When a promoter, sponsor, or other third party (or affiliated group of third parties) (each, an “Active Participant” or “AP”) provides essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts, then this prong of the test is met. Keep up with the latest legal and industry insights, news, and events from MoFo Sign Up. On December 11, 2017, SEC Chairman Jay Clayton noted that whether a digital asset is a security "will depend on the characteristics and use of that particular asset." 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. [21]. 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 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. Relevant to this inquiry is the “economic reality” [12] of the transaction and “what character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect.” [13] The inquiry, therefore, is an objective one, focused on the transaction itself and the manner in which the digital asset is offered and sold. (go back), 17See, e.g., Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce Fenner & Smith, 756 F.2d 230 (2d Cir. See discussion of “Other Relevant Considerations.”(go back), 20As noted above, under Howey, courts conduct an objective inquiry focused on the transaction itself and the manner in which it is offered. The discussion above identifies some of the factors market participants should consider in assessing whether a digital asset is offered or sold as an investment contract and, therefore, is a security. 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 are securities transactions. We expect that analysis concerning digital assets as securities may evolve over time as the digital asset market matures. Does the purchaser reasonably expect to rely on the efforts of an AP? denied, 414 U.S. 821, 94 S. Ct. 117, 38 L. Ed. The document isn’t an official SEC regulation. 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. 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. (go back), Posted by Tami Groswald Ozery, Harvard Law School Program on Corporate Governance, on, Harvard Law School Forum on Corporate Governance, on Framework for “Investment Contract” Analysis of Digital Assets. It also identifies some of the factors to be considered in determining whether and when a digital asset may no longer be a security. Are those efforts "the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise,"as opposed to efforts that are more ministerial in nature? The Supreme Court has further explained that that the term security “embodies a flexible rather than a static principle” in order to meet the “variable schemes devised by those who seek the use of the money of others on the promise of profits.” Id. We address each of the elements of the Howey test below. Whether the efforts of an AP are no longer affecting the enterprise’s success. 88 0 obj <> endobj See, e.g., Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (Exchange Act Rel. 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. The AP has raised an amount of funds in excess of what may be needed to establish a functional network or digital asset. (go back), 21See Forman, 421 U.S. at 852-53 (where a purchaser is not “’attracted solely by the prospects of a return’ on his investment . 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. hޤUmO�0�+�� �$q Uj��M�U$��ⵑҤJ����|vi 2 At the same time, the Division of Corporation Finance issued a no-action response to an aviation company in connection with its proposed offer and sale of blockchain-based digital assets … endstream endobj 89 0 obj <> endobj 90 0 obj <> endobj 91 0 obj <>stream 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. 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. 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. An AP is responsible for the development, improvement (or enhancement), operation, or promotion of the network. 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. 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). On April 3, 2019 the US-SEC published a document entitled “Framework for “Investment Contract” Analysis of Digital Assets.” It is aimed at those who are consideringan Initial Coin Offering, sometimes referred to as an “ICO,” or otherwise engaging in the offer, sale, or distribution of a digital asset. v. W. J. Howey Co., 328 U.S. 293 (1946) to digital assets. Issuers of digital assets should be guided by the regulatory framework and concepts of materiality. The trading volume for the digital asset corresponds to the level of demand for the good or service for which it may be exchanged or redeemed. (go back), 15In 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. (go back), 6Whether a contract, scheme, or transaction is an investment contract is a matter of federal, not state, law and does not turn on whether there is a formal contract between parties. �- @��]�\�?�3`�`� �2�i�;��h��� |弙;[��l̊>�'Lݠ�$���� �J�[�P;�D�� ��H�j�$��#g4��>�쎀�6� �� �@S0��� PEG�`���� B|�r���t�4;�W � ��ˬ�Uzs�N}nN�-F��� �u��N2B����99H3q�005C��� ��U� The AP monetizes the value of the digital asset, especially where the digital asset has limited functionality. We encourage market participants to seek the advice of securities counsel and engage with the Staff through www.sec.gov/finhub. 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. 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. This also can be the case where the digital asset gives the holder rights to dividends or distributions. Prospects for appreciation in the value of the digital asset are limited. See also United Housing Found., Inc. v. Forman, 421 U.S. 837 (1975) (“Forman”); Tcherepnin v. Knight, 389 U.S. 332 (1967) (“Tcherepnin”); SEC v. C. M. Joiner Leasing Corp., 320 U.S. 344 (1943) (“Joiner”). No AP has access to material, non-public information or could otherwise be deemed to hold material inside information about the digital asset. Are those efforts “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise,”. The Framework states that an investment in a digital asset would usually constitute an investment 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 " 13. 