By Amy Leisinger, J.D.
The SEC's Strategic Hub for Innovation and Financial Technology (FinHub) and Division of Corporation Finance have issued a framework for market participants to consider in assessing whether a digital asset is offered or sold as an investment contract and, thus, is a security. The framework is not intended to provide an exhaustive overview, but rather, an analytical tool to help market participants assess whether the federal securities laws apply to the offer, sale, or resale of a digital asset. Separately, CorpFin issued a response to a no-action request, indicating that it would not recommend enforcement action to the Commission if a charter flight company uses a blockchain and creates digital assets to facilitate payment for air travel without registration.
“As financial technologies, methods of capital formation, and market structures continue to evolve, market participants should be aware that they may be conducting activities that fall within our jurisdiction,” said CorpFin Director Bill Hinman and FinHub Senior Advisor Valerie Szczepanik.
“Investment contract” considerations. The framework advises those considering engaging in the offer, sale, or distribution of a digital asset to consider whether the digital asset is a “security” under the federal securities laws. The Supreme Court’s decision in SEC v. W.J. Howey Co. found that 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. The “investment of money” prong of the test is usually satisfied in an offer and sale of a digital asset because it is typically acquired in exchange for value, and a common enterprise also normally exists given the group of participants involved, according to the framework.
Where the main issue arises in a Howey analysis of digital assets is whether a purchaser has a reasonable expectation of profits derived from the efforts of others, the framework explains. A purchaser may expect to realize a return through participating in distributions or realizing appreciation on the asset, and when a promoter or sponsor provides essential managerial efforts that affect the success of the enterprise and lead to an expectation of returns, this prong of the Howey test is met. However, the focus should be on the manner in which the digital asset is offered and sold and on the transaction as a whole, according to the framework.
When considering whether there is reliance on the efforts of others, a participant should evaluate whether required efforts are significant as opposed to more ministerial and whether it is responsible for the development, improvement, or operation of the network or the digital asset. Other relevant considerations include whether the participant supports the market or price for the digital asset and whether investors would reasonably expect it to undertake efforts to promote its own interests and enhance the value of the network or digital asset. These issues may need to be reevaluated in later offers or sales, the framework notes.
In analyzing whether a reasonable expectation of profits exists, a participant also should consider whether the digital asset gives a holder the right to share in the enterprise’s profits or to realize gain from capital appreciation and whether it is offered broadly to potential purchasers compared to being targeted to expected users of the goods or services, according to the framework. Among other things, a participant also should evaluate whether there is a correlation between the purchase price of the digital asset and the market price of the particular goods or services that can be acquired with it, the framework explains.
When assessing whether there is a reasonable expectation of profit derived from the efforts of others, the framework notes that courts look to the economic reality of the transaction, including whether the digital asset is offered and sold for use or consumption by purchasers. It is less likely that the Howey test is met when holders are immediately able to use the digital asset for its intended purpose on the network or the digital asset is designed to meet the needs of a user, rather than to feed speculation as to its value, according to the framework. However, even in cases where a digital asset can be used to purchase goods or services on a network, there may be a securities transaction if, among other things, the digital asset is offered or sold at a discount to the value of the goods or services or in quantities that exceed reasonable use.
The framework notes that it is not a rule, regulation, or statement of the Commission and does not modify or replace any existing applicable laws or regulations.
No-action relief. Separately, the Division of Corporation Finance concluded that it would not object if TurnKey Jet, a provider of air-charter services, develops a token platform to facilitate token sales for air-charter services via a private blockchain network without registration. Under the program, consumers would redeem purchased tokens for air-charter services from TurnKey or other brokers on the system. The tokens would be smart contracts between TurnKey and consumers with terms that obligate TurnKey to release token escrow funds to a broker or carrier to pay for services to token holders redeeming the tokens at their equivalent value for those services. “In short, the Tokens, Platform and Network will simply be an air charter services payment debit/credit system for large financial transactions,” according to TurnKey.
TurnKey acknowledged that because the purchase of tokens will require the payments of funds and because it will run the platform for managing the tokens and allowing transfer and redemption for services, an “investment of money” and a “common enterprise” may exist under the Howey test. However, TurnKey contends, the interest represented by a token will be a consumptive right to redeem the escrowed funds to pay for air-charter services, and there is no reasonable expectation of any profit on the part of any member, as consumers will have no right to a share of any income generated or to dividends, rewards, or other distributions. Consumers also will have no reasonable expectation of profit based on capital appreciation, TurnKey explains.
According to TurnKey, all marketing materials will say clearly state that the tokens should be purchased solely for the purpose of obtaining prepaid air-charter services and not for investment purposes or with an expectation of profits. Further, consumers will be required to acknowledge that the tokens are not being acquired as an investment, that they will have no equity interest in TurnKey, and that if tokens are transferred between them, they will not represent that the tokens involve an investment opportunity.
Based on TurnKey’s representations, the staff granted the requested relief.