), cert. 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. Making or contributing to managerial level business decisions, such as how to deploy funds raised from sales of the digital asset. FinHub's framework explains the staff's views on how the "investment contract" analysis… This means that it is possible to pay for goods or services with the digital asset without first having to convert it to another digital asset or real currency. [20]  In doing so, the courts also have considered whether the instrument is offered and sold for use or consumption by purchasers.[21]. An AP is responsible for the development, improvement (or enhancement), operation, or promotion of the network. 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. [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. 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). Does the purchaser reasonably expect to rely on the efforts of an AP? In applying the framework to digital assets, the SEC focuses on three main prongs. 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“). 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’. © Copyright 2021, The Trustees of Columbia University in the City of New York. 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”. Howey Co. and subsequent case law. 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. [1] This framework represents the views of the Strategic Hub for Innovation and Financial Technology (“FinHub,” the “Staff,” or “we”) of the Securities and Exchange Commission (the “Commission”). The Framework emphasizes that it is only a guideline for analyzing whether the digital asset represents an investment contract, and that no single factor is determinative. In a so-called “airdrop,” a digital asset is distributed to holders of another digital asset, typically to promote its circulation. [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. A threshold issue is whether the digital asset is a “security” under those laws. To address the more common implementations and applications of blockchain, tokens and cryptocurrencies, Division of Corporation Finance Staff announced the release of a "Framework for 'Investment Contract' Analysis of Digital Assets… 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. 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 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 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. See discussion of “Other Relevant Considerations.”. 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. 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. at 299. 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. In these instances, purchasers would reasonably expect the AP to undertake efforts to promote its own interests and enhance the value of the network or digital asset. . © 2021 Keating Muething & Klekamp PLL. 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 … 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). [9] The 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 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. 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. 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). 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. 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. 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. 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. 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.”). Are those efforts “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise,”. The registration provisions require persons to disclose certain information to investors, and that information must be complete and not materially misleading. 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 ready transferability of the digital asset is a key selling feature. The digital asset is offered and purchased in quantities indicative of investment intent instead of quantities indicative of a user of the network. In applying the framework … 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. The second piece of guidance came in the form of a “Framework for ‘Investment Contract’ Analysis of Digital Assets” that is intended to serve as “an analytical tool to help market participants … Statement on “Framework for ‘Investment Contract’ Analysis of Digital Assets” Framework for “Investment Contract” Analysis of Digital Assets Turnkey Jet No-Action Letter SEC staff advises on … The AP monetizes the value of the digital asset, especially where the digital asset has limited functionality. 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. We expect that analysis concerning digital assets as securities may evolve over time as the digital asset market matures. For example, purchasers may reasonably rely on an AP for liquidity, such as where the AP has arranged, or promised to arrange for, the trading of the digital asset on a secondary market or platform. 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. 1992). the securities laws do not apply.”). No AP has access to material, non-public information or could otherwise be deemed to hold material inside information about the digital asset. Printer-Friendly Version. [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. 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. 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. [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. 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) … The future (and not present) functionality of the network or digital asset, and the prospect that an AP will deliver that functionality. 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 i… 2d 53 (1973) (“Turner“). Rather, under the Howey test, “form [is] disregarded for substance and the emphasis [is] on economic reality.”  Howey, 328 U.S. at 298. 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. Further, this framework does not replace or supersede existing case law, legal requirements, or statements or guidance from the Commission or Staff. Howey Co., 328 U.S. 293 (1946) (“Howey“). All rights reserved. An AP has a lead or central role in the direction of the ongoing development of the network or the digital asset. Usually, the main issue in analyzing a digital asset under the Howey test is whether a purchaser has a reasonable expectation of profits (or other financial returns) derived from the efforts of others. Among the information that must be disclosed is information relating to the essential managerial efforts that affect the success of the enterprise. If the AP facilitates the creation of a secondary market, transfers of the digital asset may only be made by and among users of the platform. On April 3, 2019, the SEC attempted to provide clarity by releasing a “Framework for ‘Investment Contract’ Analysis of Digital Assets,” 2× 2. 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). Under these facts, the digital asset would not be an investment contract. denied, 414 U.S. 821, 94 S. Ct. 117, 38 L. Ed. [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. The opportunity may result from appreciation in the value of the digital asset that comes, at least in part, from the operation, promotion, improvement, or other positive developments in the network, particularly if there is a secondary trading market that enables digital asset holders to resell their digital assets and realize gains. 