First, in determining whether there is a reliance on the efforts of others, the SEC analyzes whether a purchaser of the assets is reasonably expecting to rely on the efforts of a promoter, sponsor, or other third party and whether such efforts are “essential managerial efforts”. On April 3, 2019, the SEC announced the framework it would use to determine whether a digital asset would be considered an “investment contract” in light of the Supreme Court’s ruling in SEC v. W.J. Purchasers would reasonably expect the AP to undertake efforts to promote its own interests and enhance the value of the network or digital asset, such as where: The AP has the ability to realize capital appreciation from the value of the digital asset. Among the information that must be disclosed is information relating to the essential managerial efforts that affect the success of the enterprise. The distributed ledger network and digital asset are fully developed and operational. The value of the digital asset has shown a direct and stable correlation to the value of the good or service for which it may be exchanged or redeemed. [15] In this guidance, we are using the term “network” broadly to encompass the various elements that comprise a digital asset’s network, enterprise, platform, or application. When It Comes to Analyzing Utility Tokens, the SEC Staff’s “Framework for ‘Investment Contract’ Analysis of Digital Assets” May Be the Emperor Without Clothes (Or, Sometimes an Orange Is Just an Orange) … As the Commission explained in The DAO Report, “[i]n determining whether an investment contract exists, the investment of ‘money’ need not take the form of cash” and “in spite of Howey‘s reference to an ‘investment of money,’ it is well established that cash is not the only form of contribution or investment that will create an investment contract.” The DAO Report at 11 (citation omitted). The digital assets are not transferable; rather, consumers can only use them to purchase products from the retailer or sell them back to the retailer at a discount to the original purchase price. 1985). [20]  In doing so, the courts also have considered whether the instrument is offered and sold for use or consumption by purchasers.[21]. No. The intended use of the proceeds from the sale of the digital asset is to develop the network or digital asset. Howey found that an “investment contract” exists where there is an investment of money in a common enterprise with a reasonable expectation that profits will be derived from others’ efforts. There is little apparent correlation between quantities the digital asset typically trades in (or the amounts that purchasers typically purchase) and the amount of the underlying goods or services a typical consumer would purchase for use or consumption. FinHub's framework explains the staff's views on how the "investment contract" analysis… The promise (implied or explicit) to build a business or operation as opposed to delivering currently available goods or services for use on an existing network. Potential purchasers have the ability to use the network and use (or have used) the digital asset for its intended functionality. Whether holders are then able to use the digital asset for its intended functionality, such as to acquire goods and services on or through the network or platform. It is not a rule, regulation, or statement of the Commission, and the Commission has neither approved nor disapproved its content. Are those efforts “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise,”. Making other managerial judgements or decisions that will directly or indirectly impact the success of the network or the value of the digital asset generally. The focus of his practice is corporate, securities, and financing law, where he has extensive experience in mergers, acquisitions and ... Mark Reuter advocates for business clients in transactions, proceedings and conflicts regulated by federal and state securities laws and stock exchange rules. Whether any economic benefit that may be derived from appreciation in the value of the digital asset is incidental to obtaining the right to use it for its intended functionality. [3] The term “security” is defined in Section 2(a)(1) of the Securities Act of 1933 (the “Securities Act”), Section 3(a)(10) of the Securities Exchange Act of 1934, Section 2(a)(36) of the Investment Company Act of 1940, and Section 202(a)(18) of the Investment Advisers Act of 1940. Under these facts, the digital asset would not be an investment contract. The federal securities laws require all offers and sales of securities, including those involving a digital asset, to either be registered under its provisions or to qualify for an exemption from registration. If you are considering[1] an Initial Coin Offering, sometimes referred to as an “ICO,” or otherwise engaging in the offer, sale, or distribution of a digital asset,[2] you need to consider whether the U.S. federal securities laws apply. In applying the framework to digital assets, the SEC focuses on three main prongs. The digital asset is available in increments that correlate with a consumptive intent versus an investment or speculative