William Hinman, Director for the Division of Corporation Finance of the U.S. Securities and Exchange Commission (the “SEC”), delivered a speech on June 14, 2018, that is helpful in defining the U.S. regulatory framework surrounding digital assets. For promoters, investors, and other market participants in the blockchain and cryptocurrency space, Director Hinman's speech comes as a breath of fresh air after the SEC Chairman, Jay Clayton, stated that “every ICO I’ve seen is a security” just months ago. For others, like the legal practitioners active in the crypto assets field, this speech may be seen as creating more questions than answers.
Director Hinman directly addressed the question that has already been hinted at by other SEC (and the CFTC officials): whether a digital asset that was originally offered as a security be later sold as something other than a security. In particular, everyone had wondered whether the current sales and offers of Ether, the underlying token powering the Ethereum blockchain, were sales and offers of securities. We can all agree that Ethereum’s initial coin offering would undoubtedly be considered as a securities offering in the eyes of the SEC. Considering that Ethereum is one of the most popular platforms for tokens to run on, this is an essential issue for many in the space.
Acknowledging the possibility that a digital asset that was initially offered as a security can later be sold as a non-security, Director Hinman gave examples that would tip the scale in favor of a digital asset being a non-security. Based on Director Hinman’s examples, if the enterprise that is being invested in has become decentralized, or if the digital asset is being sold only to be used to make purchases “through the network on which it was created,” it is likely that the digital asset will not be considered a security. As to Ether, Director Hinman stated: “…the present state of Ether, the Ethereum network, and its decentralized structure, current offers, and sales of Ether are not securities transactions.”
So, it seems like the “once a security, always a security” may no longer be true in certain circumstances, once you have a “decentralized” network where the digital asset is used to make purchases on, or obtain access to, the network. It is unclear, however, how one determines the precise point in time when the security metamorphoses into just a token, and how one "transitions" out of the securities law framework.
A more general issue, of whether all ICOs constitute securities offerings, was answered with a resounding NO. However, Director Hinman made it clear that the label given to a particular digital asset, such as a “utility token,” is inconsequential as to whether it is a security or not. “Whether a transaction in a coin or token on the secondary market amounts to an offer or sale of a security requires a careful and fact-sensitive legal analysis,” Director Hinman stated.
While Director Hinman acknowledges that digital assets are “simply code,” and not inherently securities, he looks towards Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 756 F.2d 230 (2d Cir. 1985) that says that “an instrument can be part of an investment contract that is a security,” regardless of the nature of the instrument itself. There are cases where even whiskey warehouse receipts and chinchillas were deemed to be “securities.” Consequently, we must look closely at the nature of the digital asset and the parties that are involved in the transaction.
Director Hinman reiterated the SEC's determination to apply the “Howey Test,” the current test for determining whether an “investment contract” constitutes a security set forth in SEC v. W.J. Howey Co., 328 U.S. 293 (1946), to each offering of digital assets. For the “Howey Test” to be satisfied (which means that the instrument is a security), there must be: 1) an investment of money; 2) in a common enterprise; 3) with an expectation of profit, and 4) the profit is derived from the efforts of others.
The application of the Howey Test to any particular offering of digital assets requires analysis of each particular set of facts and circumstances. No two offerings are alike, and the promoters and their counsel should carefully assess each offering to determine whether the U.S. federal securities laws apply. It is possible to structure a digital asset offering more or less like a securities offering, and Director Hinman offered a list of possible features and questions that could influence the outcome:
1. Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?
2. Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading?
3. 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?
4. 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?
5. Is the asset marketed and distributed to potential users or the general public?
6. Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?
7. Is the application fully functioning or in early stages of development?
Overall, Director Hinman’s statements brought much needed clarity and guidance to the issues surrounding the offering and sale of digital assets; however, they do reflect his own views. It is unclear whether legal practitioners may rely on these statements, and if yes, then to what extent. It is helpful, though, that the SEC is now open to receiving no-action letter requests, a response to which would provide an official SEC decision. Given how policies and interpretations tend to change over time, it would be particularly helpful for those legal practitioners who are advising ICO issuers to have clear rules and bright-line tests to apply rather than statements by officials from different agencies that sometimes express conflicting views.
This article is not legal advice, and was written for general informational purposes only. If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its authors, Brad Klingener and Arina Shulga. Mr. Klingener is a second-year law school student at Brooklyn Law School and is a summer intern at Ross & Shulga PLLC. Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.
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