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 AP owns or controls ownership of intellectual property rights of the network or digital asset, directly or indirectly. 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. 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… 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. 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. 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. This requirement for disclosure furthers the federal securities laws’ goal of providing investors with the information necessary to make informed investment decisions. 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 … 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. 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Last week, the US Securities and Exchange Commission (SEC) through its strategic hub for financial innovation, FinHub, published a framework for analyzing whether a digital asset will be treated as a security under the oft cited Howey test. To the extent these facts are present, the compensated individuals can be expected to take steps to build the value of the digital asset. [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. Framework for “Investment Contract” Analysis of Digital Assets. 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. We address each of the elements of the Howey test below. No. We encourage market participants to seek the advice of securities counsel and engage with the Staff through www.sec.gov/finhub. 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. An evaluation of the digital asset should also consider whether there is a reasonable expectation of profits. [17] See, e.g., Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce Fenner & Smith, 756 F.2d 230 (2d Cir. 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. 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. [12] Howey, 328 U.S. at 298. [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.”. With respect to a digital asset that represents rights to a good or service, it currently can be redeemed within a developed network or platform to acquire or otherwise use those goods or services. What is the document? Whether or not the efforts of an AP, including any successor AP, continue to be important to the value of an investment in the digital asset. 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 … 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 … 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 … 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. The Blogs do not constitute legal advice and are not a substitute for legal advice from a licensed attorney in your state. A purchaser may expect to realize a return through participating in distributions or through other methods of realizing appreciation on the asset, such as selling at a gain in a secondary market. 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. Upon receipt of the digital asset, consumers immediately are able to purchase products on the network using the digital asset. Use of the Blogs does not create any attorney-client relationship between you and any individual KMK attorney or the firm. With respect to a digital asset referred to as a virtual currency, it can immediately be used to make payments in a wide variety of contexts, or acts as a substitute for real (or fiat) currency. The framework is not intended to be an exhaustive overview of … The intended use of the proceeds from the sale of the digital asset is to develop the network or digital asset. On April 3, 2019, the Strategic Hub for Innovation and Financial Technology – known as “FinHub” – of the U.S. Securities and Exchange Commission (the “SEC”) published a “Framework for ‘Investment Contract’ Analysis of Digital Assets” (the “Guideline”) to provide additional guidance to market participants in determining whether a “digital asset… For example, the digital asset can only be used on the network and generally can be held or transferred only in amounts that correspond to a purchaser’s expected use. The AP has raised an amount of funds in excess of what may be needed to establish a functional network or digital asset. [4] This framework is intended to be instructive and is based on the Staff’s experiences to date and relevant law and legal precedent. See, e.g., Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (Exchange Act Rel. 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 … 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. Whether a particular digital asset at the time of its offer or sale satisfies the Howey test depends on the specific facts and circumstances. 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. 1974) (citation and quotation marks omitted). 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. As part of a continuing effort to assist those seeking to comply with the U.S. federal securities laws, FinHub is publishing a framework for analyzing whether a digital asset is offered and sold as an … The following characteristics are especially relevant in an analysis of whether the third prong of the Howey test is satisfied. 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. A partner in the firm’s Business Representation & Transaction ... As a partner in the firm’s Business Representation & Transactions Group, Allie Westfall’s insight and proven analytical skills help translate the complexities of the often-challenging securities laws. 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. [5] SEC v. W.J. 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. Restrictions on the transferability of the digital asset are consistent with the asset’s use and not facilitating a speculative market. 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. 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. This also can be the case where the digital asset gives the holder rights to dividends or distributions. The digital asset is available in increments that correlate with a consumptive intent versus an investment or speculative purpose. 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. 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 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. [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. [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. . What is material depends upon the nature and structure of the issuer’s particular network and circumstances. Business Representation & Transactions Group. 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. 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… Over time as the digital asset, typically to promote its circulation relevant in an analysis of whether the prong... Goal of providing investors with the asset ’ s use and not facilitating speculative. In quantities indicative of investment intent instead framework for “investment contract” analysis of digital assets quantities indicative of a user of the Blogs does not any... 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