Recent comments by the Director of the SEC’s Division of Corporate Finance shed light on the agency’s developing approach to deal with the bourgeoning initial coin offering (ICO) and cryptocurrency markets.
Over the past several months, the SEC has repeatedly affirmed that it will subject digital tokens issued through ICOs to the Howey test, named for the Supreme Court case that established the standard inquiries for what constitutes a security for purposes of federal regulations. Under the Howey analysis, an investment contract (i.e., a security) exists where there is a transaction through which a person invests money in a common enterprise with an expectation of profit derived from the efforts of others.
It’s no secret where the SEC comes down on whether the types of ICOs currently dominating the headlines are subject to securities regulations under Howey. With billions of dollars pouring into deals in search of speculative profit, and with the high incidence of fraud across the ICO universe, you can bet SEC will continue to assert its jurisdiction against shady ICO promoters and issuers.
In a January 2018 op-ed published in the Wall Street Journal, SEC Chairman Jay Clayton and CFTC Chairman J. Christopher Giancarlo stated that their respective agencies were reviewing whether current regulatory regimes for currency transactions were adequate for cryptocurrency markets, in light of the agencies’ mandates to promote market integrity and confidence.
Just last week, through a speech entitled Digital Asset Transactions: When Howey Met Gary (Plastic) to the Yahoo Finance All Markets Summit, head of the Division of Corporate Finance William Hinman added more clarity regarding regulators’ posture toward crypto and ICOs. In it, he offered his own analysis on whether digital token transactions (including those involving cryptocurrencies like Bitcoin and Ether) are subject to securities laws.
Can a security become something other than a security?
Mr. Hinman’s comments addressed the simple question: “whether a digital asset offered as a security can, over time, become something other than a security.” If the digital token in question gives the holder a financial interest in the issuer, Mr. Hinman’s answer was no, it’s always a security. But if the token is issued to enable the holder to purchase a good or service through the network on which it was created, Mr. Hinman’s answer was a “qualified yes.” Qualified (because his remarks can’t officially bind the SEC, and) because as he explained, the answer in any situation will depend on the specific facts and circumstances. In particular, he told the audience the analysis would not focus on the token or its terms, but rather on the “circumstances surrounding the digital asset and the manner in which it is sold.”
The Howey Test in the cryptocurrency era
In essence, Mr. Hinman’s speech laid out the Howey test as applied to secondary token transactions. He noted that the digital asset in itself is “just code” and not a security, just as the orange grove in Howey, without anything more, would not be a security. Instead:
Central to determining whether a security is being sold is how it is being sold and the reasonable expectations of purchasers.
In the typical securities offering, including “most” ICOs, a third party organizes and promotes an investment transaction, and purchasers are investing for profit. Securities laws are designed to address the problem of information asymmetry by requiring the promoter to disclose material information and risk factors related to the transaction to investors.
But is a typical token transaction on a secondary market analogous to a typical securities offering? Mr. Hinman said not necessarily. He would not characterize the current offers and sales of tokens on Ethereum and Bitcoin that he observes as securities transactions. His rationale is grounded in Howey; it’s because these transactions don’t depend on the efforts of a promoter:
If the network on which the token or coin is to function is sufficiently decentralized—where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts—the assets may not represent an investment contract. [Emphasis added]
The lynchpin of Mr. Hinman’s analysis seems to be whether there is a “central actor” that is primarily responsible for the enterprise’s success, an actor upon which the SEC could impose disclosure obligations to benefit investors. For Ethereum and Bitcoin at least, the answer is a qualified no.
So, the question is not so much whether the digital asset that was initially placed as a security can morph over time into something else. Perhaps the key question, in the cryptocurrency context at least, is whether the distributed network upon which the token is exchanged becomes sufficiently decentralized that a promoter’s involvement becomes relatively meaningless. Near the end of his speech, Mr. Hinman listed non-exhaustive factors for assessing whether a token is offered as a security. Some of these factors (in my view) relate to whether the network has matured past the point of depending on a third-party promoter to drive an expectation of investor return. Some factors center around whether a promoter has significant influence over the token’s value and governance, or whether parties other than the promoter (e.g. potential users of the network) can exert meaningful influence over these things. Mr. Hinman also cited a factor of whether the network is fully functioning or in early stages of development.
It is unclear whether any other networks or applications besides those involving Ether and Bitcoin are currently sufficiently decentralized to frustrate the identification of a central actor. But if digital assets that were originally placed through Regulation D as restricted securities can now be sold through these identified channels without being fettered by securities regulations, investors in some private ICOs may have a path to liquidity.
Ethereum not a safe harbor
Although many commenters have represented Mr. Hinman’s remarks to mean that “Ether and Bitcoin are not securities,” he merely noted that the typical transactions of these that he sees today are not securities transactions. Digital assets with utility functions distributed over a decentralized network like Ethereum can still be packaged in a way to make them securities:
If a promoter were to place Bitcoin in a fund or trust and sell interests, it would create a new security. Similarly, investment contracts can be made out of virtually any asset (including virtual assets), provided the investor is reasonably expecting profits from the promoter’s efforts.
Where the SEC will go from here
I don’t think that Mr. Hinman’s comments signal a significant departure from the SEC’s view (as expressed by Chairman Clayton) that the vast majority of ICOs in the market today constitute issuances of securities. But Mr. Hinman’s speech took an intriguing turn near the end, after he encouraged promoters and counsel to get in touch with the SEC to work through questions around whether their particular token issuance is a securities offering. His invitation implies that the SEC is open to acknowledging that utility tokens may not be securities in all cases. Again, the related analysis would be guided by the manner in which the tokens are sold, and the expectations of purchasers—including whether the purchasers are motivated by consumptive or investment intent, and whether tokens are marketed only to likely network users or to the general public.
These factors, Mr. Hinman stated, are only meant to get issuers and their counsel to think and “start the dialogue” with the SEC’s staff. It will be fascinating to see how the Howey analysis will continue to play out in developing ICO and cryptocurrency contexts.