This framework is intended to be instructive and is based on the Staff’s experiences to date and relevant law and legal precedent. 1992). Issuers of digital assets should be guided by the regulatory framework and concepts of materiality. 2d 53 (1973) (“Turner”). (go back), 12Howey, 328 U.S. at 298. 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. If you are considering 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. 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. endstream endobj 89 0 obj <> endobj 90 0 obj <> endobj 91 0 obj <>stream 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. . See SEC v. Int’l Loan Network, Inc., 968 F.2d 1304, 1307 (D.C. Cir. Restrictions on the transferability of the digital asset are consistent with the asset’s use and not facilitating a speculative market. The ready transferability of the digital asset is a key selling feature. The digital asset is transferable or traded on or through a secondary market or platform, or is expected to be in the future. 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. Howey Co., 328 U.S. 293 (1946) (“Howey”). The framework is not intended to be an exhaustive overview of the law; rather, it is a tool to help market participants assess whether … Under these facts, the digital asset would not be an investment contract. Howey Co. 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). [8] Absent the disclosures required by law about those efforts and the progress and prospects of the enterprise, significant informational asymmetries may exist between the management and promoters of the enterprise on the one hand, and investors and prospective investors on the other hand. �%Փ4_`�ժ�gL{�s��( Further, this framework does not replace or supersede existing case law, legal requirements, or statements or guidance from the Commission or Staff. 488, 496 n.13 (Apr. The digital asset is available in increments that correlate with a consumptive intent versus an investment or speculative purpose. No AP has access to material, non-public information or could otherwise be deemed to hold material inside information about the digital asset. 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 … The AP continues to expend funds from proceeds or operations to enhance the functionality or value of the network or digital asset. SEC Framework for “Investment Contract” Analysis of Digital Assets On April 3, 2019, the SEC’s FinHub released a “Framework for ‘Investment Contract’ Analysis of Digital Assets.”1 The Framework is the SEC staff’s most detailed pronouncement to date on when the staff would consider Initial Coin Offerings 1985). Are those efforts “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise,”. The inquiry into whether a purchaser is relying on the efforts of others focuses on two key issues: Although no one of the following characteristics is necessarily determinative, the stronger their presence, the more likely it is that a purchaser of a digital asset is relying on the “efforts of others”: 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 “efforts of others,” including but not limited to: An evaluation of the digital asset should also consider whether there is a reasonable expectation of profits. It is not an exhaustive treatment of the legal and regulatory issues relevant to conducting an analysis of whether a product is a security, including an investment contract analysis with respect to digital assets generally. No. We expect that analysis concerning digital assets as securities may evolve over time as the digital asset market matures. 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. The analysis provides guidance for applying the Howey test to digital assets to determine if they are investment contracts or securities.The test was created in the 1946 U.S. Supreme Court case, SEC v. W.J. Amid a flurry of calls for more clarity within the cryptospace, two leading SEC crypto experts released a documen t this week called the Framework for Investment Contract Analysis of Digital Assets. [4] The new FinHub framework delivers on that announcement, providing a useful analytical tool for … The AP monetizes the value of the digital asset, especially where the digital asset has limited functionality. See In re Tomahawk Exploration LLC, Securities Act Rel. 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. 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. 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. To show the markets that the Securities and Exchange Commission is not just about slapping around wrong-doers, but also trying to help people navigate the securities laws, the SEC’s FinHub published a framework for analyzing whether a digital asset is a security. Upon receipt of the digital asset, consumers immediately are able to purchase products on the network using the digital asset. (go back), 6Whether a contract, scheme, or transaction is an investment contract is a matter of federal, not state, law and does not turn on whether there is a formal contract between parties. This can be demonstrated, for example, if the AP retains a stake or interest in the digital asset. On April 3, 2019, the SEC announced the framework it would use to determine whether a digital asset would be considered an “investment contract” in light of the Supreme Court’s ruling in SEC v. W.J. The report is titled Framework for “Investment Contract” Analysis of Digital Assets, and is prefaced by the following Public Statement framing it. The digital asset is offered and purchased in quantities indicative of investment intent instead of quantities indicative of a user of the network. 88 0 obj <> endobj 2. Framework for Investment Contract Analysis of Digital Asset Transactions. Purchasers would reasonably expect the AP to undertake efforts to promote its own interests and enhance the value of the network or digital asset, such as where: The AP has the ability to realize capital appreciation from the value of the digital asset. An AP has a lead or central role in the direction of the ongoing development of the network or the digital asset. 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. This requirement for disclosure furthers the federal securities laws’ goal of providing investors with the information necessary to make informed investment decisions. Are those efforts "the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise,"as opposed to efforts that are more ministerial in nature? 0 %%EOF 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). 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. 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. [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. Making or contributing to managerial level business decisions, such as how to deploy funds raised from sales of the digital asset. 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. Last week, the US Securities and Exchange Commission (SEC) through its strategic hub for financial innovation, FinHub, published a framework for analyzing whether a digital asset will be treated as a security under the oft cited Howey test. 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) (Part I) Oct 28, 2019 1974) (citation and quotation marks omitted). 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. Further, the lack of monetary consideration for digital assets, such as those distributed via a so- called “air drop,” does not mean that the investment of money prong is not satisfied; therefore, an airdrop may constitute a sale or distribution of securities. To the extent these facts are present, the compensated individuals can be expected to take steps to build the value of the digital asset. 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. 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. (go back), 16We 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. 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. 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. 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. On April 3, 2019, the SEC issued a "Framework for 'Investment Contract' Analysis of Digital Assets," which explains the analysis provided in SEC v. W.J. In a so-called “airdrop,” a digital asset is distributed to holders of another digital asset, typically to promote its circulation. � �\_�g�9��Ǒ@E�$Ѝ ʡ��gL� .t�!J)��l���O�I��:;×�j�TImOc For all those market participants who were unclear as to whether or not their token constituted a security, on April 3, 2019, the SEC released its long-awaited guidance titled "Framework for 'Investment Contract' Analysis of Digital Assets"1 (the "Framework").The Framework represents the Staff's views and is not a rule, … %PDF-1.6 %���� [but] is motivated by a desire to use or consume the item purchased . ), cert. [10] In evaluating digital assets, we have found that a “common enterprise” typically exists. 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). 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 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. 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. 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. [9], Courts generally have analyzed a “common enterprise” as a distinct element of an investment contract. Whether a particular digital asset at the time of its offer or sale satisfies the Howey test depends on the specific facts and circumstances. 1This 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”). Among the information that must be disclosed is information relating to the essential managerial efforts that affect the success of the enterprise. A threshold issue is whether the digital asset is a “security” under those laws. 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 linked to each other or to the success of the promoter's efforts " 13. . the securities laws do not apply.”). 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. 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 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. 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. When a promoter, sponsor, or other third party (or affiliated group of third parties) (each, an “Active Participant” or “AP”) provides essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts, then this prong of the test is met. denied, 414 U.S. 821, 94 S. Ct. 117, 38 L. Ed. (go back), 7Issuers of digital assets, like all issuers, must provide full and fair disclosure of material information consistent with the requirements of the federal securities laws. 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. (go back), 11Based 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. (go back), 9The 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. Rather, the guide helps investors and companies determine the classification of a particular token. While this framework did not rise to the level of an official statement by the SEC, it generated a lot of excitement in the industry. Whether the efforts of an AP are no longer affecting the enterprise’s success. 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). The registration provisions require persons to disclose certain information to investors, and that information must be complete and not materially misleading. 1 Framework for “Investment Contract” Analysis of Digital Assets1 I. 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