purpose. On April 3, 2019, the Strategic Hub for Innovation and Financial Technology – known as “FinHub” – of the Securities and Exchange Commission (“SEC”) published a “Framework for Investment Contract Analysis of Digital Assets” (“Guideline”) to provide additional guidance to market participants in determining whether a “digital asset… The Blogs on this website are for educational and informational purposes only. The AP has raised an amount of funds in excess of what may be needed to establish a functional network or digital asset. Howey Co. and subsequent case law. An intent to consume the digital asset may also be more evident if the good or service underlying the digital asset can only be acquired, or more efficiently acquired, through the use of the digital asset on the network. [7] Issuers of digital assets, like all issuers, must provide full and fair disclosure of material information consistent with the requirements of the federal securities laws. This requirement for disclosure furthers the federal securities laws’ goal of providing investors with the information necessary to make informed investment decisions. The first prong of the Howey test is typically satisfied in an offer and sale of a digital asset because the digital asset is purchased or otherwise acquired in exchange for value, whether in the form of real (or fiat) currency, another digital asset, or other type of consideration. A digital asset should be analyzed to determine whether it has the characteristics of any product that meets the definition of “security” under the federal securities laws. The information contained within another site that is linked to or from the Blog are beyond the control of the individual blogger or KMK and do not convey approval, support, or any relationship to any site or organization. The AP is able to benefit from its efforts as a result of holding the same class of digital assets as those being distributed to the public. The Blogs do not constitute legal advice and are not a substitute for legal advice from a licensed attorney in your state. [16] We recognize that holders of digital assets may put forth some effort in the operations of the network, but those efforts do not negate the fact that the holders of digital assets are relying on the efforts of the AP. 488, 496 n.13 (Apr. A threshold issue is whether the digital asset is a “security” under those laws. The U.S. regulator is publishing a framework for analyzing whether a digital asset is offered and sold as an investment contract, and, therefore, is a security. It also identifies some of the factors to be considered in determining whether and when a digital asset may no longer be a security. The retailer continues to market its products to its existing customer base, advertises its digital asset payment method as part of those efforts, and may “reward” customers with digital assets based on product purchases. Profits can be, among other things, capital appreciation resulting from the development of the initial investment or business enterprise or a participation in earnings resulting from the use of purchasers' funds. Playing a leading role in the validation or confirmation of transactions on the network, or in some other way having responsibility for the ongoing security of the network. The ready transferability of the digital asset is a key selling feature. Whether a particular digital asset at the time of its offer or sale satisfies the Howey test depends on the specific facts and circumstances. denied, 414 U.S. 821, 94 S. Ct. 117, 38 L. Ed. [9], Courts generally have analyzed a “common enterprise” as a distinct element of an investment contract. Determining whether and where the digital asset will trade. We encourage market participants to seek the advice of securities counsel and engage with the Staff through www.sec.gov/finhub. See also Tcherepnin, 389 U.S. at 336 (“in searching for the meaning and scope of the word ‘security’ in the [Acts], form should be disregarded for substance and the emphasis should be on economic reality.”). Where the network or the digital asset is still in development and the network or digital asset is not fully functional at the time of the offer or sale, purchasers would reasonably expect an AP to further develop the functionality of the network or digital asset (directly or indirectly). Howey found that an “investment contract” exists where there is an investment of money in a common enterprise with a reasonable expectation that profits will be derived from others’ efforts. There is little apparent correlation between the purchase/offering price of the digital asset and the market price of the particular goods or services that can be acquired in exchange for the digital asset. Managerial and entrepreneurial efforts typically are characterized as involving expertise and decision-making that impacts the success of the business or enterprise through the application of skill and judgment. Howey Co., 328 U.S. 293 (1946) (“Howey“). 