On April 3, 2019, the Strategic Hub for Innovation and Financial Technology – known as “FinHub” – of the U.S. Securities and Exchange Commission (the “SEC”) published a “Framework for ‘Investment Contract’ Analysis of Digital Assets” (the “Guideline”) to provide additional guidance to market participants in determining whether a “digital asset… Making other managerial judgements or decisions that will directly or indirectly impact the success of the network or the value of the digital asset generally. [5]  The so-called “Howey test” applies to any contract, scheme, or transaction, regardless of whether it has any of the characteristics of typical securities. Allie’s counsel ... Chris Brinkman practices in the firm's Business Representation & Transactions Group with a concentration in venture capital/private equity, start-ups & growth companies, securities, and mergers and acquisitions. 81207) (July 25, 2017) (“The DAO Report“); William Hinman, Digital Asset Transactions: When Howey Met Gary (Plastic), Remarks at the Yahoo Finance All Markets Summit: Crypto (June 14, 2018), available at https://www.sec.gov/news/speech/speech-hinman-061418. This can be demonstrated, for example, if the AP retains a stake or interest in the digital asset. SEC, Framework for “Investment Contract” Analysis of Digital Assets … As noted above, under the Howey test, 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. Profits can be, among other things, capital appreciation resulting from the development of the initial investment or business enterprise or a participation in earnings resulting from the use of purchasers' funds. Howey found that an “investment contract” exists where there is an investment of money in a common enterprise with a reasonable expectation that profits will be derived from others’ efforts. publishing a framework for analyzing whether a digital asset is offered and sold as an investment contract, and, therefore, is a security. The framework is not intended to be an exhaustive overview of … 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. The U.S. regulator is publishing a framework for analyzing whether a digital asset is offered and sold as an investment contract, and, therefore, is a security. SEC FinHub Publishes Framework for Investment Contract Analysis of Digital Assets 04.08.19 On April 3, 2019, the Strategic Hub for Innovation and Financial Technology (“FinHub”) released a framework for … The AP monetizes the value of the digital asset, especially where the digital asset has limited functionality. The future (and not present) functionality of the network or digital asset, and the prospect that an AP will deliver that functionality. Business Representation & Transactions Group. The Strategic Hub for Innovation and Financial Technology ("Staff") of the Securities and Exchanges Commission ("SEC") recently released a Framework for 'Investment Contract' Analysis of Digital Assets ("Framework" or "Document") 1.These are essentially guidelines to assess whether an investment into a digital asset (which, per the document includes any asset … Printer-Friendly Version. The digital asset is offered broadly to potential purchasers as compared to being targeted to expected users of the goods or services or those who have a need for the functionality of the network. See, e.g., Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (Exchange Act Rel. When It Comes to Analyzing Utility Tokens, the SEC Staff’s “Framework for ‘Investment Contract’ Analysis of Digital Assets” May Be the Emperor Without Clothes (Or, Sometimes an Orange Is Just an Orange) … [15] In this guidance, we are using the term “network” broadly to encompass the various elements that comprise a digital asset’s network, enterprise, platform, or application. The new framework provides an in-depth description of how the SEC uses a measure called the Howey Test to determine whether a given asset qualifies as a type of security called an … Whether or not the efforts of an AP, including any successor AP, continue to be important to the value of an investment in the digital asset. Even in cases where a digital asset can be used to purchase goods or services on a network, where that network’s or digital asset’s functionality is being developed or improved, there may be securities transactions if, among other factors, the following is present:  the digital asset is offered or sold to purchasers at a discount to the value of the goods or services; the digital asset is offered or sold to purchasers in quantities that exceed reasonable use; and/or there are limited or no restrictions on reselling those digital assets, particularly where an AP is continuing in its efforts to increase the value of the digital assets or has facilitated a secondary market. On April 3, 2019, the Strategic Hub for Innovation and Financial Technology – known as “FinHub” – of the Securities and Exchange Commission (“SEC”) published a “Framework for Investment Contract Analysis of Digital Assets” (“Guideline”) to provide additional guidance to market participants in determining whether a “digital asset… Whether a particular digital asset at the time of its offer or sale satisfies the Howey test depends on the specific facts and circumstances. Making or contributing to managerial level business decisions, such as how to deploy funds raised from sales of the digital asset. With respect to a digital asset that represents rights to a good or service, it currently can be redeemed within a developed network or platform to acquire or otherwise use those goods or services. It is not a rule, regulation, or statement of the Commission, and the Commission has neither approved nor disapproved its content. A partner in the firm’s Business Representation & Transaction ... As a partner in the firm’s Business Representation & Transactions Group, Allie Westfall’s