The SEC just released a framework for “Investment Contract: Analysis of Digital Assets.” The framework covers the SEC’s perspectives on whether a cryptocurrency is a security. For the past few years, the SEC has been very open and supportive to the blockchain industry (unless you did something obviously wrong), and the content of the framework may not seem new to many of us.
I’m self-digesting and reading other opinions on Twitter/Medium.
First things first, the framework has no legally binding effect. The SEC said it themselves “it’s not a rule, regulation, or statement of the Commission.” Securities law depends on various facts and circumstances of each particular case, so the SEC won’t give any bright-line rule for ICO. The framework gives a long list of characteristics that you should avoid, but many of the points might not hold up in court. Using Stephen Palley’s words, a way to read it is “the SEC wrote you a memo because you kept bugging us. Now go hire a lawyer and stop screwing around. We mean it this time!”
(*In case you need some background knowledge) The reason why you don’t want your ICO constitutes securities offering is that securities registration is very expensive and time-consuming. The SEC requires so because the information in the securities market is oftentimes asymmetric, and the SEC wants to protect investors by requiring registrations and a solid amount of information disclosures by the token issuers.
The SEC uses The Howey Test to examine whether a digital asset is a security, or put it more specifically, “investment contract”. The test has three prongs and all have to be satisfied. All in all, The Howey Test is a test that you actually wanna fail.
The SEC didn’t give much analysis on the first and second prong (“investment of money” and “in a common enterprise”), assuming they are both satisfied. We know it’s not gonna work in court but so far there was only one case brought to the court, so okay.
There are some points I wanna emphasize here:
- The SEC said tokens under a “bounty program” constitute securities because “the issuer provided the tokens in exchange for services designed to advance the issuer’s economic interest and foster a trading market for its securities.” This is too broad an interpretation of “investment”! Bounty rewards could be offered to people who perform certain tasks to promote the network, such as translators who help ensure a global reach by translating documents, or coders who test and detect flaws in the blockchain. In most cases, providing labor and receiving tokens as rewards doesn’t appear to be an investment to me.
- Airdrop might be a securities offering, even no monetary investment is made. I’m hoping that the SEC could give a specific example of that, but anyway if nothing is given to the issuer as a consideration, there is no contract and thus no “investment contract” as securities.
- The “common enterprise” prong gets short shrift from the SEC. However, the court would require that there be either “horizontal commonality” or “vertical commonality”, which complicates the analysis.
Reliance on the efforts of others
This element asks whether your ICO is decentralized enough.
Realistically most of the projects, at least at their early stages, would rely on a third party to develop, manage and operate the platform/token. Just because tokens have great value in bootstrapping, incentivizing people to get involved and push things forward, the blockchain industry was facilitated and boosted. Without these tokens, most of the blockchain projects today including Ethereum wouldn’t exist. Some raised the question that can our laws allow tokens to be regulated as something in between securities and softwares, thus they could be traded freely like softwares, however they might have some securities features, instead of being subjected to securities law? It would be an interesting question that the regulator need to consider.
The active participant in blockchain, also called AP (thanks to SEC for a new jargon), refers to a promoter, sponsor, or other third party or affiliated group of third parties which provides essential managerial efforts that affect the success of the enterprise, and leading investors to reasonably expect to derive profit from those efforts.
For example, you’ll be an AP if you’re responsible for the development or improvement of the platform/token; if you create or support a secondary market; lead in deciding governance issues, code updates, how others participate in TXs validation; make managerial decisions such as compensation and secondary market arrangement; lead in the validation/confirmation of TXs or network security.
If an AP’s effort in the platform is a significant one and affects the success of the platform, the third prong is satisfied.
Some points worth noticing:
- By saying that an AP’s effort affects the success of the network, I agree with Coincenter’s point that such “success” should be existential prospects of the network.
- Where some groups have massive mining power or some stakeholders own a big portion of stakes and play a leading role in the validation or confirmation of TXs, they might be considered as AP.
