Introduction

When assessing whether a digital asset is a security, the key question to ask is whether a third party is driving the expectation of a return, says a senior Securities and Exchange Commission (SEC) official.

In wide-reaching remarks at the Yahoo Finance All Markets Summit: Crypto on June 14, 2018, William Hinman, the director of the SEC’s Division of Corporation Finance, affirmed that lawyers and promoters should focus on to the economic substance of a digital transaction, rather than to the label in analyzing whether the U.S. securities laws apply._[1]

Hinman emphasized that whether a person or group is responsible for the possibility of a return will be crucial in the analysis. He also confirmed that the SEC uses a “fact-sensitive” approach in assessing whether a digital asset is a security, and that important facts in the analysis will be how it is sold and the reasonable expectations of those that purchase it.

A Digital Howey Test

The Howey analysis is alive and well, Hinman said, referring to the seminal Supreme Court case, SEC v. Howey,_[2] when analyzing whether a digital asset is a security. That is, the analysis turns on whether the purchase of the digital asset is an investment of money in a common enterprise with an expectation of profit derived from the efforts of others (known as the “Howey Test”). As applied to coin or token offerings, “in many cases, the economic substance is the same as a conventional securities offerings. When investors expect that the promoters will build their system and investors can earn a return on the instrument—usually by selling their tokens in the secondary market once the promoters create something of value with the proceeds and the value of the digital enterprise increases.”

Whether and When Digital Assets Are Securities

Hinman said that the “is it a security” analysis should focus on whether someone (an individual or a group) targets a sale to a broad group of passive investors that are not necessarily target users of those digital assets, and the promoter maintains significant influence over development and value creation. In these cases, the digital assets “[look] a lot like a bet on the success of the enterprise and not the purchase of something used to exchange for goods or services on the network.” For these passive investors to be able to make informed decisions, it is important that the U.S. federal securities regulations apply to ensure publication of material information about any group or person promoting such a security.

Hinman does not believe all digital assets are securities, or always will be securities. Digital asset networks that are “sufficiently decentralized,” such that the digital asset’s value or success is not reliant upon central third parties, simply do not raise the same information asymmetry concerns and, from a practical perspective, identifying which groups or people should make such disclosures becomes “difficult, and less meaningful.”

Using bitcoin and ether to illustrate this point, Hinman offered that both the Bitcoin and Ethereum networks are sufficiently decentralized, such that their value is not reliant upon any central third parties, and so current offers and sales of such digital assets are not securities transactions. While Hinman did not take a position on ether’s initial issuance, his clear statement on current offers and sales of ether may dispel some of the anxieties concerning current and future ether transactions.

Hinman also uses these examples to shed light on the fact that “the analysis of whether something is a security is not static and does not strictly inhere to the instrument.” Although the initial offering of a digital asset may represent an investment contract, if the network becomes increasingly decentralized and the ability to identify an issuer or promoter becomes more difficult over time, eventually the digital asset may no longer be subject to U.S. securities regulations.

Guiding Questions

Hinman encouraged market participants to request additional guidance from the SEC as they work through their securities analyses, affirming that the SEC is willing to provide more formal interpretive or no-action guidance as relevant. To jumpstart this engagement, Hinman posed the following series of questions that lawyers and promoters should consider when determining whether a digital asset sale is an investment contract (and therefore a security):

• 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?

• Do persons or entities other than the promoter exercise governance rights or meaningful influence?

Hinman also provided the following additional series of guiding questions lawyers and promoters should consider when assessing the structure of a digital asset and the economic substance of any subsequent transactions in respect of the U.S. securities regulations:

• 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?

Although Hinman cautioned that these questions are simply intended to encourage industry engagement with SEC staff and are not a list of all necessary factors to consider, this list will serve as an important reference point for promoters and lawyers going forward.