Through the Howey Prism: The SEC Examines ICOs

On 3 April the US Securities and Exchange Commissions (SEC) clarified the criteria for digital tokens and similar assets to qualify as “securities” under US law through the release of new framework guidance (the “Framework”) by its Strategic Hub for Innovation and Financial Technology (“FinHub”). Once classed as a security, the issuance of these digital assets in an initial coin offering (ICO) is subject to the SEC’s registration requirements. These registration requirements can be unwieldy and expose the issuer to investor lawsuits for any arguably misleading claims. While there are multiple exemptions to the registration requirement, any such exemption must be identified, evaluated and affirmatively adopted. Crucially, this not a new standard, but rather a comprehensive restatement of the current rules as applied to digital assets. Thus, the analysis applies to prior ICOs, which at the time may have been assessed – reasonably but incorrectly – not to qualify as a security offering (which may then require a curing of the initial non-registration).
 
What is the Framework?
In spite of multiple public announcements on the treatment of ICOs under federal securities law, the Framework is the first piece of written, consolidated guidance from the SEC on the regulation of digital tokens. Curiously, following such considerable wait and anticipation, the guidance is non-binding on the agency. Rather than a regulation or formal statement of the SEC’s position, the Framework is a compilation of existing jurisprudence on the defining characteristics of a “security” and their application to digital assets. Despite such an odd provenance, the Framework provides invaluable details and insights into the SEC’s perception of digital tokens as securities. Coupled with the SEC’S first “no-action” letter in the ICO sphere (see below), released in parallel with the Framework, 3 April marks the date on which the SEC unveiled its views on ICOs to the crypto community.
 
What does the Framework do?
Beyond the traditional understanding of securities such as stocks and bonds, US federal securities law (the 1933 and 1934 Acts together) includes the category of “investment contracts”. As the Framework acknowledges, the investment contract category is the one the SEC uses to capture “unique or novel instruments or arrangements.” As the term itself is sufficiently vague to be both substantially over- and under-inclusive, US federal courts developed criteria to narrow the scope, while sustaining the core objectives of the securities laws. In the SEC v. W. J. Howey Co. holding of 1946, the US Supreme Court provided a defining set of analytical factors known since as the Howey Test. Per the Howey Test, a financial instrument or arrangement qualifies as an investment contract for purposes of the US federal securities law if there is:

1. An investment of money (or other consideration of value);
2. In a common enterprise;
3. With a reasonable expectation of profits;
4. To be derived from the efforts of others.

Notably, the Framework asserts that the criteria be assessed on matters beyond the terms and forms of the digital assets themselves. Accordingly, a proper analysis must additionally contemplate the circumstances surrounding the asset, including the “network” (defined as broadly encompassing all elements comprising the digital asset’s network, enterprise, platform or application), its marketing and its sale and potential re-sale. Tested against this broader background, if an investment satisfies all four elements of the Howey Test, then such investment would qualify as an investment contract and thus a security.
 
The Framework explores each of the four elements, but operates on the assumption that most digital assets squarely satisfy the first two elements – both of which are broadly construed by the SEC, if sometimes less so by US courts. Accordingly the Framework eschews significant investigation into them. Instead, it targets the “reasonable profit expectation” and “efforts of others” factors as the elements ripe for uncertainty and thus in want of further guidance.

In conceptual terms, these two factors - taken together - effectively query whether based on “economic reality” an investor expects to be enriched thanks to someone else’s efforts that are essential to the success of the enterprise. Delving into this concept, the Frameworks sets out a litany of evidentiary factors for issuers of digital tokens to consider, such as the following:

• Whether the digital token allows the investor to benefit from income streams or value appreciation;
• Whether there is a secondary market for the digital token (or one is anticipated);
• Whether the issuer or other parties in control of the “network” (referred to in the Framework as the “Active Participant” or “AP”) will benefit from appreciation in the value of the digital token and, if so, how;
• Whether the digital asset’s “network” is fully realized or will be financed in part by funds raised through the ICO and subsequently completed;
• Whether the digital token is offered to a broad group of prospective buyers or limited to a small clan of expected “network” users and in quantities in excess of expected use on the “network”;
• Whether there is strong correlation between the price of the digital assets and that of the goods or services available through the “network”; and
• Whether the ICO is marketed as an investment opportunity.

 
No one factor from the list of evidentiary factors is dispositive and the list itself is not exhaustive. Rather, the more of these evidentiary factors that are met and the more squarely each factor is met, the more likely that a digital token will qualify as a security.
 
Finally, an initial analysis may be reconsidered if the characteristics of the digital assets evolve. Digital assets that qualify as securities upon issuance may develop or lose characteristics relevant to the Howey Test and permit subsequent re-appraisal as non-securities (and, presumably, vice versa).
 
What does qualification as a security entail?
Qualification as a security carries an unwelcome burden. Absent an exemption, an issuer of securities must register the security prior to sale by divulging the following required information:

• A description of the commercial purpose of the issuer;
• A description of the security;
• Relevant background on the issuer’s senior management; and
• Financial statements certified by independent accountants.

For many token issuers, SEC registration requirements are too steep a price for an ICO and alone could deter the issuer from embarking on one (especially as misstatements in the registration materials may be grounds for private fraud claims against the issuer). Luckily, Regulation D of the Securities Act (“Reg D”) permits unregistered issuances (also called “private placements”) in a variety of scenarios. The eligibility of an issuance for an exemption under Reg D pivots on two primary factors: The total value of securities issued and the types of investors to whom the securities are sold.
 
What does all of the above mean for an issuer of digital assets?
Generally, the Framework is a positive development for issuers of digital assets as it introduces greater certainty into the analytical process. Despite the odd conditions of the Framework (i.e. not a formal SEC ruling or the like), such a comprehensive exploration of the relevant concepts and legal holdings, further contoured to the ICO sphere, should be regarded as the blueprint for the securities law inquiry prior to an ICO.

In furtherance of these standards, the SEC’S first ICO no-action letter (essentially, a private letter ruling on a securities law matter) hewed to the Framework analysis in declaring that the agency did not regard the pending ICO by TurnKey Jet, Inc. as security issuance. This letter also illuminates how rigidly the SEC will apply the evidentiary factors set forth in the Framework, how the agency will weight certain factors and how the SEC generally views digital assets as securities.

​Coupling the Framework with the no-action letter, the SEC’s publications on 3 April 2019 provided the guidance necessary to assess ICOs under the US federal laws. Any party contemplating an ICO ought to determine (a) whether the tokens issued will qualify as a “security” by means of the Framework analysis and, if so, (b) whether an exemption from registration is available, before deciding (c) whether, based on (a) and (b), the ICO remains worthwhile in its present form.
 
If you wish to discuss this topic in further detail please contact me at: info@millentaxandlegal.ch