insight and proven analytical skills help translate the complexities of the often-challenging securities laws. With respect to a digital asset referred to as a virtual currency, it can immediately be used to make payments in a wide variety of contexts, or acts as a substitute for real (or fiat) currency. [but] is motivated by a desire to use or consume the item purchased  . No AP has access to material, non-public information or could otherwise be deemed to hold material inside information about the digital asset. If it is characterized as a virtual currency, the digital asset actually operates as a store of value that can be saved, retrieved, and exchanged for something of value at a later time. In these instances, purchasers would reasonably expect the AP to undertake efforts to promote its own interests and enhance the value of the network or digital asset. Profits can be, among other things, capital appreciation resulting from the development of the initial investment or business enterprise or a participation in earnings resulting from the use of purchasers’ funds. Usually, the main issue in analyzing a digital asset under the Howey test is whether a purchaser has a reasonable expectation of profits (or other financial returns) derived from the efforts of others. To the extent these facts are present, the compensated individuals can be expected to take steps to build the value of the digital asset. On April 3, 2019, the SEC attempted to provide clarity by releasing a “Framework for ‘Investment Contract’ Analysis of Digital Assets,” 2× 2. See Turner, 474 U.S. at 482; see also The DAO Report (although DAO token holders had certain voting rights, they nonetheless reasonably relied on the managerial efforts of others). . The intended use of the proceeds from the sale of the digital asset is to develop the network or digital asset. Purchasers reasonably would expect that an AP’s efforts will result in capital appreciation of the digital asset and therefore be able to earn a return on their purchase. For example, it is offered and purchased in quantities significantly greater than any likely user would reasonably need, or so small as to make actual use of the asset in the network impractical. [6]  The focus of the Howey analysis is not only on the form and terms of the instrument itself (in this case, the digital asset) but also on the circumstances surrounding the digital asset and the manner in which it is offered, sold, or resold (which includes secondary market sales). Whether the efforts of an AP are no longer affecting the enterprise’s success. The following characteristics are especially relevant in an analysis of whether the third prong of the Howey test is satisfied. In this guidance, we provide a framework for analyzing whether a digital asset has the characteristics of one particular type of security – an “investment contract.”4Both the Commission and the federal courts frequently use the “investment contract” analysis to determine whether unique or novel instruments or arrangements, such as digital assets… The Framework states that an investment in a digital asset would usually constitute an investment in a common enterprise because “ the fortunes of digital asset purchasers have been … Community Development Financial Institutions Fund, Stimulus Package Reverses IRS’s Position on Deductibility of PPP Expenses and Other Loan Forgiveness Issues, Nasdaq Proposes New Listing Rules to Advance Board Diversity: Comply or Explain, More Disclosure Modernization: SEC Adopts Significant Amendments to Financial Disclosure Rules, SEC Eases Limits and Rules on Private Offerings, SEC Proposes Conditional Exemption for "Finders" Involved in Capital Raising, Ohio Adopts Protections for Ohio Businesses from Coronavirus - Related Lawsuits, SEC Scales Back Financial Disclosures for Business Combinations, State of Ohio Issues Urgent Health Advisory and Partial Rescission of “Stay at Home” Order, SEC Adopts Temporary Rules to Expedite Regulation Crowdfunding Offerings Amid COVID-19 Pandemic, Treasury Releases PPP Loan Forgiveness Application. Relevant factors may include: There is a correlation between the purchase price of the digital asset and a market price of the particular good or service for which it may be redeemed or exchanged. Third, the SEC considers other relevant considerations, including whether the digital asset is fully developed and operational and whether there would be an appreciation in value incidental to the asset obtaining its intended functionality. In applying the framework to digital assets, the SEC focuses on three main prongs. Howey Co., 328 U.S. 293 (1946), to determine whether a digital asset … In a so-called “airdrop,” a digital asset is distributed to holders of another digital asset, typically to promote its circulation. The Role of Institutional Investor Regulation in Restoring a Fair, Sustainable Economy, Short Sellers and Plaintiffs’ Firms: A Symbiotic Ecosystem, ESG, Common Ownership, and Systematic Risk: How They Intersect, Activist Short Selling Today: The Two Sides of the Coin, https://www.sec.gov/news/speech/speech-hinman-061418. 1974) (citation and quotation marks omitted). The digital asset is marketed in a manner that emphasizes the functionality of the digital asset, and not the potential for the increase in market value of the digital asset. All rights reserved. Upon receipt of the digital asset, consumers immediately are able to purchase products on the network using the digital asset. A digital asset should be analyzed to determine whether it has the characteristics of any product that meets the definition of “security” under the federal securities laws. Statement on “Framework for ‘Investment Contract’ Analysis of Digital Assets” Framework for “Investment Contract” Analysis of Digital Assets Turnkey Jet No-Action Letter SEC staff advises on … Relevant to this inquiry is the “economic reality”[12] of the transaction and “what character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect.”