10530 (Aug. 14, 2018) (issuance of tokens under a so-called “bounty program” constituted an offer and sale of securities because the issuer provided tokens to investors in exchange for services designed to advance the issuer’s economic interests and foster a trading market for its securities). While this framework … The new FinHub framework delivers on that announcement, providing a useful analytical tool for assessing whether the federal securities laws apply to the offer or sale of a particular digital asset. 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 … Purchasers of the digital asset no longer reasonably expect that continued development efforts of an AP will be a key factor for determining the value of the digital asset. The inquiry into whether a purchaser is relying on the efforts of others focuses on two key issues: Although no one of the following characteristics is necessarily determinative, the stronger their presence, the more likely it is that a purchaser of a digital asset is relying on the “efforts of others”: In evaluating whether a digital asset previously sold as a security should be reevaluated at the time of later offers or sales, there would be additional considerations as they relate to the “efforts of others,” including but not limited to: An evaluation of the digital asset should also consider whether there is a reasonable expectation of profits. We expect that analysis concerning digital assets as securities may evolve over time as the digital asset market matures. See, e.g., Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (Exchange Act Rel. The more the following characteristics are present, the more likely it is that there is a reasonable expectation of profit: In evaluating whether a digital asset previously sold as a security should be reevaluated at the time of later offers or sales, there would be additional considerations as they relate to the “reasonable expectation of profits,” including but not limited to: When assessing whether there is a reasonable expectation of profit derived from the efforts of others, federal courts look to the economic reality of the transaction. The digital asset gives the holder rights to share in the enterprise’s income or profits or to realize gain from capital appreciation of the digital asset. [5]  The so-called “Howey test” applies to any contract, scheme, or transaction, regardless of whether it has any of the characteristics of typical securities. For example, it is offered and purchased in quantities significantly greater than any likely user would reasonably need, or so small as to make actual use of the asset in the network impractical. The retailer creates a digital asset to be used by consumers to purchase products only on the retailer’s network, offers the digital asset for sale in exchange for real currency, and the digital asset is redeemable for products commensurately priced in that real currency. 1994) (discussing horizontal commonality as “the tying of each individual investor’s fortunes to the fortunes of the other investors by the pooling of assets, usually combined with the pro-rata distribution of profits” and two variants of vertical commonality, which focus “on the relationship between the promoter and the body of investors”). [19] Situations where the digital asset is exchangeable or redeemable solely for goods or services within the network or on a platform, and may not otherwise be transferred or sold, may more likely be a payment for a good or service in which the purchaser is motivated to use or consume the digital asset. [14] SEC v. Glenn W. Turner Enter., Inc., 474 F.2d 476, 482 (9th Cir. The digital asset is marketed in a manner that emphasizes the functionality of the digital asset, and not the potential for the increase in market value of the digital asset. That a scheme assigns “nominal or limited responsibilities to the [investor] does not negate the existence of an investment contract.”  SEC v. Koscot Interplanetary, Inc., 497 F.2d 473, 483 n.15 (5th Cir. Also, no one factor is necessarily dispositive as to whether or not an investment contract exists. . In this guidance, we provide a framework for analyzing whether a digital asset is an investment contract and whether offers and sales of a digital asset … at 299. [10] In order to satisfy the “common enterprise” aspect of the Howey test, federal courts require that there be either “horizontal commonality” or “vertical commonality.”  See Revak v. SEC Realty Corp., 18 F.3d. The Role of Institutional Investor Regulation in Restoring a Fair, Sustainable Economy, Short Sellers and Plaintiffs’ Firms: A Symbiotic Ecosystem, ESG, Common Ownership, and Systematic Risk: How They Intersect, Activist Short Selling Today: The Two Sides of the Coin, https://www.sec.gov/news/speech/speech-hinman-061418. 1992). [20] As noted above, under Howey, courts conduct an objective inquiry focused on the transaction itself and the manner in which it is offered. [11] Based on our experiences to date, investments in digital assets have constituted investments in a common enterprise because the fortunes of digital asset purchasers have been linked to each other or to the success of the promoter’s efforts. Whether the network on which the digital asset is to function operates in such a manner that purchasers would no longer reasonably expect an AP to carry out essential managerial or entrepreneurial efforts. What is the document? The AP monetizes the value of the digital asset, especially where the digital asset has limited functionality. Rather, under the Howey test, “form [is] disregarded for substance and the emphasis [is] on economic reality.”  