The SEC Framework for Analysis of Digital Assets: Explanation and Five General Takeaways
On April 3, 2019, the SEC issued the “Framework for ‘Investment Contract’ Analysis of Digital Assets.” Recognizing that “Blockchain and distributed ledger technology can catalyze a wide range of innovation,” and understanding that digital assets present a new challenge to those seeking to comply with U.S. securities laws, staff in the SEC’s Division of Corporate Finance have endeavored to explain how the Division or Commission might analyze whether a particular digital asset constitutes an investment contract and therefore a security. And the Framework tells us quite a lot, even if it’s not what many in the crypto space wanted to hear.
It merits more than a footnote to point out that the Framework “is not a statement of the [SEC];” does not constitute a rule or regulation; and, “like other staff guidance, is not binding” on the SEC. This is something of a sticking point for some crypto advocates and attorneys, who are disappointed that the framework (a “nothingburger,” as attorney Preston Byrne put it) doesn’t give them much to rely on. But, not only is the Framework the best insight we have so far into the minds of the people who will be making real-world enforcement decisions, there’s also a real possibility that courts will adopt the Framework’s analysis and turn it into law. This sort of thing has already happened in the crypto space, as I recently discussed. The bottom line is that it’s likely that the reasoning we see in the Framework will drive SEC and court decisions going forward.
What follows is an explanation of important parts of the Framework, and some analysis of its likely consequences for the classification of digital assets as securities under United States law.
Background: The Howey Test
The Securities Act of 1933 defines the term “securities.” The laundry list definition includes familiar financial instruments like stocks and bonds, but also includes some more vague entries, including “investment contracts.” In 1946, in SEC v. Howey, the U.S. Supreme Court faced a case where the SEC claimed that a sale of land in a citrus grove, bundled with a service contract for the cultivation and sale of citrus, constituted an investment contract and therefore a security.
The Court created a three-part test — the now well-known “Howey test,” where it defined an “investment contract” as an (1) investment of money (2) in a common enterprise,with (3) an expectation of profits solely from the efforts of the promoter or a third party. (In Howey, the citrus land and accompanying service agreement did constitute an investment contract.)
Contemporary interest in the Howey test has recently been stoked as analysts, advocates and participants in the market for digital assets have anticipated it would determine whether these assets constitute securities under U.S. law and therefore are subject to, for example, registration requirements when sold to the public in an “ICO” (initial coin offering). The Framework addresses each element of the Howey test.
Investment of Money
The Framework only briefly addresses the “investment of money” element, indicating that offering and sale of digital assets are typically satisfied because the asset is exchanged for value (either government-backed currency, another digital asset, or another type of consideration). In fact, it’s hard to imagine how a sale of a digital asset would not satisfy the “investment of money” element, and it therefore makes sense that, when facing a lawsuit or enforcement action, digital-asset developers often concede this point (see, for example, a court opinion from a lawsuit involving ATB Coin, where the defendants argued that ATB Coin was not a security, but conceded that the sale of the coins involved an “investment of money”).
The Framework has only two sentences (and a footnote) to say about the “common enterprise” element. What’s more interesting than the assertion that “‘common enterprise’ typically exists” in digital asset scenarios, is the explanation that the SEC would prefer us the think about the Howey test as a two-prong test: (1) Investment of money with (2) reasonable expectation of profits to be derived from efforts of others. The authors of the Framework say that although courts view “common enterprise” as a distinct element of an “investment contract,” the SEC “does not view a ‘common enterprise’ as a distinct element of the term ‘investment contract.” The history of, justification for and sensibility of this view is outside the scope of this article. The important take-away is that those interested in whether digital-asset offers/sales constitute securities according to the SEC should primarily focus on the third element — expectation of profits derived from efforts of others.
Reasonable Expectation of Profits Derived from Efforts of Others
This is the “main issue,” the authors of the Framework point out. Profits derived from the efforts of others can include appreciation of the asset and its sale at a gain in a secondary market — and this is often exactly what a digital-asset purchaser has in mind when participating in an ICO. The Framework suggests an “objective” inquiry, focused on the the “economic reality” of the transaction, including two main factors: (1) reliance on the efforts of others, and (2) reasonable expectation of profit.
Efforts of Others
This factor includes two main concepts itself: efforts, and others. There’s also an underlying question of purchaser expectations.
“Others” can include promoters, sponsors and third parties. Importantly, the Framework contemplates a distinction between a manager-type “other” (called an “AP,” or “Active Participant”) and “an unaffiliated, dispersed community of network users.” I predict that the distinction between “dispersed community” and affiliated, managerial “active participant” will be a primary deciding factor in real-world cases. More so than whether there are “efforts,” or “expectation of profits,” the hotly-contested issue will be whether developers and promoters are sufficiently dispersed and unaffiliated such that the third prong of the Howey test is not met.