[13]  The inquiry, therefore, is an objective one, focused on the transaction itself and the manner in which the digital asset is offered and sold. Use of the Blogs does not create any attorney-client relationship between you and any individual KMK attorney or the firm. Rather, under the Howey test, “form [is] disregarded for substance and the emphasis [is] on economic reality.”  Howey, 328 U.S. at 298. Playing a leading role in the validation or confirmation of transactions on the network, or in some other way having responsibility for the ongoing security of the network. [9] The lack of monetary consideration for digital assets, such as those distributed via a so-called “bounty program” does not mean that the investment of money prong is not satisfied. That a scheme assigns “nominal or limited responsibilities to the [investor] does not negate the existence of an investment contract.”  SEC v. Koscot Interplanetary, Inc., 497 F.2d 473, 483 n.15 (5th Cir. The federal securities laws require all offers and sales of securities, including those involving a digital asset, to either be registered under its provisions or to qualify for an exemption from registration. An AP is responsible for the development, improvement (or enhancement), operation, or promotion of the network. . No. This means that it is possible to pay for goods or services with the digital asset without first having to convert it to another digital asset or real currency. In this guidance, we provide a framework for analyzing whether a digital asset has the characteristics of one particular type of security – an “investment contract.”[4]  Both the Commission and the federal courts frequently use the “investment contract” analysis to determine whether unique or novel instruments or arrangements, such as digital assets, are securities subject to the federal securities laws. In this guidance, we provide a framework for analyzing whether a digital asset is an investment contract and whether offers and sales of a digital asset … Issuers of digital assets should be guided by the regulatory framework and concepts of materiality. 1985). [18]  Price appreciation resulting solely from external market forces (such as general inflationary trends or the economy) impacting the supply and demand for an underlying asset generally is not considered “profit” under the Howey test. [9], Courts generally have analyzed a “common enterprise” as a distinct element of an investment contract. Rather, the framework provides additional guidance in the areas that the Commission or Staff has previously addressed. [2] The term “digital asset,” as used in this framework, refers to an asset that is issued and transferred using distributed ledger or blockchain technology, including, but not limited to, so-called “virtual currencies,” “coins,” and “tokens.”. Therefore, issuers and other persons and entities engaged in the marketing, offer, sale, resale, or distribution of any digital asset will need to analyze the relevant transactions to determine if the federal securities laws apply. The AP continues to expend funds from proceeds or operations to enhance the functionality or value of the network or digital asset. If the AP facilitates the creation of a secondary market, transfers of the digital asset may only be made by and among users of the platform. On April 3, 2019, the SEC’s Strategic Hub for Innovation and Financial Technology (“FinHub”) 1 published a framework for analyzing whether a digital asset is offered and sold as an investment contract and, therefore, is a security (the “Framework… 81, 87-88 (2d Cir. The AP is able to benefit from its efforts as a result of holding the same class of digital assets as those being distributed to the public. The more the following characteristics are present, the more likely it is that there is a reasonable expectation of profit: In evaluating whether a digital asset previously sold as a security should be reevaluated at the time of later offers or sales, there would be additional considerations as they relate to the “reasonable expectation of profits,” including but not limited to: When assessing whether there is a reasonable expectation of profit derived from the efforts of others, federal courts look to the economic reality of the transaction. Howey found that an “investment contract” exists where there is an investment of money in a common enterprise with a reasonable expectation that profits will be derived from others’ efforts. We expect that analysis concerning digital assets as securities may evolve over time as the digital asset market matures. The information contained within another site that is linked to or from the Blog are beyond the control of the individual blogger or KMK and do not convey approval, support, or any relationship to any site or organization. denied, 414 U.S. 821, 94 S. Ct. 117, 38 L. Ed. Whether the network on which the digital asset is to function operates in such a manner that purchasers would no longer reasonably expect an AP to carry out essential managerial or entrepreneurial efforts. The discussion above identifies some of the factors market participants should consider in assessing whether a digital asset is offered or sold as an investment contract and, therefore, is a security. SEC Offers Framework for “Investment Contract” Analysis of Digital Assets By Securities and Exchange Commission April 8, 2019 by renholding If you are considering [1] an Initial Coin Offering, sometimes referred to as an “ICO,” or otherwise engaging in the offer, sale, or distribution of a digital asset, … The first prong of the Howey test is typically satisfied in an offer and sale of a digital asset because the digital