“Is this token a security?” – this is, or at least should be, the first question companies involved in issuing or trading digital assets ask – according to the US Securities and Exchange Commission’s (SEC) recently released “Framework for ‘Investment Contract’ Analysis of Digital Assets”.
The framework, however, does not give a clear-cut answer to that question, instead it provides an in-depth look at the nature of blockchain-based cryptoassets so that companies can try to answer it for themselves. Unfortunately, the answer they find might not be the one they were hoping for, as the framework indicates that most ICO tokens would likely be classified as securities.
“The good news for issuers is that this guidance offers quite a bit of new clarity, the bad news is that most of the ICOs we’ve seen would clearly be securities at issuance under this guidance,” says Stephen McKeon, chief strategy advisor to Security Token Academy and a finance professor at the University of Oregon.
The SEC’s framework focuses on one type of security – an “investment contract”. Why this one? Because it’s the securities model the commission, and federal courts, most often use to “determine whether unique or novel instruments or arrangements, such as digital assets, are securities subject to the federal securities laws,” explain the framework’s authors.
Having established this premise, it doesn’t take long for the framework to fall back on SEC’s favorite method of determining whether an asset is a security – the Howey Test. This 1946 ruling established that “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”.
Furthermore, this test applies to “any contract, scheme, or transaction, regardless of whether it has any of the characteristics of typical securities”. In effect, this means in order to establish if a digital asset is a security, not only do you need to analyze the asset itself but also the relevant transactions.
The framework emphasizes the importance of information disclosure in deciding whether a security, including one in the form of a digital asset, needs to be registered with the SEC or not and then moves on to apply the Howey Test to digital assets.
To that goal, the authors examine the Howey Test definition of an “investment contract” and whether it applies to digital assets, such as those issued through an ICO. The result? Well, given that digital assets issued through ICOs typically involve “the investment of money in a common enterprise” with a “reasonable expectation of profits derived from efforts of others” they are likely to satisfy the definition and therefore come under the scope of securities laws – although the framework stops short of providing any definitive answers.
Further on, in the “Other Relevant Considerations” section, the framework highlights circumstances in which digital assets might fail the Howey Test and therefore fall outside the scope of securities laws. Such circumstances could include:
- The digital asset being fully developed and operational on a fully developed and operational distributed ledger network.
- The digital assets’ holders’ ability to immediately use it for its intended functionality on the network, particularly where there are built-in incentives to encourage such use.
- The digital assets’ design being focused on meeting the needs of its users, rather than to feed speculation as to its value or development of its network.
- A limited prospect of the assets’ value appreciation.
- Virtual currency’s immediate ability to be used to make payments in a wide variety of contexts.
- The digital asset’s potential for value appreciation being incidental to obtaining the right to use it for its intended functionality.
- Marketing for digital assets focusing on its functionality.
- Transfers of the digital asset in the secondary market available only among users of the platform.
“Digital assets with these types of use or consumption characteristics are less likely to be investment contracts,” states the framework, while cautioning that even in such cases assets might still be considered securities under specific circumstances, such as if they are being offered at a discount to the value of the goods or services or in quantities that exceed reasonable use.
“The descriptions are broad and open to interpretation, so they’ll need to be tightened up over time, but this is a step in the right direction,” says Professor McKeon.
Commenting on the development, lawyers Margaret Rosenfeld, Robert Crea, Jonathan Miner, and Steven Levine from K&L Gates say the framework doesn’t contain anything “substantially new for US securities law practitioners who have been giving guidance to companies regarding digital assets (or utility tokens, security tokens or digital securities depending upon your term of choice) for some time, but serves as a good reminder of the SEC staff’s thought process in this area for those new to the space”.
“A silver lining is that the guidance more clearly posits that the security designation can be transitional. A token can begin its lifecycle as a security but can later reach a point where it is no longer deemed to be a security,” notes Professor McKeon.
In its conclusion, the framework emphasizes that no single factor is determinative in evaluating the nature of digital assets and that the framework itself is intended only as guidance which “represents Staff views and is not a rule, regulation, or statement of the Commission”. Faced with this lack of clarity, market participants are encouraged to seek advice from suitably qualified legal counsel and engage with SEC staff via: www.sec.gov/finhub.