“Efforts” are significant managerial efforts that affect the failure or success of the enterprise.
Efforts can include:
- Developing the network (including building the asset’s functionality, and managing the direction of the development)
- Promoting the network
- Controlling the creation and issuance of the asset
- Playing a lead role in the confirmation of transactions on the network
Expectations about efforts of others: Within the “efforts of others” section, the Framework contemplates that when an AP retains a stake or interest in the asset, this supports a reasonable expectation by a purchaser that profits will be derived from an AP engaging in “efforts” like the ones listed above. This reminds us that we’re interested in purchaser expectations.
This is a distinct point, and one likely to require its own attention: Aside from whether APs planned or made managerial efforts, did purchasers expect APs to make managerial efforts? Those questions are of course related (and the existence of efforts can of course support an expectation of efforts) but are distinct.
The right approach to this might be, then:
(1) Does the purchaser expect anyone to make efforts that will lead to profits by the purchaser?
If so, (2) are the ones who are expected to make efforts the right kind of “others” — are they APs?
If so, (3) are the kinds of efforts expected the kinds of efforts that are “essential managerial efforts”?
(Interestingly, the Framework includes this both here and under the “Reasonable Expectation of Profits” section. In the latter section it’s included as “[p]urchasers reasonably would expect that an AP’s efforts will result in capital appreciation of the digital asset.” I believe it belongs better in the “expectation of profits” section but its presence in the “efforts of others” section reminds us that this is all about [reasonable] purchaser expectation.)
Reasonable Expectation of Profits
The Framework here mainly focuses on factors that support a conclusion that purchasers would reasonably expect profits. (That is, as distinct from what in fact constitutes “profits.” The concept of “profits” here includes capital appreciation and isn’t subject to much mystery.)
Transferability of a digital asset (i.e., whether it can be sent from one digital “wallet” to another, and therefore traded) weighs in favor of reasonable expectation of profit. It also exists in digital assets almost universally.
Secondary Market Trading, which also exists almost across the board, supports reasonable expectation of profit.
Broad offering, as opposed to being targeted to expected users of the goods or services, supports reasonable expectation of profit. For example, Ambrosus is a digital asset meant to enable next-generation supply chains on the “Internet of things,” with physical sensors that interact with a blockchain. If the Ambrosus token is offered generally, versus being targeted for sale to companies likely to have a need for supply-chain management, that would weigh in favor of a determination that the sale of Ambrosus meets the “reasonable expectation of profits” element.
Marketing that supports an expectation of profits also weighs in favor of purchaser expectation of profits. Importantly, marketing that suggests future functionality of the network / asset (where that functionality is to be delivered by an AP) weights in favor of purchaser expectation of profits. So does marketing that indicates that: proceeds of the ICO will be used to develop the network / asset; ready transferability of the asset is a key feature; a trading market for the asset will be created; or there is an (even implicit) promise to build an operation, versus delivering currently available goods or services for use on an existing network.
Considerations weighing against reasonable expectation of profit from the efforts of others
The Framework also lists situations that weigh against classification as a security under Howey. Those include:
- Digital assets sold for use or consumption by purchasers. For example, this might include a digital asset that can be “redeemed” for computing time or storage space on a cloud computing platform.
- Digital assets sold to meet the needs of users, rather than to “feed speculation” as to its value or development of its network. In particular, assets that currently can be redeemed for goods or services.
- Digital assets meant to be “virtual currencies” that can be immediately used to make payments in a wide variety of contexts, including paying for goods and services without needing to convert the virtual currency to another currency.
- Digital assets marketed to emphasize functionality, versus potential for increased market value.
The Framework extinguished any remaining question about the SEC’s plans to allow the crypto space to remain an unregulated wild west. The most important takeaways are:
(1) There is an important distinction between dispersed networks of developers versus centralized management / development teams. The SEC guidance on this point is likely to lead to some interesting litigation and also impact the organization of future projects.
(2) “Digital currencies” are likely to get treatment different from utility tokens. But, digital currencies’ offer and sale can still take place under circumstances that cause them to be classified as investment contracts and therefore securities.
(3) Marketing matters. But it’s not all the matters. To an extent, the messages promoters send to the public about digital-asset sales make a difference for purchasers’ expectations, and therefore whether an investment contract / security is involved.
(4) The “economic reality” behind the marketing is ultimately what matters. Promoters should not expect to escape regulation merely by being careful or clever with messaging.
(5) Most digital assets (among those existing as of now, in early 2019) will be classified as securities. Asset transferabililty and the managerial / development work done by core stakeholders will mean this.
The Framework tells us that the SEC understands the intricacies of the market and technology. From that perspective at least, it’s very welcome news.