On Wednesday (April 3), two employees of the U.S. Securities and Exchange Commission (SEC), Bill Hinman, Director of Division of Corporation Finance and Valerie Szczepanik, Senior Advisor for Digital Assets and Innovation, released a public statement, which said that “to assist those seeking to comply with the U.S. federal securities laws,” the SEC’s Strategic Hub for Innovation and Financial Technology (FinHub), which is headed by Szczepanik, has published a framework for “analyzing whether a digital asset is offered and sold as an investment contract, and, therefore, is a security.”
This statement pointed out that this framework “represents Staff views and is not a rule, regulation, or statement of the Commission,” that the Commission had “neither approved nor disapproved its content,” and that “like other Staff guidance”,” it is “not binding on the Divisions or the Commission.”
With that said, it is time to take a closer look at this framework.
The case “Securities and Exchange Commission v. W. J. Howey Co.”, which was heard by the U.S. Supreme Court in 1946, resulted in a test, which later became known as the “Howey test”, to determine” whether an instrument qualifies as an ‘investment contract’ for the purposes of the Securities Act.” According to this test, an “investment contract” exists “when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.” FinHub says that the Howey analysis “is not only on the form and terms of the instrument itself” but “also on the circumstances surrounding the digital asset and the manner in which it is offered, sold, or resold (which includes secondary market sales).” So, “issuers and other persons and entities engaged in the marketing, offer, sale, resale, or distribution of any digital asset will need to analyze the relevant transactions to determine if the federal securities laws apply..”
Also, we should keep in mind that “federal securities laws require all offers and sales of securities, including those involving a digital asset, to either be registered under its provisions or to qualify for an exemption from registration.”
Next, FinHub’s guidance note talks about application of Howey to digital assets, and examines each of the three required elements of the Howey test:
- The Investment of Money: “The first prong of the Howey test is typically satisfied in an offer and sale of a digital asset because the digital asset is purchased or otherwise acquired in exchange for value, whether in the form of real (or fiat) currency, another digital asset, or other type of consideration.”
- Common Enterprise: “Courts generally have analyzed a ‘common enterprise’ as a distinct element of an investment contract. In evaluating digital assets, we have found that a “common enterprise” typically exists.”
- Reasonable Expectation of Profits Derived from Efforts of Others: “Usually, the main issue in analyzing a digital asset under the Howey test is whether a purchaser has a reasonable expectation of profits (or other financial returns) derived from the efforts of others. A purchaser may expect to realize a return through participating in 3 distributions or through other methods of realizing appreciation on the asset, such as selling at a gain in a secondary market. When a promoter, sponsor, or other third party (or affiliated group of third parties) (each, an ‘Active Participant’ or ‘AP’) provides essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts, then this prong of the test is met.”
The main difficulty in determining if a digital asset is a security comes when we try to decide if the “Reasonable Expectation of Profits Derived from Efforts of Others” part of the Howey test is satisified. Although the guidance note takes a detailed look at this, it still does not make it easy for crypto companies or their lawyers to apply the Howey test because it is possible to take one digital asset and for two lawyers to come up with conflicting answers to the question of whether that asset is a security or not since things are not always black and white.
As New York City-based lawyer Presron Byrne points out on Twitter:
Everyone's freaking out that the SEC released guidance on token sales / Howey today.
There's really nothing new here. Any lawyer looking realistically at token sales will have given advice along these lines for years.
— Preston Byrne (@prestonjbyrne) April 3, 2019
Anyway. tl;dr, the SEC doc and the no-action letter are, legally speaking, nothingburgers. What these documents tell us is that the Commission understands the issues and is unlikely to be swayed by technobabble.
Structure accordingly.
— Preston Byrne (@prestonjbyrne) April 3, 2019
Meanwhile, another New York City-based lawyer, Jake Chervinsky, while generally feeling more positive about this framework, had this to say:
I'll thread later, but my hot take: it's a useful primer & will help people like me defend companies that already did ICOs, but focuses on low-hanging fruit that securities lawyers should already know, doesn't address tough questions, & adds up to “do private placements, y'all.”
— Jake Chervinsky (@jchervinsky) April 3, 2019
We also need to remember that the Commission says that the guidance provided by FinHub in their published “framework” has not been approved/disapproved and that it is not in any way legally binding. It seems that there was a lot of pressure on the SEC (partly from Commissioner Hester Peirce) to provide some clear guidance on this issue to crypto companies, and now the SEC can clear this item off its checklist, leaving crypto companies just as confused as before.
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