On April 3, 2019, the SEC’s Strategic Hub for Innovation and Financial Technology (“FinHub”) issued a long-awaited framework for analyzing whether a given digital asset constitutes a “security” under federal law and is thus subject to the vast complex of federal securities laws and regulations. Simultaneously, the SEC’s Division of Corporate Finance issued its first “no-action” letter for a digital token offering, stating that it will not recommend enforcement action to the Commission based on tokens issued by TurnKey Jet, Inc., on the grounds that the tokens do not constitute securities. These two pronouncements will provide useful guidance to blockchain companies that issue digital assets.
- In its Framework for “Investment Contract” Analysis of Digital Assets, the SEC’s FinHub has set forth a number of factors it will consider when determining whether a given digital asset constitutes a security. In general, it is likely that the SEC will consider a digital asset to be a security if (1) it is freely tradeable for profit and (2) appreciation in asset value derives not only from market value but from efforts of a common enterprise—which does not include the efforts of a distributed network. These criteria thus apparently exclude the true cryptocurrencies (e.g. Bitcoin), stablecoins, and pure utility tokens that cannot be exchanged for profit.
- Consistent with this framework, the SEC’s Division of Corporate Finance issued a no-action letter to TurnKey Jet, Inc. with respect to TurnKey’s sale of a token, which holders can use to purchase commercial jet charters. The no-action letter states the Division does not consider this token to constitute a security because holders cannot profit for a variety of reasons, most notably that they cannot sell the token outside of a private blockchain created by TurnKey, and TurnKey will sell tokens on an ongoing basis for $1 US, preventing any appreciation in value.
Framework for “Investment Contract” Analysis of Digital Assets
As described in prior articles (for example, here and here), in determining whether a digital asset constitutes a security under federal law, the SEC and federal courts have looked to the Supreme Court decision SEC v. Howey and analyzed whether the asset constitutes a specific type of security called an “investment contract.” Under Howey, an investment contract has four elements: (1) investment for profit (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived from the efforts of others. If a digital asset is a security, then it is subject to the vast complex of federal (and state) securities laws, including the federal statute that requires all offers and sales of securities to be registered with the SEC (a non-trivial undertaking) or exempt from registration.
Prior SEC guidance on determining whether a digital asset constitutes a security came in the form of SEC statements, speeches, press releases, and allegations in SEC enforcement actions against digital asset issuers for allegedly unregistered (and sometimes fraudulent) offers and sales. But this guidance came piecemeal, informally, and was fact-specific. The industry sought more generalized, comprehensive, and reliable guidance, which FinHub has been promising to deliver for some time.
On April 3, 2019, FinHub finally issued a Framework for “Investment Contract” Analysis of Digital Assets (available here). The Framework represents the views of FinHub but is not a rule, regulation, or statement of the SEC itself—i.e., it has not been formally approved by the SEC’s commissioners. The SEC could theoretically disregard the framework in whole or part. That said, it is generally expected that the Framework represents the views of SEC staff tasked with analyzing this specific issue and that the SEC as an organization will hew to it.
Focusing on the Howey test, the Framework states that digital assets typically satisfy the first two elements (investment for profit and common enterprise). Regarding the investment for profit requirement, the Framework notes that digital assets are typically acquired in exchange for value (either another digital asset or fiat currency). Regarding the common enterprise requirement, the Framework reasons in somewhat conclusory fashion that the “fortunes of digital asset purchasers have been linked to each other or to the success of the promoter’s efforts.”
The bulk of the Framework focuses on the third and fourth Howey elements (reasonable expectation of profits and efforts of others). Regarding the third element (reasonable expectation of profits), the Framework sets forth a non-exclusive list of characteristics for consideration. The stronger the presence of any characteristic, the more likely it is this element will be satisfied. As a note, relevant profit may come from a variety of sources, such as capital appreciation or earnings participation, but market demand alone generally is not considered “profit” under Howey. The characteristics (consolidated and summarized) include the following:
- The asset gives the holder rights to share in capital appreciation, income, or profits.
- The asset is traded on a secondary market (or expected to do so).
- Purchasers reasonably expect that efforts of a promoter, sponsor, or other third party (“Active Participant” or “AP”) will cause capital appreciation.
- The digital asset is offered broadly rather than targeted to expected network users.
- The digital asset is offered, purchased, or traded in quantities indicative of investment rather than network use.
- There exists little correlation between the purchase price and the market price of goods or services provided by the network.
- The AP has raised funds in excess of what those needed for network function.
- The AP benefits as a holder of similar digital assets.
- The AP spends proceeds from the sale to enhance the network.
- Asset value depends upon future (and not present) functionality of the network.
- The asset is marketed as a liquid investment for profit, rather than for current utility.
The Framework adds that a digital asset previously sold as a security may be reclassified at a later time based on similar considerations.
Regarding the fourth element (profits resulting from the efforts of others), the Framework sets forth another non-exclusive list of characteristics. Again, the stronger the presence of any characteristic, the more likely it is this element will be satisfied. The characteristics (consolidated and summarized) include the following:
- An AP develops, improves, operates, manages, or promotes the digital asset “network” (including any platform or application), particularly where an AP promises additional development to increase the asset’s value. Examples include AP control over code updates, the venues on which the asset will trade, and validating transactions.
- Some essential tasks are performed by an AP, rather than a decentralized network.