asset is purchased or otherwise acquired in exchange for value, whether in the form of real (or fiat) currency, another digital asset, or other type of consideration. A threshold issue is whether the digital asset is a “security” under those laws. Holders of the digital asset are immediately able to use it for its intended functionality on the network, particularly where there are built-in incentives to encourage such use. See also United Housing Found., Inc. v. Forman, 421 U.S. 837 (1975) (“Forman“); Tcherepnin v. Knight, 389 U.S. 332 (1967) (“Tcherepnin“); SEC v. C. M. Joiner Leasing Corp., 320 U.S. 344 (1943) (“Joiner“). There is little apparent correlation between the purchase/offering price of the digital asset and the market price of the particular goods or services that can be acquired in exchange for the digital asset. [21] See Forman, 421 U.S. at 852-53 (where a purchaser is not “‘attracted solely by the prospects of a return’ on his investment . The Blogs do not constitute legal advice and are not a substitute for legal advice from a licensed attorney in your state. A digital asset should be analyzed to determine whether it has the characteristics of any product that meets the definition of “security” under the federal securities laws. Whether 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. [17] See, e.g., Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce Fenner & Smith, 756 F.2d 230 (2d Cir. The Framework emphasizes that it is only a guideline for analyzing whether the digital asset represents an investment contract, and that no single factor is determinative. [11] Based on our experiences to date, investments in digital assets have constituted investments in a common enterprise because the fortunes of digital asset purchasers have been linked to each other or to the success of the promoter’s efforts. The digital assets are not transferable; rather, consumers can only use them to purchase products from the retailer or sell them back to the retailer at a discount to the original purchase price. [1] This framework represents the views of the Strategic Hub for Innovation and Financial Technology (“FinHub,” the “Staff,” or “we”) of the Securities and Exchange Commission (the “Commission”). The Framework only briefly addresses the “investment of money” element, indicating that offering and sale of digital assets are typically satisfied because the asset is exchanged for value … [3] The term “security” is defined in Section 2(a)(1) of the Securities Act of 1933 (the “Securities Act”), Section 3(a)(10) of the Securities Exchange Act of 1934, Section 2(a)(36) of the Investment Company Act of 1940, and Section 202(a)(18) of the Investment Advisers Act of 1940. Potential purchasers have the ability to use the network and use (or have used) the digital asset for its intended functionality. If you are considering[1] an Initial Coin Offering, sometimes referred to as an “ICO,” or otherwise engaging in the offer, sale, or distribution of a digital asset,[2] you need to consider whether the U.S. federal securities laws apply. Purchasers of the digital asset no longer reasonably expect that continued development efforts of an AP will be a key factor for determining the value of the digital asset. The digital asset is marketed, directly or indirectly, using any of the following: The expertise of an AP or its ability to build or grow the value of the network or digital asset. For example, take the case of an online retailer with a fully-developed operating business. The potential profitability of the operations of the network, or the potential appreciation in the value of the digital asset, is emphasized in marketing or other promotional materials. An AP has a lead or central role in the direction of the ongoing development of the network or the digital asset. The distributed ledger network and digital asset are fully developed and operational. The Commission, on the other hand, does not require vertical or horizontal commonality per se, nor does it view a “common enterprise” as a distinct element of the term “investment contract.”  In re Barkate, 57 S.E.C. The second piece of guidance came in the form of a “Framework for ‘Investment Contract’ Analysis of Digital Assets” that is intended to serve as “an analytical tool to help market participants … Are those efforts “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise,”. See TSC Industries v. Northway, 426 U.S. 438, 449 (1976) (a fact is material “if there is a substantial likelihood that a reasonable shareholder would consider it important” in making an investment decision or if it “would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available” to the shareholder). We address each of the elements of the Howey test below. Also, no one factor is necessarily dispositive as to whether or not an investment contract exists. In this guidance, we provide a framework for analyzing whether a digital asset is an investment contract and whether offers and sales of a digital asset are securities transactions. Where the network or the digital asset is still in development and the network or digital asset is not fully functional at the time of the offer or sale, purchasers would reasonably expect an AP to further develop the functionality of the network or digital asset (directly or indirectly). What is the document? The Supreme Court has further explained that that the term security “embodies a flexible rather than a static principle” in order to meet the “variable schemes devised by those who seek the use of the money of others on the promise of profits.”  Id. Whether holders are then able to use the digital asset for its intended functionality, such as to acquire goods and services on or through the network or platform. If the AP provides efforts that are “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise,” and the AP is not merely performing ministerial or routine tasks, then there likely is an investment contract. [10]  In evaluating digital assets, we have found that a “common enterprise” typically exists.