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Since the Securities and Exchange Commission (SEC) issued the DAO Report in June 2017, pulled the plug on the Munchee Inc. ICO in December 2017, and then initiated its “Crypto Industry Sweep” in early 2018, companies have been waiting anxiously for clear guidance from the regulator on what types of digital assets fall under the SEC’s jurisdiction. Nearly two years later, the SEC responded with its “Framework for ‘Investment Contract’ Analysis of Digital Assets” (Framework), a 13-page memorandum that describes the factors used by SEC staff for assessing whether digital assets are “investment contracts” subject to federal securities laws. After providing a high-level overview of the Framework and explaining how the SEC staff is likely to analyze digital assets, this article examines the concept that digital assets can reach a tipping point—an “evolutionary moment” in their development—where they transform from a security to non-security. While SEC staff referenced this concept in passing during two speeches last year, it was not until the issuance of the Framework that it was more formally addressed.
Overview of the Framework
The Framework is intended to serve 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.” It centers on the application of the Supreme Court’s Howey test—the long-recognized standard for determining if an instrument or contract qualifies as an “investment instrument” and thus a security or whether a scheme or transaction (e.g., the sale of a digital asset) qualifies as a sale of securities. The Howey test requires (1) an investment of money; (2) in a common enterprise; (3) with an expectation of profits; (4) predominantly derived from, or in reliance on, the efforts of others. Federal securities laws require that all offers and sales of investment contracts and other securities be registered or qualify for an exemption from registration.
The Framework contains little discussion of the first two prongs of the Howey test claiming that those requirements are typically satisfied due to the nature of digital asset transactions. Instead, the Framework focuses on the third and fourth prongs, which are satisfied when the digital token issuers or third parties (e.g., promotors or sponsors)—referred to in the Framework as “Active Participants” (APs)—provide “essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts.”
In assessing whether the “reasonable expectation of profits” and “reliance on the efforts of others” requirements are satisfied, the SEC’s staff will focus on the “economic reality” of digital asset transactions including the “terms of the offer, the plan of distribution, and the economic inducements” to encourage sales. If purchasers are believed to reasonably expect profits and to have relied on the efforts of others, then the SEC staff will view the digital asset as a security.
In the Framework, the SEC staff outlined a number of factors that will support a finding that digital asset purchasers have a reasonable expectation of profits, making it more likely the digital asset is a security. A non-exhaustive list of these considerations include: (1) whether the digital asset gives purchasers the right to share in an enterprise’s income/profits or to realize a gain from the asset’s capital appreciation; (2) whether the digital asset can be traded or transferred on or through a secondary market or platform; (3) whether the quantities of digital assets offered or purchased are “significantly greater than any likely user would reasonably need;” (4) whether there is little apparent correlation between digital asset trading or purchase quantities and “the amount of the underlying goods or services a typical consumer would purchase for use or consumption;” (5) whether the digital asset is offered to an audience beyond those who are likely to use the goods/services or have a need for the network’s functionality; and (6) whether promotional and marketing activities suggest a reasonable expectation of profits.
The SEC staff also identified factors that weigh against a finding that digital asset purchasers have a reasonable expectation of profits. These factors focus on whether purchasers are buying the assets for consumptive use rather than as a speculative investment and include consideration of: (1) whether the digital assets and associated network are fully developed/operational at the time of offer/sale, and purchasers are “immediately able to use them for their intended functionality;” and (2) whether the digital assets have limited prospects for appreciation.
Similarly, the Framework highlights a number of factors supporting the conclusion that digital asset purchasers are relying on the efforts of others to achieve those profits, again making it more likely that the digital asset will be considered a security, including: (1) whether the AP is responsible for the development, improvement, enhancement, operation, or promotion of the network for the digital asset; (2) whether the AP creates or supports a market for, or the price of, the digital asset; (3) whether the AP has a “lead or central role in deciding governance issues, code updates, or how third parties participate in the validation of transactions that occur with respect to the digital asset;” (4) and whether the AP has the ability to realize capital appreciation from the value of the digital asset.