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. See In re Tomahawk Exploration LLC, Securities Act Rel. �P���Z�Sj���9�{����������B���%��m��΂�ֈų?������Y��m���`�������%�^���0W��}s���e��gᾡ9΂ =���ý b-��,w8M3�f�e�3�~�������,�`Բ0zY�4x��d�w�o�sv�FnQ;o���mV��\a����CD�ꁺz`�z��!��ت�Q���VoT������t�>�ٻ'��m����j����Q�F�Vנw���{�^�. 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.”)(go back), 14SEC v. Glenn W. Turner Enter., Inc., 474 F.2d 476, 482 (9th Cir. at 299. 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. Determining whether and where the digital asset will trade. [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. 0 The digital asset is offered and purchased in quantities indicative of investment intent instead of quantities indicative of a user of the network. An AP has a lead or central role in the direction of the ongoing development of the network or the digital asset. The ready transferability of the digital asset is a key selling feature. It is not a rule, regulation, or statement of the Commission, and the Commission has neither approved nor disapproved its content. (go back), 9The lack of monetary consideration for digital assets, such as those distributed via a so-called “bounty program” does not mean that the investment of money prong is not satisfied. 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. [4] The new FinHub framework delivers on that announcement, providing a useful analytical tool for … This post is based on the Framework prepared by the SEC’s Strategic Hub for Innovation and Financial Technology (“FinHub”) staff. %PDF-1.6 %���� While this framework did not rise to the level of an official statement by the SEC, it generated a lot of excitement in the industry. 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. Further, the lack of monetary consideration for digital assets, such as those distributed via a so- called “air drop,” does not mean that the investment of money prong is not satisfied; therefore, an airdrop may constitute a sale or distribution of securities. If it is characterized as a virtual currency, the digital asset actually operates as a store of value that can be saved, retrieved, and exchanged for something of value at a later time. Rather, under the Howey test, “form [is] disregarded for substance and the emphasis [is] on economic reality.” Howey, 328 U.S. at 298. See SEC v. Int’l Loan Network, Inc., 968 F.2d 1304, 1307 (D.C. Cir. 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). The reduction of these information asymmetries through required disclosures protects investors and is one of the primary purposes of the federal securities laws. h�b```f``���� ���� SEC FinHub Publishes Framework for Investment Contract Analysis of Digital Assets 04.08.19 On April 3, 2019, the Strategic Hub for Innovation and Financial Technology (“FinHub”) released a framework for analyzing the application of U.S. federal securities laws to digital assets (the “Framework”). It is not an exhaustive treatment of the legal and regulatory issues relevant to conducting an analysis of whether a product is a security, including an investment contract analysis with respect to digital assets generally. 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 investment contract. h�bbd```b``���`� D�T�H�� 2LH2Έ�u� ���/20�>�g`$����X� � �, No. 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, … 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. 1 Framework for “Investment Contract” Analysis of Digital Assets1 I. 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 … (FinHub) attempted to provide some clarity by issuing a “Framework for ‘Investment Contract’ Analysis of Digital Assets,” which provides a toolkit to apply the Howey test to digital assets… Even in cases where a digital asset can be used to purchase goods or services on a network, where that network’s or digital asset’s functionality is being developed or improved, there may be securities transactions if, among other factors, the following is present: the digital asset is offered or sold to purchasers at a discount to the value of the goods or services; the digital asset is offered or sold to purchasers in quantities that exceed reasonable use; and/or there are limited or no restrictions on reselling those digital assets, particularly where an AP is continuing in its efforts to increase the value of the digital assets or has facilitated a secondary market. %%EOF 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. These factors are not intended to be exhaustive in evaluating whether a digital asset is an investment contract or any other type of security, and no single factor is determinative; rather, we are providing them to assist those engaging in the offer, sale, or distribution of a digital asset, and their counsel, as they consider these issues. 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. 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. 1992). 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. The registration provisions require persons to disclose certain information to investors, and that information must be complete and not materially misleading. The digital asset is available in increments that correlate with a consumptive intent versus an investment or speculative purpose. 97 0 obj <>/Filter/FlateDecode/ID[<2316C906D61ED7488A91FD10B5249514>]/Index[88 21]/Info 87 0 R/Length 68/Prev 226202/Root 89 0 R/Size 109/Type/XRef/W[1 3 1]>>stream [20] In doing so, the courts also have considered whether the instrument is offered and sold for use or consumption by purchasers. 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. 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