The SEC has Spoken – “Long Live the Utility Token!”Cryptocurrency, Securities Attorneys (Exchange Act)
Finally, the U.S. Securities and Exchange Commission, the SEC, has issued a framework for analyzing whether digital assets, or tokens, are securities. In a long-awaited publication (1), the staff of the SEC’s FinHub (2) has provided guidance (3) as to how to apply a Howey analysis to determine whether a digital asset is an “investment contract,” a form of security under U.S. federal securities laws. Howey, a Supreme Court case from 1946, provides a multi-prong test used by the SEC to determine whether an investment contract (read security) exists and U.S. securities laws are implicated. In its framework, the FinHub staff has broken the Howey test into four components: (i) an investment of money, (ii) in a common enterprise, (iii) with the reasonable expectation of profits, (iv) to be derived from the efforts of others.
Interestingly, and as expected, the SEC has stated that, under the Howey test, and citing The Dao Report, the investment of money need not take the form of cash. The SEC has now clarified in a footnote to the framework that so-called “bounty programs” and “airdrops” implicate the investment of money component of Howey even though no cash may be paid as consideration for tokens received. Bottom line, bounty programs and airdrops in the U.S. must be analyzed under Howey to determine whether and to what extent U.S. securities laws apply.
More interestingly, the staff of the SEC has now spoken in considerable detail about a possible path from a security token to a utility token. A digital asset that has been characterized as a security and offered and sold in compliance with U.S. securities laws, may at some point in its life cycle no longer be deemed a security – it may morph into a utility token with future offers and sales no longer being governed by previously applicable securities laws. That’s good news – You may not need to wait 12 months (the typical restricted security holding period) to use your token!
According to the framework, if the distributed network on which the token will be used is fully developed and operational, the network development efforts of the promoters, sponsors or other third parties or affiliated groups of third parties (now referred to in the framework as “Active Participants” or “APs”) are no longer important to the investment value of the token or the success of the network, and token purchasers no longer have reasonable expectations that the APs will be carrying out essential managerial or entrepreneurial efforts with respect to the network, the “efforts of others” prong of the Howey test might disappear.
Similarly, the “reasonable expectation of profits” prong of the Howey test may no longer apply if digital asset purchasers no longer reasonably expect that continued efforts of the APs will be a key factor in determining the value of the token, the value of the token shows a direct and stable correlation to the value of the good or service for which it may be exchanged or used, the trading volume of the token corresponds to the level of demand for the good or service, holders of the token are able to use it for its intended functionality, no economic benefit may be derived from an appreciation on the value of the token other than incidental to the value of its use purpose, and no AP holds material, nonpublic information about the token.
Of course, the FinHub framework is full of caveats and qualifications and any meaningful assessment will ultimately hinge on a facts and circumstances analysis of the economic reality under review. A big question mark remains with respect to secondary markets for a digital asset. According to the framework, with trading of tokens outside of the walled garden of a distributed network, such as on one of the newly developing regulated alternative trading systems (ATSs) where price fluctuation may be a reflection of investment speculation and purchasers other than users may be able to buy and sell the token, we still may be talking about securities transactions. This view would put a damper on the ability of a fully functioning distributed network to utilize a secondary market to facilitate the user exchange of utility tokens.
Unfortunately, the framework does not provide any specific guidance as to how a reevaluation can work in the real world, as a practical matter. How practitioners can get comfortable exiting a securities law framework with an existing digital asset that has already been distributed to purchasers has not been addressed. This will have to wait for future FinHub pronouncements, SEC regulation or case law, and only brave souls will wade out into these unchartered waters without a safe harbor to rely on.
If you have any questions about this post or the regulation of utility tokens or security token offerings in general, please feel free to contact me directly at 202-869-0888 (ex. 103) or by sending me an email. You can also contact our team of business lawyers if I am unavailable by calling (202) 869-0888. The information in this post is general and should not be considered legal advice.
1. “Framework for ‘Investment Contract’ Analysis of Digital Assets,” April 3, 2019.
2. The SEC’s Strategic Hub for Innovation and Financial Technology
3. This framework represents the views of the FinHub staff only. It is not a rule, regulation or official statement of the SEC and it does not replace or supersede existing law.