Digital Assets May Evolve Beyond Initial Security Status
In 2018, several senior SEC officials suggested that the regulator may not view all digital assets as falling under its purview, and that some digital assets could reach a tipping point—a transformative moment in their development and application—when they would shift from securities to non-securities. This messaging did not appear in published guidance, memoranda, or court filings, but rather was communicated during speeches at conferences.
In May 2018, SEC Commissioner Hester M. Peirce addressed the transformative nature of digital assets during a speech at the Medici Conference. During her remarks, she suggested that improvements to digital assets and their affiliated technology may, over time, shift them from “securities” to “something else,” such as commodities or currencies. As explained by Commissioner Peirce:
Designating certain ICOs securities offerings does not end the inquiry once and for all. What, for example, are the coins once the environment is completed? Are they still securities, subject to all the regulations that follow securities into the secondary market? Or are they something else? A commodity? A currency? Something in the nature of a Chuck E. Cheese token? When do they change into something new? When the environment is minimally functional? What if its developers make substantial upgrades to its functionality such that the value of the coins increases with the increased access to the new functionality? These are tough questions that still need answers. They are questions that turn on facts and circumstances, but we should strive to provide some guidance.
See Hester Peirce, “Beaches and Bitcoin: Remarks before the Medici Conference,” Medici Conference (May 2, 2018).
This theme resurfaced in a June 2018 speech by SEC Director of Division of Corporation Finance William Hinman, who suggested that digital assets may reach a state of development in which their sales transform from securities transactions to a non-securities transactions. See William Hinman, “Digital Asset Transactions: When Howey Met Gary (Plastic),” Yahoo Finance All Markets Summit (June 14, 2018). Director Hinman focused on the concept of decentralization, noting that “when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede” and “as a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult.” In support of this theory, he cited two of the most well-known cryptocurrencies: Bitcoin and Ether.
For Bitcoin, Director Hinman noted the lack of “a central third party whose efforts are a key determining factor in the enterprise” and the presence of a network that “is operational and appears to have been decentralized for some time, perhaps from inception.” As a result, he concluded that “applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value.”
For Ether, Director Hinman indicated that while “fundraising” sales helped to develop the digital asset and its associated technology, they have—over time—become sufficiently decentralized and functional to allow Ether to move beyond its initial “securities transactions” classification: “Putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.”
While the argument that digital assets could evolve beyond their status as securities generated a lot of buzz among industry participants, that interest and speculation was tempered when SEC Chairman Jay Clayton issued a rare, strongly-worded statement in September 2018 that “staff statements are nonbinding and create no enforceable legal rights or obligations of the Commission or other parties.” See Chairman Jay Clayton, “Statement Regarding SEC Staff Views“ (Sept. 13, 2018). Market participants were left with more questions than answers about the theory of digital asset transformation, and it was not until the issuance of the Framework that the SEC once again confronted the issue.
The Journey From Security to Non-Security
The Framework is the first time the SEC staff has outlined any specific considerations for assessing how a digital asset can transition from a security to a non-security. The staff’s guidance articulates a number of factors that may lead the SEC staff to conclude that a digital asset once subject to securities regulation is no longer subject to such regulation. Again, the analysis emphasizes the final two prongs of the Howey analysis: expectation of profits and reliance on the efforts of others. Despite Hinman’s June 2018 comments regarding Bitcoin and Ether, the Framework’s focus on a direct and stable correlation between the value of the digital asset and the value of the good or service for which it may be exchanged or redeemed seems to suggest that something more than a widely used digital asset on a fully decentralized network is necessary to avoid securities regulation.
In assessing whether a digital asset purchaser no longer has a reasonable expectation of profits such that the asset is no longer a security, the SEC staff will consider:
• The Role of the AP: The Framework identifies two questions for assessing whether the AP’s role weighs in favor of finding that a digital asset has transitioned from a security to a non-security. First, are continued development efforts of the AP necessary for determining the value of the digital asset? Second, does the AP continue to have access to material, non-public information or key insider information? If the answer to those questions is “no,” the SEC staff is likely to view the AP as no longer a “key factor” in determining the value of the digital asset. Consequently, it is more likely that the SEC staff will find that the digital token is no longer a security.