- If the AP owns/controls the IP rights of the network/token then this prong might be satisfied, because when the source code is proprietary instead of open source, the AP who owns the IP is essential to the development of the platform (if they step away, they will jeopardize the viability of the platform.)
- Marketing that emphasizes AP’s expertise such as their professional or educational background raises a red flag that AP is expected to enhance the value of tokens, and this prong might be satisfied.
- AP would probably be discouraged from developing and promoting the platform for the incentive of failing the prong. But SEC is sending out the message that “We want you to succeed, come talk and work along with us.” In most of the cases, you should work closely with SEC and inquire of the staffs if you have doubts on securities law requirements.
- So far it’s hard for passive investors to find a way to support these promising blockchain projects and enjoy some upsides of the potential success. Investors would want to participate at the early stage where the token is cheaper, instead of wait until the project is well developed and functional.
When the listed characteristics recede, the token will be reevaluated.
Reasonable Expectation Of Profit
Price appreciation resulting solely from external market forces such as general inflationary trends or the economy is not considered “profit”, rather, SEC look at the appreciation comes from the operation, improvement, promotion of the network.
There are a couple of characteristics where this prong is likely satisfied. For example, holders have rights to share income/profits/dividends; the tokens are transferable or have a secondary market; token is offered broadly to potential purchasers as compared to being targeted to expected users of good/services; there are little correlations between the price/quantity of token and those of the goods/services; you raise an amount of funds in excess of what may be needed to establish a functional network/token… also how you market the ICO matters.
- Re a secondary market, Patrick Berarducci made a good argument here. He said, “the Framework doesn’t do enough to acknowledge that tokens, just like every other consumer good, can trade on market places and appreciate in value. And that doesn’t make the good itself a security.” I personally think that it’d be a bit farfetched to compare a token with a consumer good. Most tokens lack the fundamental characteristics of consumer good and could not be transformed into usable products. And for tokens to be freely traded on market and appreciate in value, it would seem more like securities than consumer goods.
- With regards to the correlations between quantities of tokens offered and products being sold, I saw lots of arguments saying that “quantities” may not indicate investment intent, and should not be an indication of securities transactions. For tokens that are characterized as currencies, token purchasers might perceive it as stores of value and intend to buy more tokens than they actually need in exchange for the goods/services because it's cheaper at the moment.
The SEC also looks to whether the tokens are offered or sold for use or consumption. The characteristics include the token purchasers can actually use the platform/token as intended, and the prospect for appreciation is limited.
- For tokens that represent rights to goods/services, it should be currently available to be redeemed/used to acquire goods, especially “goods that can only be acquired or more efficiently acquired through the use of tokens.” I’d like to quote Coin Center’s opinion here —“There are some services only a public blockchain network can provide. Censorship resistance, user-sovereignty, privacy, interoperability are difficult or impossible to achieve if a centralized party is essential. These functions only work if a valuable token provides incentives to the network.”
- Facilitating secondary markets for tokens is acceptable, if transfer may only be made by and among users of the platform.
Even if there is a fully-developed operating business and tokens can be used to purchase products only on the retailer’s network, if 1) tokens are sold at a discount to the value of the goods/services; 2) tokens are sold in quantities >reasonble use; 3) no restriction on reselling, there may be securities TXs.
In a decentralized system, tokens can create marketplaces which allocate the production and consumption of various useful resources, where the value of goods/services are exactly the price at which the tokens trade. But as Lewis Cohen pointed out, expecting a token will reflect the “value” of smth off-chain fundamentally misunderstands what this technology actually does. And oftentimes users determine the price of goods based on the price users are willing to pay for the tokens.
There are more questions still waiting to be answered. How is DEX that listed securities tokens regulated? What will the SEC do with offshore exchanges open to US citizens? What will SEC do to the ICOs where the APs are anonymous?
The inquiry goes on.
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