[11]. [14] SEC v. Glenn W. Turner Enter., Inc., 474 F.2d 476, 482 (9th Cir. The AP distributes the digital asset as compensation to management or the AP’s compensation is tied to the price of the digital asset in the secondary market. As the Commission explained in The DAO Report, “[i]n determining whether an investment contract exists, the investment of ‘money’ need not take the form of cash” and “in spite of Howey‘s reference to an ‘investment of money,’ it is well established that cash is not the only form of contribution or investment that will create an investment contract.” The DAO Report at 11 (citation omitted). See discussion of “Other Relevant Considerations.”. Second, the SEC examines whether there is a reasonable expectation of profits by looking at several factors, including whether the purchaser has a right to the enterprise’s income or profits and whether there is an ability to trade the asset through a market or platform. Restrictions on the transferability of the digital asset are consistent with the asset’s use and not facilitating a speculative market. A purchaser may expect to realize a return through participating in distributions or through other methods of realizing appreciation on the asset, such as selling at a gain in a secondary market. Although no one of the following characteristics of use or consumption is necessarily determinative, the stronger their presence, the less likely the Howey test is met: Digital assets with these types of use or consumption characteristics are less likely to be investment contracts. To address the more common implementations and applications of blockchain, tokens and cryptocurrencies, Division of Corporation Finance Staff announced the release of a "Framework for 'Investment Contract' Analysis of Digital Assets… FinHub's framework explains the staff's views on how the "investment contract" analysis… The retailer creates a digital asset to be used by consumers to purchase products only on the retailer’s network, offers the digital asset for sale in exchange for real currency, and the digital asset is redeemable for products commensurately priced in that real currency. Howey Co., 328 U.S. 293 (1946) (“Howey“). See also Tcherepnin, 389 U.S. at 336 (“in searching for the meaning and scope of the word ‘security’ in the [Acts], form should be disregarded for substance and the emphasis should be on economic reality.”). For example, purchasers may reasonably rely on an AP for liquidity, such as where the AP has arranged, or promised to arrange for, the trading of the digital asset on a secondary market or platform. © 2021 Keating Muething & Klekamp PLL. Ascertaining the status of digital asset as an investment contract and as a security will now be easier courtesy of the framework published on 3 April by the United States Securities and Exchange Commission (SEC) titled ‘Framework for ‘Investment Contract’ Analysis of Digital Assets’. Under these facts, the digital asset would not be an investment contract. In applying the framework … [5] SEC v. W.J. Determining whether and where the digital asset will trade. The U.S. Supreme Court’s Howey case and subsequent case law have found 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. 10530 (Aug. 14, 2018) (issuance of tokens under a so-called “bounty program” constituted an offer and sale of securities because the issuer provided tokens to investors in exchange for services designed to advance the issuer’s economic interests and foster a trading market for its securities). the securities laws do not apply.”). The digital asset is available in increments that correlate with a consumptive intent versus an investment or speculative purpose. The digital asset is offered and purchased in quantities indicative of investment intent instead of quantities indicative of a user of the network. See SEC v. Int’l Loan Network, Inc., 968 F.2d 1304, 1307 (D.C. Cir. In particular, an AP plays 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. The registration provisions require persons to disclose certain information to investors, and that information must be complete and not materially misleading. [16] We recognize that holders of digital assets may put forth some effort in the operations of the network, but those efforts do not negate the fact that the holders of digital assets are relying on the efforts of the AP. The digital asset gives the holder rights to share in the enterprise’s income or profits or to realize gain from capital appreciation of the digital asset. [20] As noted above, under Howey, courts conduct an objective inquiry focused on the transaction itself and the manner in which it is offered. For example, the design of the digital asset provides that its value will remain constant or even degrade over time, and, therefore, a reasonable purchaser would not be expected to hold the digital asset for extended periods as an investment. Howey Co. and subsequent case law. What is material depends upon the nature and structure of the issuer’s particular network and circumstances. For example, the digital asset can only be used on the network and generally can be held or transferred only in amounts that correspond to a purchaser’s expected use. [12] Howey, 328 U.S. at 298. The availability of a market for the trading of the digital asset, particularly where the AP implicitly or explicitly promises to create or otherwise support a trading market for the digital asset. Managerial and entrepreneurial efforts typically are characterized as involving expertise and decision-making that impacts the success of the business or enterprise through the application of skill and judgment.