This comes as welcome news, in contrast to SEC Chairman Jay Clayton’s statements over the last year, which left little doubt about his views on ICOs and token sales: most, if not all, are securities and, therefore, are subject to the federal securities laws and SEC jurisdiction. Formal statements from the SEC and other remarks from SEC commissioners and SEC staff have generally fallen in line with his statements. These statements have mostly addressed only the initial nature of these assets as securities at the time of their issuance. Absent from guidance up to this point has been the question of whether a token that begins as a security is able to transition to something other than a security.
Director Hinman’s statements, while not the formal views of the SEC, are instructive.
- A Digital Security May Later Constitute a Non-Security. The SEC appears open to the notion that a digital asset originally sold in a securities offering may – depending on the subsequent development of the technology – later be sold in a manner that does not constitute a securities offering.In other words, a token is able to be issued as a security and eventually become an asset that is not a security, meaning that it may later be bought and sold without implicating federal securities laws. Director Hinman remarked that “the analysis of whether something is a security is not static and does not strictly inhere to the instrument.” Instead, “the circumstances surrounding the digital asset and the manner in which it is sold,” rather than simply the asset itself, determine whether the sale is or is not a securities sale.
Director Hinman confirmed what the SEC has said since it issued the DAO report almost a year ago: that a token will be a security “where the digital asset represents a set of rights that gives the holder a financial interest in an enterprise.” In other words, where the asset conveys equity in the enterprise or rights to capital or profit distributions, the asset likely begins as and would remain a security.
However, a token can, in effect, morph over time from a security to a non-security asset where the enterprise or platform achieves decentralization – or where the asset is “sold only to be used to purchase a good or service available through the network on which it was created.” (Emphasis added.) Conversely, and very importantly, Director Hinman’s remarks suggest that the SEC’s view likely remains unchanged as to tokens issued by entities whose enterprises and platforms continue to be operated, supported, and/or managed by the founders or their delegates, even where holdings of the corresponding token are significantly dispersed.
And there may be relatively few tokens at this point that are sold “only” for use on the network/platform. Thus, Director Hinman’s remarks leave residual questions that could scuttle theories that the utility of a token negates security status. For instance, does secondary trading on a third-party exchange void the “only” element of Director Hinman’s statement? Does the token need to be locked down for use “only” on the network/platform? What if holders transmit tokens to each other on a peer-to-peer basis?
Decentralization as a Path to Non-Security Status. Director Hinman’s remarks provide a clearer roadmap of the factors the SEC may consider when determining whether a digital asset is or is not a security at any point in its life cycle. At the heart of the analysis is whether the project, enterprise or platform has achieved decentralization, such that its success or viability is no longer driven by a single person, entity or coordinated group. Where decentralization has been achieved, the asset would, in theory, no longer derive its value “solely from the efforts of the promoter or a third party,” and thus not possess that important characteristic of a security under the Howey test.
Regarding decentralization, Director Hinman noted that “[i]f the network on which the token or coin is to function is sufficiently decentralized – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts – the assets may not represent an investment contract. Moreover, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede.” (Emphasis added.) This may serve as a beacon of hope for those who take the view that the decentralization of a platform over time erodes the characteristics of an investment contract and therefore of a security.
Director Hinman provided the following non-exhaustive list of factors that would indicate that the asset remains a security:
- Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value?
- Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?
- Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?
- Are purchasers “investing,” that is seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?
- Does application of the Securities Act of 1933 protections “make sense”? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?
- Do persons or entities other than the promoter exercise governance rights or meaningful influence?
- Utility (Exclusively) as a Path to Non-Security Status. Director Hinman also noted that “there are contractual or technical ways to structure digital assets so they function more like a consumer item and less like a security” and identified the following factors that may influence the SEC toward deeming the digital asset to have been sold “only” for utility:
- Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?
- Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading?
- Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent?
- Are the tokens distributed in ways to meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?
- Is the asset marketed and distributed to potential users or the general public?
- Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?
- Is the application fully functioning or in early stages of development?
- Bitcoin and Ether Are Not Securities. The SEC is unlikely to view current and future transactions in Bitcoin as securities transactions and, arguably, this is also the case going back to the “genesis” event. The SEC also is unlikely to view current and future transactions in Ether as securities transactions. This should give considerable reassurance to the various existing platforms that permit trading of Bitcoin, Ether and certain other coins that they likely are not subject to the SEC’s jurisdiction and, therefore, that they are not required to comply with, for example, securities broker and securities exchange requirements. Director Hinman’s remarks reaffirm observations of SEC Commissioner Hester Peirce who, in a May 2018 speech, stated that cryptocurrencies like Bitcoin “may be currency, commodities, or something else, but it is unlikely that, on their own, they’re actually securities.” SEC Chairman Clayton has also previously indicated his view that Bitcoin is not a security, although he has been reluctant to conclude the same with respect to Ether. The status and fate of other coins remain less clear. Director Hinman’s remarks also “[put] aside the fundraising that accompanied the creation of Ether,” thereby leaving open the notion that the original minting of Ether may have been a securities offering.
Over the better part of the past 12 months, the SEC has provided intermittent, incremental guidance – both formal and informal – on cryptocurrency, ICOs and other related topics potentially within its jurisdictional reach. Almost all point to prohibitions and tight securities regulation, rather than permissible activity. Director Hinman’s remarks, while not binding on the SEC, represent a significant step toward greater clarity as to viable paths for token sales in an industry that is seeking to read the tea leaves in an evolving U.S. regulatory regime. The SEC will likely provide formal guidance or findings on these and other topics in the near future, and we will share those updates with you as we receive them.
Mitzi ChangPartnerCo-Chair, Digital Currency & Blockchain, Fintech
John J. Falvey Jr.Partner
Grant P. FondoPartnerCo-Chair, Digital Currency & Blockchain
Nicholas J. LosurdoPartner
Meghan K. SpillanePartner