Are digital tokens issued by blockchain companies securities under U.S. law? Much of the industry, including several prominent law firms, has taken the position that they are not. The Securities and Exchange Commission (SEC) has consistently stated that many or even most are securities. It recently issued a "Framework" that laid out a host of criteria that will guide the agency's analysis. With the framework and its first blockchain no-action letter, the SEC has now articulated three scenarios where a digital token may not be a security: 1) if the token is merely a store of value like Bitcoin; 2) pursuant to its no action letter, if the token exists in essentially a closed system designed for consumptive use only and has a fixed value pegged to the dollar; or 3) where the "efforts of others" prong from the Howey test is not met. The framework focuses mostly on the third case.
We will review the framework, and suggest a way to strengthen the SEC's standard to clarify how a digital token could transition to a non-security even if initially issued as a security. We believe that if a clear and workable regime is not adopted soon, the U.S. risks being left behind in the race to unlock blockchain's transformative potential.
What (Historically) Constitutes a Security? The Howey Test
The Supreme Court considered how to define a security in 1946 in SEC vs. Howey. There, hotel guests were given the chance to purchase strips of an orange grove after the hotel's owners entered into a bundle of contracts granting the guests a right to profits from the processing of the oranges through the owners' managerial efforts. The Court determined that the hotel guests were investing in a security, holding that a security is not defined by what the issuer happens to call it, but rather by the facts and circumstances around the transaction. The Court's test of a security is to ask whether there is 1) an investment of money into 2) a common enterprise with 3) an expectation of profit on behalf of the investors (the hotel guests) 4) from the efforts of the promoters (the hotel owners).
The SEC's "Framework"
Until now, Howey has been the north star, as neither Congress nor the SEC has made any definitive law on the topic. But on April 4, the SEC's Strategic Hub for Innovation and Financial Technology ("FinHub") issued the aforementioned framework, the Commission's most comprehensive guidance to date. To be sure, the framework does not constitute binding authority. But it is full of indicators on how, at least conceptually, the Commission is considering the question of whether to regulate cryptocurrencies as securities.
The SEC predictably stayed within the Howey model. The framework dispenses with the first two prongs, arguing that in any initial coin offering, there is an investment of money and a "common enterprise." The key inquiry becomes whether there was a reasonable expectation of profits that is derived from the efforts of others.
The SEC emphasized that this is an objective inquiry, and focused on several characteristics to determine whether there was an expectation of profits. The first issue is whether there is reliance on the efforts of others. Key questions are
- Are those efforts the "undeniably significant ones" that determine the success or failure of the enterprise?
- Is the expectation that these "active participants" will be overseeing the tasks necessary for the digital asset to achieve its intended purpose or functionality?
- Does the offeror attempt to control the market value by limiting supply or ensuring scarcity?
All of these questions answered in the affirmative would be further indicia that the promoters or issuers are taking an active role and are not leaving the fate of the token to a decentralized network, leading to the conclusion that the asset or token is a security.
A Workable Standard for Transitioning Away from a Security: Essential Efforts and Sustainable Value
Embedded in FinHub's framework is the rather explicit admission that it is possible for a digital token to be so widely employed on a decentralized blockchain solution that the token itself no longer derives its value from the efforts of the original issuer. The inherent logic is that there must come a point where a digital token that may have started out as a security ceases to be a security. But despite the lengthy discussion on how to determine if a token is a security, the SEC's framework is inadequate in identifying what is necessary to make that transition.
The standard we propose to determine when this change takes place is as follows: when the entrepreneur provides essential value to a digital token, and where those efforts are needed to make the value sustainable, it is a security.
Why "essential"? Courts state that when the entrepreneur provides the "predominant" source of value, a security exists. But using "predominant" as a standard becomes tricky, as it leaves courts in the unenviable position of attempting to put a number on the input of each party. "Essential" is more workable.
Why "sustainable"? A token that could temporarily survive without the efforts of the entrepreneur is still a security. The value must endure to become a commodity. We believe both elements – essential and sustainable – should be considered in determining when the "efforts of others" prong of Howey fails and a digital token becomes a commodity.
FinHub's "framework" is a helpful first step in providing clarity to stakeholders in the blockchain universe. Legislation or formal rulemaking, however, would be more helpful. And where the framework is lacking, we feel our "essential and sustainable" language could fill in the gaps to provide an even more coherent standard.