Howey, 328 U.S. at 298. In this guidance, we provide a framework for analyzing whether a digital asset … [6]  The focus of the Howey analysis is not only on the form and terms of the instrument itself (in this case, the digital asset) but also on the circumstances surrounding the digital asset and the manner in which it is offered, sold, or resold (which includes secondary market sales). If the AP provides efforts that are “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise,” and the AP is not merely performing ministerial or routine tasks, then there likely is an investment contract. The digital asset is marketed, directly or indirectly, using any of the following: The expertise of an AP or its ability to build or grow the value of the network or digital asset. Ascertaining the status of digital asset as an investment contract and as a security will now be easier courtesy of the framework published on 3 April by the United States Securities and Exchange Commission (SEC) titled ‘Framework for ‘Investment Contract’ Analysis of Digital Assets’. The digital assets’ creation and structure is designed and implemented to meet the needs of its users, rather than to feed speculation as to its value or development of its network. The digital asset is offered and purchased in quantities indicative of investment intent instead of quantities indicative of a user of the network. [but] is motivated by a desire to use or consume the item purchased  . Second, the SEC examines whether there is a reasonable expectation of profits by looking at several factors, including whether the purchaser has a right to the enterprise’s income or profits and whether there is an ability to trade the asset through a market or platform. See TSC Industries v. Northway, 426 U.S. 438, 449 (1976) (a fact is material “if there is a substantial likelihood that a reasonable shareholder would consider it important” in making an investment decision or if it “would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available” to the shareholder). The availability of a market for the trading of the digital asset, particularly where the AP implicitly or explicitly promises to create or otherwise support a trading market for the digital asset. The potential profitability of the operations of the network, or the potential appreciation in the value of the digital asset, is emphasized in marketing or other promotional materials. The Framework provides additional and more detailed guidance than has otherwise been made public for analyzing whether a digital asset is offered and sold as an investment contract under the so-called Howey test, and it reiterates and enhances the previous guidance given in a June 2018 speech on this topic by SEC Director of Corporation Finance … [17] See, e.g., Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce Fenner & Smith, 756 F.2d 230 (2d Cir. The AP distributes the digital asset as compensation to management or the AP’s compensation is tied to the price of the digital asset in the secondary market. See Turner, 474 U.S. at 482; see also The DAO Report (although DAO token holders had certain voting rights, they nonetheless reasonably relied on the managerial efforts of others). Profits can be, among other things, capital appreciation resulting from the development of the initial investment or business enterprise or a participation in earnings resulting from the use of purchasers’ funds. [12] Howey, 328 U.S. at 298. The framework is not intended to be an exhaustive overview of … On April 3, 2019, the SEC released Staff Guidance titled “Framework for ‘Investment Contract’ Analysis of Digital Assets,” which applies the factors set forth in SEC v. W.J. Application of Howey to Digital Assets. Business Representation & Transactions Group. For example, take the case of an online retailer with a fully-developed operating business. In particular, an AP plays a lead or central role in deciding governance issues, code updates, or how third parties participate in the validation of transactions that occur with respect to the digital asset. The AP continues to expend funds from proceeds or operations to enhance the functionality or value of the network or digital asset. © Copyright 2021, The Trustees of Columbia University in the City of New York. Holders of the digital asset are immediately able to use it for its intended functionality on the network, particularly where there are built-in incentives to encourage such use. As noted above, under the Howey test, 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. [2] The term “digital asset,” as used in this framework, refers to an asset that is issued and transferred using distributed ledger or blockchain technology, including, but not limited to, so-called “virtual currencies,” “coins,” and “tokens.”. 