Earlier this month, the Securities and Exchange Commission (“SEC”) provided additional guidance on digital assets, which include “tokens” and “coins.” The SEC’s Strategic Hub for Innovation and Financial Technology (“FinHub”) published a framework for analyzing whether digital assets are offered and sold as “investment contracts” and, therefore, “securities” under the federal securities laws. On the same day, the SEC’s Division of Corporation Finance (the “Division”) issued a no-action letter involving a proposed token offering without registration under the federal securities laws.
The Framework
FinHub’s guidance provides a framework for analyzing whether a digital asset is an investment contract and, therefore, a security. The framework endorses the SEC’s longstanding practice of applying the Supreme Court’s so-called Howey test to determine whether offers and sales of a digital asset are securities. Under the Howey test and subsequent case law, an “investment contract” exists when there is (i) an investment of money (ii) in a common enterprise (iii) with a reasonable expectation of profits to be derived from the efforts of others.
The framework applies each element of the three-pronged Howey test to digital assets and concludes that the first two prongs (i.e., the investment of money, common enterprise) are typically satisfied. As a result, the framework focuses on the most complex issue under the Howey test concerning “whether a purchaser has a reasonable expectation of profits (or other financial returns) derived from the efforts of others.”
The framework provides a list of characteristics relevant in analyzing whether the third prong of the Howey test is satisfied. The “reasonable expectation of profits” component is analyzed by applying a list of factors to the digital asset. Those factors include whether (i) the holder has the right to share in the capital appreciation of the digital asset, (ii) the digital asset is transferable or traded in a secondary market, (iii) the digital asset is offered broadly, and (iv) there is little correlation between the 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.
The framework also provides another list of factors to be considered when analyzing whether a purchaser is relying on the efforts of others. Those factors include whether there is an expectation that sponsors, promoters, or other third parties (“Active Participants”) perform certain activities for the benefit of the digital asset or network, including whether Active Participants are responsible for the development or improvement of the network or create or support a market for, or the price of, the digital asset.
The framework is certainly not the final word on digital assets from SEC Staff. It is noteworthy that the framework also provides guidance on when a digital asset sold as a security can evolve such that it is no longer a security. This suggests the SEC can re-evaluate whether existing digital assets are securities as those assets evolve over time.
TurnKey Jet, Inc. (“TKJ”) No-Action Letter
The Division also issued the first no-action letter on a digital asset contemporaneously with the release of the framework. The Division’s no-action letter was issued to TKJ, an air charter service proposing to launch a token membership program and develop a platform to facilitate sales of tokens for air charter services. In the no-action letter, the Division, consistent with the factors set forth in the framework, agreed not to recommend enforcement action to the SEC if TKJ were to offer and sell its tokens without registration under the federal securities laws in accordance with certain conditions, including:
- TKJ cannot use proceeds from issuing tokens to develop its platform, network, or mobile app, each of which must be fully developed at the time any tokens are sold
- TKJ tokens will be immediately usable for their intended functionality—the purchase of air charter services—at the time they are sold
- TKJ tokens cannot be transferred outside the TKJ network and can only be sold back to TKJ at a discount to their face value
- TKJ tokens will remain priced at a fixed U.S. dollar amount per token
- TKJ tokens must be marketed in a way that emphasizes their functionality as a token and not their investment potential
Together, the framework and the TKJ no-action letter provide some clarity to an emerging Fintech industry. The SEC’s actions underscore that its approach is to apply existing legal standards to innovative products instead of creating a whole new regulatory framework. Until Congressional action or new case law governing the offering and sale of digital assets emerges, the SEC’s framework and future administrative guidance, enforcement actions, and no-action letters will be critical considerations for entities considering initial coin offerings or offerings or sales of other forms of digital assets.