• The Function and Character of the Digital Asset: The SEC staff will assess whether the value of the digital asset derives from its status as an investment contract or from its intended use. If the value of the digital asset derives from its intended use, SEC staff is more likely to view the asset as having transitioned from a security to a non-security.
• In assessing the function and character of the digital asset, the SEC staff will consider whether:
- purchasers are able to use the digital asset for its intended functionality, such as to acquire goods and services on or through the network or platform;
- the value of the digital asset has shown a direct and stable correlation to the value of the good or service for which it may be exchanged or redeemed;
- the trading volume for the digital asset corresponds to the level of demand for the good or service for which it may be exchanged or redeemed; and
- any economic benefit that may be derived from appreciation in the value of the digital asset is incidental to obtaining the right to use it for its intended functionality.
In considering whether digital asset purchasers are no longer relying on the efforts of others, the SEC staff will assess:
• The Role of the AP: Similar to its evaluation of whether a purchaser has a reasonable expectation of profits, the SEC staff will ask whether the AP remains an important part of the value of the investment. If the value of the digital asset is no longer largely driven by efforts of the AP and value generation has been transferred to the broader user community, it is more likely that the SEC staff will view the digital asset has having evolved into a non-security.
• The Network’s Functional Independence: The SEC staff will also look at whether the network on which the asset operates has become sufficiently decentralized, meaning that the network is capable of functioning without the managerial or entrepreneurial efforts of the AP. If the purchaser is unlikely to “reasonably expect” the AP to carry out essential functions in managing the network, then the network is more likely to be found to be decentralized—and the associated digital asset is more likely to be found to have evolved into a non-security.
• The Impact of the AP: The SEC staff will also consider the role of the AP’s efforts in the enterprise’s success. The more that the enterprise’s success is independent from the efforts of the AP, the more likely that the digital asset has evolved from a security to a non-security.
Even if a digital asset is initially classified as a security, as it and the ecosystem on which it operates expand, the asset may evolve into an asset that is not a security. The SEC staff has acknowledged that digital assets once considered to be securities may reach an evolutionary moment when they transcend that classification and should no longer be treated as securities. Thus, even if an early version of a digital asset requires registration, as the asset and its associated technology evolve, the asset may reach a point where sales of the asset are no longer properly viewed as sales of investment contracts and are not, therefore, subject to the securities laws. It is unclear, however, if once the asset reaches that point, all of the assets originally classified as securities lose that status perhaps allowing for deregistration of the digital asset. The Framework does not discuss what happens when a digital asset once registered as a security evolves to a point where it is no longer a security.
The closer the digital asset is to operating within fully functioning networks, the more likely it is that the SEC staff will consider the digital asset to have “evolved” from a security to a non-security. The recently released Framework is a step forward for industry participants seeking to understand what types of digital assets may not be subject to regulation under federal securities laws. The possibility that a digital asset will no longer be considered a security is increased when there is a complete network that is not using proceeds from the offer, purchase, or sale of a digital asset to fund development of the platform. Exactly where this tipping point is, however, has not been defined by the SEC, leaving industry participants to wonder exactly when they have entered into this different classification.
Companies should act cautiously before offering, selling or distributing a new digital asset. The SEC staff’s approach to digital assets is still developing. Companies working in this area will have to remain diligent in their structuring of offerings in order to avoid running afoul of securities laws. Likely, this will involve open communication with SEC staff prior to any ICO to preemptively address any potential concerns the SEC may raise.
The Framework has its limits. The Framework comprises the views of the SEC’s staff. By its terms, the Framework is neither exhaustive nor binding. The SEC staff has left plenty of flexibility in addressing these issues. Most importantly, it is important to remember Chairman Clayton’s warning that “staff statements are nonbinding and create no enforceable legal rights or obligations of the Commission or other parties.”
Deborah R. Meshulam is a partner at DLA Piper and a former assistant chief litigation counsel in the SEC’s enforcement division. Benjamin D. Klein is a senior associate at the firm and a former international prosecutor. Richard Kelley is an associate at the firm.