Last week the SEC offered its clearest guidance yet on when blockchain tokens and other digital assets would be classified as “securities” under U.S. securities law and subject to SEC regulation.
Specifically, the SEC’s Strategic Hub for Innovation and Financial Technology (FinHub) issued its first-ever “Framework for ‘Investment Contract’ Analysis of Digital Assets.”
The guidance provides a much-needed framework for analyzing when a digital asset is an investment contract and when offers and sales of a digital asset are securities transactions. In short, the guidance explains how the SEC applies the Howey test to the issuance and sale of digital assets and what factors are key in determining whether a token sale is a securities transaction.
Unsurprisingly, one of the most significant factors is the “Reasonable Expectation of Profits Derived from Efforts of Others” prong of the Howey test. The framework provides that when a promoter, sponsor, or other third party provides “essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts,” then the token sale is likely to be considered a securities offering.
The framework also provides a list of factors that, while not necessarily determinative, weigh against a securities classification. These include, among others, when the distributed ledger network and digital asset are fully developed and operational, when prospects for appreciation in the value of the digital asset are limited, and when the asset is marketed in a manner that emphasizes its functionality.
In addition, the SEC, in another first, issued a no-action letter to a company (TurnKey Jet, Inc.) that was proposing to launch a token sale. The letter states that the SEC’s Division of Corporation Finance will not recommend an enforcement action against the company if it goes forward with the token sale.
Consistent with the digital asset framework, the no-action letter sets out a number of significant factors that lead the Division to its conclusion. These, among others, include the following:
- The fact that the company will not use any funds from the token sale to develop its platform, token, or any associated App;
- The token, platform, and associated app will be fully developed, operational, and usable at the time of the token sale;
- Tokens cannot be transferred outside of the platform;
- The token is and will remain pegged at one USD per token, representing TurnKey Jet’s obligation to supply air charter services at a value of one USD per token; and
- The token is marketed in a manner that emphasizes its functionality and not the potential for an increase in its market value.
While the letter purports not to provide an express legal conclusion, these factors provide a concrete example, consistent with the digital asset framework, of when a token sale will escape classification as a securities transaction. While the TurnKey no-action letter and the digital asset framework are not truly surprising in substance, offering a fairly predictable application of the Howey test, the fact the SEC has now issued this guidance is a significant step forward for the industry.