The U.S. Securities and Exchange Commission recently issued its first formal (though legally non-binding) guidance on when digital assets (typically recorded on a blockchain ledger and called “Tokens” or “Coins”) meet the legal definition of a “security.” The Framework for “Investment Contract” Analysis of Digital Assets (the “Framework”) was met with a great deal of anticipation by those in the cryptocurrency, blockchain, and capital markets fields, particularly for the purpose of evaluating the legality of fundraising through an Initial Coin Offering (“ICO”). As Paul Vigna wrote in the Wall Street Journal at the end of March, “[t]he market for initial coin offerings, which boomed last year, has ground to a halt” in 2019 because of the SEC’s enforcement actions and subsequent investor uncertainty in this space.
Crypto-enthusiasts still see ICOs as a compelling alternative source of non-equity financing. Skeptics see little more than a risky securities offering by another name. Below is a summary of the SEC’s newly‑released thoughts on the matter.
Summary of the Framework
Federal securities laws require all offers and sales of securities to fall into one of three mutually exclusive buckets: (1) registered, (2) exempt, or (3) illegal.
Bucket 3 is, obviously, undesirable. The extensive costs and ongoing reporting requirements of registering (Bucket 1) incentivizes offerors—from early-stage startups to private equity giants raising multibillion-dollar funds—to work as hard as possible to find an exemption for their security offering under Bucket 2.
In an attempt to avoid the problem altogether, ICO proponents have argued that Tokens should not be classified as securities in the first place, because Tokens are closer to coupons to purchase goods and/or services than they are to stock. No one would expect grocery stores to register their coupons with the SEC the same way we expect companies to do so with their stock.
The key here, as outlined by the SEC in the Framework, is whether a Token is an “investment contract,” which is included in the statutory definition of a security. The Supreme Court, in the seminal 1946 case SEC v. W.J. Howey Co., set forth a three-factor test to interpret this catch-all term. In applying the so-called Howey Test, the Supreme Court held that selling patches of Florida orange groves to various investors to be grown, harvested and sold by the landowner were investment contracts and, therefore, securities.
The Framework begins by emphasizing that the Howey Test applies to Tokens no differently than any other investment instrument or scheme. The Howey Test has three parts, looking to find whether Tokens are an investment instrument or scheme involving:
(1) an investment of money;
(2) in a common enterprise;
(3) with the reasonable expectation of profits derived from the efforts of others.
If a Token “passes” all three parts, then it is considered an investment contract (i.e., a security). The SEC’s Framework makes clear that the first two factors are typically met for Token sales because buyers are purchasing Tokens in exchange for value (whether cash or other cryptocurrencies), and the value they pay is going into the same company.
Accordingly, the majority of the Framework’s attention is focused on what factors determine whether the third part is met. The Framework states: “When a promoter, sponsor, or third party (or affiliated group of third parties) (“Active Participants”) provides (A) essential managerial efforts that affect the success of the enterprise, and (B) investors reasonably expect to derive profit from those efforts, then this prong of the [Howey Test] is met.”
To evaluate whether the “reliance on efforts of others” subpart is met, the Framework looks to answer some of the following questions. The more emphatic the answer is “yes,” the more likely this subpart of the Howey Test is met:
- Is the Active Participant responsible for developing the Token?
- Is the Active Participant creating or supporting a market for the Token?
- Does the Active Participant have a managerial role in making decisions or exercising judgment concerning the Token?
To evaluate whether the “reasonable expectations of profits” subpart is met, the Framework looks to answer some of these bulleted questions:
- Do holders of the Token receive rights to income, profits or potential gain from capital appreciation of the Token?
- Is the Token offered broadly and transferable or traded on a secondary market or platform (or is it expected to be in the future)?
- Is there little apparent correlation between the offering price/quantities of the Token and the price/quantity of the goods or services that can be acquired in exchange for the Token?
Importantly, the Framework also offers some “Other Relevant Considerations,” or characteristics about Tokens that, if true, would make it less likely the Token will pass the Howey Test. Some of these are:
- The network underlying the Token and the Token itself is fully developed and operational.
- Holders of the digital assets are immediately able to use the Tokens for their intended functionality.
- Prospects for appreciation in the value of the Token are limited (e.g., remain constant or lose value over time) and are incidental to the right to use the Token for its intended purpose.
While far from the complete list of the characteristics of the Framework’s inquiry on the Howey Test, the factors listed above are some fundamental highlights. Application of the Framework to specific circumstances will require detailed analysis, and the outcome in any given case is not entirely clear.
Upon analysis, the Framework leads to a number of important practical implications:
- It is clear that Tokens remain subject to the analysis of the Howey Test. As such, careful attention must be paid to the Framework before embarking on any Token project, above all an ICO.
- The Framework does not foreclose altogether the possibility of compliant, legal ICOs. If a Token is a security, then the securities law exemptions can still apply if the Token offering is properly structured.
- The SEC has given more guidance on when a Token will not be considered a security, again if properly structured.
Finally, this is far from the last word the SEC will provide in this area. The Framework provides a starting point for the analysis of tokens under the Howey Test, but, as noted, it is non-binding. Further, we believe important new details on application and enforcement in this arena will emerge through other SEC announcements and actions in the future.
 SEC, Framework for “Investment Contract” Analysis of Digital Assets (Apr. 3, 2019), available at https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets.
 Citing data from TokenData, Vigna reports that ICO activity has fallen off a cliff from $2.57 billion raised in February of last year to just $300 million last month.
Donald R. Reynolds is a member of the Capital Markets practice group of Wyrick Robbins, which represents clients across a broad range of industries in connection with their significant financing transactions and advises public companies on SEC and stock exchange rules, securities law compliance, disclosure and corporate governance matters. He is also a member of the Wyrick Robbins Blockchain Initiative, which advises all stages of companies and investors in raising funds and building businesses through blockchain-enabled means. The firm publishes Client Alerts periodically as a service to clients and friends. The purpose of this Client Alert is to provide general information, and it is not intended to provide, and should not be relied upon as, legal advice.