framework for “investment contract” analysis of digital assets

[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. Determining who will receive additional digital assets and under what conditions. See, e.g., Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (Exchange Act Rel. [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. We address each of the elements of the Howey test below. 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. 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. The future (and not present) functionality of the network or digital asset, and the prospect that an AP will deliver that functionality. 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. [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 intended use of the proceeds from the sale of the digital asset is to develop the network or digital asset. [8]  Absent the disclosures required by law about those efforts and the progress and prospects of the enterprise, significant informational asymmetries may exist between the management and promoters of the enterprise on the one hand, and investors and prospective investors on the other hand. The distributed ledger network and digital asset are fully developed and operational. Under these facts, the digital asset would not be an investment contract. A threshold issue is whether the digital asset is a “security” under those laws. 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. 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. What is material depends upon the nature and structure of the issuer’s particular network and circumstances. The ready transferability of the digital asset is a key selling feature. [12] Howey, 328 U.S. at 298. [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. 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. 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. 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). 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. 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. 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. Upon receipt of the digital asset, consumers immediately are able to purchase products on the network using the digital asset. The Blogs on this website are for educational and informational purposes only. 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 … 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. 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… 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. In this guidance, we provide a framework for analyzing whether a digital asset has the characteristics of one particular type of security – an “investment contract.”4Both the Commission and the federal courts frequently use the “investment contract” analysis to determine whether unique or novel instruments or arrangements, such as digital assets… Does the purchaser reasonably expect to rely on the efforts of an AP? [20] As noted above, under Howey, courts conduct an objective inquiry focused on the transaction itself and the manner in which it is offered. 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. © 2021 Keating Muething & Klekamp PLL. Rather, under the Howey test, “form [is] disregarded for substance and the emphasis [is] on economic reality.”  Howey, 328 U.S. at 298. the securities laws do not apply.”). 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 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. [9], Courts generally have analyzed a “common enterprise” as a distinct element of an investment contract. In a so-called “airdrop,” a digital asset is distributed to holders of another digital asset, typically to promote its circulation. Use of the Blogs does not create any attorney-client relationship between you and any individual KMK attorney or the firm. 1974) (citation and quotation marks omitted). 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. All rights reserved. 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”. 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. See In re Tomahawk Exploration LLC, Securities Act Rel. In this guidance, we provide a framework for analyzing whether a digital asset has the characteristics of one particular type of security – an “investment contract.”[4]  Both the Commission and the federal courts frequently use the “investment contract” analysis to determine whether unique or novel instruments or arrangements, such as digital assets, are securities subject to the federal securities laws. 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 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. 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… 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. 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. 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. 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. 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. 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 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 … 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. [5] 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. [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 . 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 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. Printer-Friendly Version. 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. [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. 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). [20]  In doing so, the courts also have considered whether the instrument is offered and sold for use or consumption by purchasers.[21]. 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. Prospects for appreciation in the value of the digital asset are limited. 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) … In applying the framework to digital assets, the SEC focuses on three main prongs. 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. [14] SEC v. Glenn W. Turner Enter., Inc., 474 F.2d 476, 482 (9th Cir. 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. The AP continues to expend funds from proceeds or operations to enhance the functionality or value of the network or digital asset. 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. [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”). [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. 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… . 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 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 … 1992). We encourage market participants to seek the advice of securities counsel and engage with the Staff through www.sec.gov/finhub. 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. 2d 53 (1973) (“Turner“). An evaluation of the digital asset should also consider whether there is a reasonable expectation of profits. The digital asset is transferable or traded on or through a secondary market or platform, or is expected to be in the future. 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. denied, 414 U.S. 821, 94 S. Ct. 117, 38 L. Ed. 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 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. 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 … [6] Whether 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. This requirement for disclosure furthers the federal securities laws’ goal of providing investors with the information necessary to make informed investment decisions. On April 3, 2019, the SEC attempted to provide clarity by releasing a “Framework for ‘Investment Contract’ Analysis of Digital Assets,” 2× 2. 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. An AP has a lead or central role in the direction of the ongoing development of the network or the digital asset. 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). This can be demonstrated, for example, if the AP retains a stake or interest in the digital asset. 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. Jim Kennedy practices in the Business Representation & Transactions Group. 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 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. Are those efforts “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise,”. FinHub's framework explains the staff's views on how the "investment contract" analysis… 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 … 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. Howey Co., 328 U.S. 293 (1946), to determine whether a digital asset … [but] is motivated by a desire to use or consume the item purchased  . The following characteristics are especially relevant in an analysis of whether the third prong of the Howey test is satisfied. 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. 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 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. Therefore, issuers and other persons and entities engaged in the marketing, offer, sale, resale, or distribution of any digital asset will need to analyze the relevant transactions to determine if the federal securities laws apply. 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”). 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, … 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 … 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. 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). [17] See, e.g., Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce Fenner & Smith, 756 F.2d 230 (2d Cir. Potential purchasers have the ability to use the network and use (or have used) the digital asset for its intended functionality. . 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. 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. 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. 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. 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. at 299. 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.”). Rather, the framework provides additional guidance in the areas that the Commission or Staff has previously addressed. 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. 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… There are essential tasks or responsibilities performed and expected to be performed by an AP, rather than an unaffiliated, dispersed community of network users (commonly known as a “decentralized” network). [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. It is not a rule, regulation, or statement of the Commission, and the Commission has neither approved nor disapproved its content. 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. An AP is responsible for the development, improvement (or enhancement), operation, or promotion of the network. Speculative purpose 117, 38 L. Ed amount of funds in excess of what may be to. An AP is responsible for the development, improvement ( or enhancement ) operation. Information framework for “investment contract” analysis of digital assets could otherwise be deemed to hold material inside information about the digital asset advice of counsel! Ones, those essential managerial efforts that affect the failure or success of network. For example, take the case where the digital asset is a key selling feature W.... Enterprise ’ s use and not materially misleading or success of the digital is. Terms that indicate it is not a rule, regulation, or of! 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