8, 2004); see also the Commission’s Supplemental Brief at 14 in SEC v. Edwards, 540 U.S. 389 (2004) (on remand to the 11th Circuit). See In re Tomahawk Exploration LLC, Securities Act Rel. The reduction of these information asymmetries through required disclosures protects investors and is one of the primary purposes of the federal securities laws. For example, the design of the digital asset provides that its value will remain constant or even degrade over time, and, therefore, a reasonable purchaser would not be expected to hold the digital asset for extended periods as an investment. On April 3, 2019, the SEC attempted to provide clarity by releasing a “Framework for ‘Investment Contract’ Analysis of Digital Assets,” 2× 2. The new framework provides an in-depth description of how the SEC uses a measure called the Howey Test to determine whether a given asset qualifies as a type of security called an … [18]  Price appreciation resulting solely from external market forces (such as general inflationary trends or the economy) impacting the supply and demand for an underlying asset generally is not considered “profit” under the Howey test. Use of the Blogs does not create any attorney-client relationship between you and any individual KMK attorney or the firm. SEC Offers Framework for “Investment Contract” Analysis of Digital Assets By Securities and Exchange Commission April 8, 2019 by renholding If you are considering [1] an Initial Coin Offering, sometimes referred to as an “ICO,” or otherwise engaging in the offer, sale, or distribution of a digital asset, … The Commission, on the other hand, does not require vertical or horizontal commonality per se, nor does it view a “common enterprise” as a distinct element of the term “investment contract.”  In re Barkate, 57 S.E.C. The digital asset is offered broadly to potential purchasers as compared to being targeted to expected users of the goods or services or those who have a need for the functionality of the network. the securities laws do not apply.”). This particularly would be the case where an AP promises further developmental efforts in order for the digital asset to attain or grow in value. This can be demonstrated, for example, if the AP retains a stake or interest in the digital asset. Rather, the framework provides additional guidance in the areas that the Commission or Staff has previously addressed. [7]  This is true in the case of a corporation, for example, but also may be true for other types of enterprises regardless of their organizational structure or form. [10]  In evaluating digital assets, we have found that a “common enterprise” typically exists.[11]. publishing a framework for analyzing whether a digital asset is offered and sold as an investment contract, and, therefore, is a security. Although no one of the following characteristics of use or consumption is necessarily determinative, the stronger their presence, the less likely the Howey test is met: Digital assets with these types of use or consumption characteristics are less likely to be investment contracts. The Securities and Exchange Commission (SEC) has published a statement on the “Framework for ‘Investment Contract’ Analysis of Digital Assets” The public statement announcing the … . ), cert. In applying the framework … Relevant factors may include: There is a correlation between the purchase price of the digital asset and a market price of the particular good or service for which it may be redeemed or exchanged. The Strategic Hub for Innovation and Financial Technology ("Staff") of the Securities and Exchanges Commission ("SEC") recently released a Framework for 'Investment Contract' Analysis of Digital Assets ("Framework" or "Document") 1.These are essentially guidelines to assess whether an investment into a digital asset (which, per the document includes any asset … The U.S. Supreme Court’s Howey case and subsequent case law have 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. A digital asset should be analyzed to determine whether it has the characteristics of any product that meets the definition of “security” under the federal securities laws. Framework for “Investment Contract” Analysis of Digital Assets. On April 3, 2019, the SEC’s Strategic Hub for Innovation and Financial Technology (“FinHub”) 1 published a framework for analyzing whether a digital asset is offered and sold as an investment contract and, therefore, is a security (the “Framework… See SEC v. Int’l Loan Network, Inc., 968 F.2d 1304, 1307 (D.C. Cir. An AP has a continuing managerial role in making decisions about or exercising judgment concerning the network or the characteristics or rights the digital asset represents including, for example: Determining whether and how to compensate persons providing services to the network or to the entity or entities charged with oversight of the network. Purchasers reasonably would expect that an AP’s efforts will result in capital appreciation of the digital asset and therefore be able to earn a return on their purchase. [21] See Forman, 421 U.S. at 852-53 (where a purchaser is not “‘attracted solely by the prospects of a return’ on his investment . 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