. Under the test, an investment contract exists when there is 1) an investment of money 2) in a common enterprise 3) with a reasonable expectation of profits to be derived from the efforts of others.
Much of the SEC’s 13-page guidance is directed toward the third prong, which is often the main factor when analyzing a digital token under the test.
Reliance on Efforts of Others, and Reasonable Expectation of Profits
The question of whether a buyer is relying on the efforts of others focuses on two key issues. The first is whether the buyer reasonably expected to rely on the efforts of the sponsor or another third party. The second is whether those efforts were managerial efforts that affected the success of the enterprise.
While there are no determinative factors, there are certain characteristics of a token sale that can make it more likely that the buyer is relying on the efforts of others, the SEC said. For example, the sponsor being responsible for developing or improving the network can be one such characteristic. Another may be when essential tasks are to be performed by the sponsor, as opposed to decentralized network where dispersed network of users perform the tasks.
Profits can include capital appreciation resulting from the development of the initial investment or a participation in earnings resulting from the use of the purchasers’ funds. Similar to the reliance on efforts of others, certain characteristics of a sale may indicate an expectation of profits.
Among other things, this includes when the asset can, or is expected to be, traded through a secondary market. When the digital token gives the buyer rights to share in the business’ income can also be indicative of an expectation of profits. The SEC further highlighted a situation where the token is offered broadly to potential purchasers, rather than being targeted to users of the goods or services.
There are other relevant considerations in the Howey test, the SEC said, noting that federal courts have looked to the economic realities of the transaction when analyzing whether there is a reasonable expectation of profits based on the work of others.
One characteristic that would make it less likely the test is met is the distributed ledger network is fully operational. Other indications, the SEC said, are the holders of the token are immediately able to use the token for its intended functionality, and the prospect for appreciation in value of the token are limited.
The SEC’s framework serves as helpful guidance to companies considering an Initial Coin Offering, providing a comprehensive collection of factors to consider when analyzing the legal status of digital tokens. That said, there is nothing all together groundbreaking in the framework, which largely consolidates a view of digital tokens the SEC has outlined in recent cases and public statements.
Concurrent with the publication of the framework, the agency issued a no-action letter to private jet startup TurnKey, confirming it would not take enforcement action if the company sells “tokenized”jet cards that its members can use to purchase air charter services. The agency highlighted, among other things, that TurnKey’s network will be fully operational when the tokens are sold. It also highlighted that the tokens, which will be immediately useable, will be restricted to TurnKey’s platform.