- An AP takes some role in creating or supporting a market for the asset, such as by limiting supply through buybacks.
- An AP has incentives to perform the above, such as where the AP would realize capital appreciation from increased asset value or where the AP compensates its management with the digital asset.
The Framework again notes that a digital asset previously sold as a security may be reclassified at a later time based on similar considerations.
The Framework also sets forth a number of other characteristics to consider, many of which are similar to those described above. The stronger the presence of each, the less likely the asset will be considered a security. These characteristics include the following:
- The asset’s creation and structure, including transferability, are generally designed to meet user needs, rather than feed speculation as to value.
- The asset’s value has limited potential for appreciation, such as in the case of a stablecoin.
- The asset is a virtual currency, in that holders can immediately exchange it directly (without conversion) for a wide variety of goods and services.
- The asset is a pure utility, representing a right to a good or service, and generally bears the hallmark of a utility token (e.g. correlation between price and market value of the good or service provided).
- Appreciation of value is incidental rather than primary.
With this Framework in mind, we now turn to the SEC’s no-action letter to TurnKey Jet, Inc.
No-Action Letter to TurnKey Jet, Inc.
By way of background, when an individual or entity who is uncertain about whether a particular action might violate federal securities law, they may request a “no-action” letter from the staff of the relevant SEC regulating division. If the SEC grants the request and provides such a letter, it will typically state that the staff will not recommend that the Commission take enforcement action against the requester based on the facts and representations described in the request.
On or about April 2, 2019, TurnKey Jet, Inc. submitted a request for a no-action letter to the SEC’s Division of Corporation Finance concerning an offer and sale of digital tokens (request is available here). Note that it is likely that TurnKey had been in discussions with the SEC staff for some time about this and that this letter represented only the final, agreed-upon version following a long negotiation with the SEC that may have begun months before. As stated in the letter, TurnKey provides interstate air charter services. In the letter, TurnKey proposes to create and sell a token via a private blockchain that consumers (persons booking flights), flight brokers, and flight carriers can use to complete transactions for the purchase, brokerage, and sale of charter flight services. Consumers can buy tokens for $1 US per token—throughout the life of the entire program—and then use those tokens to purchase flights from brokers or carriers, with TurnKey acting as a middleman for the transaction. According to the request, TurnKey seeks to implement a token payment system to mitigate costs and inefficiencies of fiat payment, including concerning settlement and regulatory compliance. Only consumers would be permitted to buy tokens from TurnKey; following that, consumers can trade them only between other consumers, brokers, or carriers within the network. TurnKey ensures this in part by preventing transfers to wallets other than those created and provided by TurnKey. Construction of the entire platform will be funded by TurnKey from existing capital resources and not from token sales. TurnKey’s marketing materials state that consumers should not purchase the tokens for investment purposes and require consumers to enter various agreements under which consumers represent, among other things, that they are purchasing the token only to obtain prepaid on-demand air charter services, not for investment.
Based on these facts, TurnKey’s attorney, who authored the request, opines that TurnKey’s token does not constitute a security under federal law and asks the SEC for a no-action letter. At the outset, the request readily concedes that the token satisfies the first two Howey elements (investment of money and common enterprise). Regarding the third and fourth elements (profit expectation from efforts of others), however, the request argues that consumers cannot obtain any profit for at least the following reasons:
- They cannot freely transfer the tokens.
- They were advised and have represented the purchase was not for profit.
- They have no right to capital appreciation, profit, or similar payments.
- TrueKey offers ongoing token sales for $1 US per token, preventing any token appreciation in value.
The staff of the Division of Corporation Finance responded with a brief no-action letter (available here), stating that the Division would not recommend enforcement action if TurnKey offers and sells the token without registration as described in the request. In agreeing with TurnKey’s position that the tokens did not constitute securities, the letter emphasized the following:
- TrueKey will not use the sale proceeds to develop the network.
- The network will be fully developed at the time of sale.
- Token sale will be restricted.
- TrueKey will sell tokens for $1 US on an ongoing basis, and any repurchases will be at a discount from face value.
- TrueKey has marketed the token for its functionality, not investment potential.
Neither the Framework nor the no-action letter represents a departure or even a modification of prior positions taken by the SEC (and increasingly by federal courts). They do, however, crystallize some detailed considerations that issuers and others in the industry can look to for guidance. Overall, it seems that tokens will likely be considered securities by the SEC if they (1) are freely tradeable for profit and (2) derive value in part not just from market forces but also from an underlying common enterprise (such as an issuer enterprise that provides token holders with profit payments, equity, or even services). This explains the apparent exclusions for pure cryptocurrencies such as Bitcoin, which do not derive value from an underlying common enterprise (the SEC has now clarified that a distributed enterprise, such as a group of mining nodes, will not qualify); for stablecoins, which by definition should not be profitable; and for pure utility tokens, like TurnKey’s token, that also should not be profitable.
More generally, in our view the Framework and TurnKey’s no-action letter symbolize a maturing of the industry and acceptance by regulators. The SEC has now stated more clearly than ever that not every digital asset is a security and that prudent digital asset issuers can avoid securities regulation under certain circumstances. At the same time, it remains clear that calling an asset a “token” or a “coin” will have little, if any, bearing on whether the SEC will view it as a “security.” As always, digital asset issuers will need to carefully analyze the characteristics of those assets before determining what regulatory scheme(s) may apply.