On April 3, 2019, the Securities and Exchange Commission (“SEC”) released the “Framework for ‘Investment Contract’ Analysis of Digital Assets” (the “Framework”). The Framework—published by the SEC’s Strategic Hub for Innovation and Financial Technology (“FinHub”) —is the most comprehensive guidance the SEC has provided to date with respect to a method of analyzing whether digital assets fall within existing securities laws. Although the Framework is not a binding rule, regulation or statement of the SEC, it provides much needed guidance to the public on analyzing whether a particular token is likely to be considered a security. The Framework builds on the SEC’s previous analysis, as articulated in The DAO Investigative Report,[1] the Munchee settlement[2] and other enforcement actions and informal statements by the Commission.[3]
The Framework
Consistent with the SEC’s prior guidance, the Framework outlines the applicable standard for analyzing digital assets under the securities laws by applying the “investment contract” test articulated in S.E.C. v. W. J. Howey Co., 328 U.S. 293 (1946) to digital assets. The Framework presents the SEC’s view that the first two prongs of the Howey test—whether there is: (1) an investment of money; and (2) a common enterprise —as typically satisfied in the case of digital assets. As a result, much of the SEC’s analysis turns on application of the third prong, namely whether there is a reasonable expectation of profits to be derived from the efforts of others. The SEC breaks this prong into two components: (i) whether purchasers are reliant on the managerial efforts of others; and (ii) whether purchasers are led to expect profits from such efforts.
The Framework articulates an illustrative list of factors that may suggest that purchasers are relying on the managerial efforts of others, including whether there is an expectation that other parties—including sponsors, promoters or other third-parties—perform the following activities for the benefit of the digital asset or network:
- Develops or maintains the functionality of the network;
- Attains growth in the value of the digital asset;
- Take steps to support a market price by limiting supply or forcing scarcity, for example, through buybacks or “burning;” and/or
- Exercises continuing managerial oversight of the digital asset or network, including (i) making decisions about compensating individuals for work related to the asset or network; (ii) determining whether a digital asset will be traded on a secondary market or platform; (iv) establishing criteria for distributing additional digital assets to individuals; (v) making business decisions about using the proceeds of a digital asset sale; (vi) playing an integral role in validating transactions; (vii) overseeing network security; and (viii) otherwise making decisions that will impact the success of the digital asset or network, in addition to other factors.
The Framework also outlines factors that may suggest that a purchaser has a reasonable expectation of profits, including where:
- Purchasers share in the capital appreciation of the digital asset;
- The digital asset can be traded on the secondary market;
- The digital asset is sold to purchasers who are not likely to use the asset for anything other than investment purposes;
- The digital asset is marketed or promoted as an investment;
- Proceeds from the sale of the digital asset are used to increase the value of the digital asset or functionality of the network; and/or
- The digital asset bears little correlation to the value of goods or services the digital asset can be exchanged for.
The Framework also includes a list of factors that may suggest that an instrument is not a security. These factors largely focus on the ability to use a digital asset for consumer or commercial purposes, and not primarily as an investment. For example, the following factors may indicate that a digital asset is less likely to be considered a security:
- The network or platform is fully developed and operational;
- The digital asset was designed for use rather than investment;
- The potential for appreciation of the digital asset is limited;
- Trading or transfer of the digital asset is restricted;
- The digital asset can be used as a payment tool for goods or services; and/or
- Any appreciation in value of the asset is incidental to its intended use.
The Framework also notes that partial functionality, or an expectation that either a network will grow substantially or digital assets will appreciate in value, may lead to the conclusion that even a functional token is actually a security.
Implications of The Framework for Issuers and Purchasers of Digital Assets
While the Framework clarifies guidance previously articulated by the SEC through enforcement actions and comments of Commissioners, the Framework does not radically alter the analytic approach as to whether digital assets are securities. The Framework is helpful, however, in distilling the relevant factors that have been articulated in a variety of sources into one operative document. Further, the Framework is instructive as it implicitly endorses the notion that a digital security that was once deemed a security may no longer be a security after the asset achieves certain developmental milestones, such as achieving its intended functionality, including use as a medium of exchange, without requiring ongoing efforts of others. The Framework also articulates several additional factors that may indicate that, “at the time of later offers or sales,” an instrument may no longer be a security.
Going forward, insights from the Framework will be helpful to issuers and their advisors as they (1) seek to prospectively structure their platforms and digital assets in a manner that will not implicate the securities laws; or (2) seek to evaluate whether existing digital assets have become sufficiently decentralized such that they may no longer be considered securities. The Framework is also significant for exchanges, alternative trading systems and other platforms that support trading or exchange of digital assets, which can benefit from integrating this guidance into their existing rubrics for evaluating whether digital assets that are traded on their platforms may implicate the securities laws.
Where these comments are non-binding, issuers and exchanges should not assume that their adherence to the factors articulated in the Framework will necessarily be dispositive in the securities analysis in an individual case. The Framework does, however, provide yet another helpful touchpoint in the mix of information available as the industry attempts to structure securities-compliant blockchain platforms and digital assets.
[1] See, e.g., Report of Investigation Pursuant to Section 21(a) of the Securities and Exchange Act of 1934: The DAO (Exchange Act Rel. No. 81207) (July 25, 2017) (“The DAO Investigative Report”).
[2] In re Munchee Inc., Securities Act Release No. 10445 (December 11, 2017).
[3] See, e.g., 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.