By Tyler Horowitz
Finally, we have some guidance.
On June 14, 2018, William Hinman, head of the Division of Corporate Finance at the Securities Exchange Commission (SEC), provided some direction as to the classification of Bitcoin, Ethereum, and future cryptocurrencies at the Yahoo All Markets Summit. According to Hinman, Bitcoin and Ethereum are not securities, but many other coins offered in Initial Coin Offerings (ICOs) may be.
Hinman explained, “Central to determining whether a security is being sold is how it is being sold and the reasonable expectations of purchasers”. Hinman further elaborated by stating Bitcoin and Ether are not deemed securities because they are currently decentralized, meaning there is no central decision-maker or promoter to identify.
While the current landscape of securities regulation seems ambiguous with respect to digital assets, Hinman alluded to the SEC v. W.J. Howey Co. to determine whether a company’s issuance of tokens is a sale of securities. The “Howey Test” was created by the Supreme Court for determining whether a transaction constitutes as an investment contract. If so, the transaction is protected under the purview of the SEC. To qualify as an investment contract, the transaction needs to meet the following elements: (i) an investment of money (ii) is made in a common enterprise (iii) with an expectation of profits (iv) to be derived from the efforts of others.
Supported by the Howey test, Hinman focused on the fact that investors in Bitcoin and Ethereum can “no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts.” Therefore, the virtual currency cannot represent an investment contract. Hinman clarified that securities laws apply to investors who purchase tokens or coins from networks that rely on central actors who are “key to the success of the enterprise”. In other words, if an investor bought a cryptocurrency with the expectation of a profit and an issuing company sponsored the creation or sale of the asset, it seems like it would be deemed as security.
While this may provide relief to future issuers and cryptocurrency holders, this outcome will certainly raise questions and concerns with respect to Ethereum’s pre-sale. Given how the Ethereum network issued its coin through a pre-sale, it is plausible that the SEC could ultimately view its creator’s efforts as a common enterprise. By this logic, the network was centralized; therefore, the Howey test could survive.
Nevertheless, Hinman indicated and emphasized that the classification of a company’s tokens is “not static and does not strictly inhere to the instrument.” As in the case of Ethereum, an issuer’s network can become decentralized over time, even after the issuance of its tokens.
Hinman provided insight as to how to determine whether a token is, or is not, a security. From his speech, we are left with two important pillars of guidance. The first being, who is involved in the transaction? Secondly, what is the nature of the digital asset?
In order to assess whether a digital asset meets the “investment contract” standard established by Howey, practitioners should ask: Who are the parties involved? Hinman provided an illustrative list to determine whether a third-party drives the expectation of a return under the Howey test.
Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and continued maintenance of the asset and its potential increase in value?
Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?
Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?
Are purchasers “investing,” that is seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?
Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?
Do persons or entities other than the promoter exercise governance rights or meaningful influence?”
Next, Hinman emphasized how various ways of structuring the digital asset can function like a consumer item rather than a security:
Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?
Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading?
Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent?
Are the tokens distributed in ways to meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?
Is the asset marketed and distributed to potential users or the general public?
Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?
Is the application fully functioning or in early stages of development?
Hinman made clear that tokens that are initially classified as securities can be deemed as non-securities under certain circumstances, such as a decentralization effect. This leaves companies that plan on conducting a Securitized Token Offering (STOs) with inconclusive guidance. While companies may choose to conduct their offering under securities exemptions, the SEC ultimately may conclude that the token is not security under the Howey test. Perhaps we can expect to see more companies requesting no-action letters from the SEC on this front.
The future of the securities regulation landscape of crypto assets is unpredictable. Nonetheless, Hinman’s comments provide some blueprint guidance to the SEC’s position in the cryptocurrency industry. While this statement has no legal force or effect, Hinman’s remarks may serve as a building-block for the future of securities regulation in this emerging field.