Working with our clients over the last year, we're seeing many similar questions and issues arising in the digital assets space. This is the first of several topics we'll be writing about to highlight the key legal issues that people in this space should know if they want to minimize the chances of adverse regulatory action.
Back to Basics
The definition of a security provided in the Securities Act of 1933 includes "investment contracts." Unlike stocks and bonds, investment contracts are often misunderstood because the term itself is defined by common law, and because the SEC's views may not always be completely coherent with the interpretations of the courts.
In the seminal case of SEC v. W.J. Howey Co., the U.S. Supreme Court defined an investment contract as:
(a) the investment of money (or other consideration e.g. cryptocurrencies, other digital assets);
(b) in a common enterprise;
(c) with the expectation of profits (whether from e.g. distributions, sale of an appreciated asset);
(d) derived from the efforts of others.
While federal courts have explained and applied this definition for decades, the industry has more recently received guidance on the concept of an investment contract in the digital asset context. For example, in 2019, the Strategic Hub for Innovation and Financial Technology ("FinHub") of the SEC noted several factors that may indicate the existence of an investment contract.
Purchasers Often Expect Profits
Often, projects sell digital assets to purchasers knowing that those purchasers expect to profit from their purchase. In its 2019 guidance, the SEC noted that a purchaser may have a reasonable expectation of profits where:
- the digital asset gives the holder rights to share in the enterprise's income or profits or to realize gain from capital appreciation;
- appreciation may result from operation, promotion, or development of the network;
- the digital asset is or will be traded on a secondary market or platform;
- the digital asset is offered broadly to potential purchasers rather than targeted to expected users of the goods/services accessed through the asset;
- the digital asset is offered and purchased in quantities indicative of investment intent;
- there is limited correlation between the purchase/offering price of the digital asset and the market price of the underlying goods or services;
- funds from proceeds are used to operate/enhance the network or digital asset; or
- the marketing of the digital asset points to the expertise of a third party, the development of the network or asset, the ready transferability of the digital asset, or the availability of a market for the trading of the digital asset.
Conversely, an asset may have been purchased for utility/consumption rather than for investment purposes if:
- the digital asset and its related network are fully developed and operational when the asset is sold;
- the digital asset’s purchase price is correlated with the market price of the good/service for which the asset may be redeemed;
- the asset is purchased and transferred in amounts corresponding to expected use;
- prospects for appreciation are limited (e.g., because the price is controlled, or the supply is unlimited);
- appreciation is incidental to obtaining the right to use the asset for its intended functionality; or
- transfers of the digital asset may only be made by and among users of the platform.
Crucially, an asset may still be an investment even if it has obvious utility.
Purchasers Often Rely on Efforts of Others
Frequently, purchasers rely on the efforts of others to see a return on their investment. In 2019, FinHub noted that a purchaser may be relying on the "undeniably significant" efforts of a third party if that third party:
- develops, operates, or promotes the network in which the digital asset can operate;
- creates or supports a market for or the price of the digital asset;
- limits supply or ensures scarcity of the digital asset;
- manages the network (e.g., determines compensation issues, use of funds, or validating of transactions on the network); or
- retains a stake or interest in the digital asset.
SEC No-Action Letters Provide Limited Help; Enforcement Actions are Scary
The few no-action letters published by the SEC in this space provide limited safety for issuers of digital assets. The SEC has generally advised against enforcement action only in the context of issuers of assets in closed-loop systems with a fixed price and unlimited supply.
Although the SEC’s enforcement actions in this space have largely involved digital assets that were obviously securities, issuers should be wary that the SEC often regulates by enforcement. In time, the SEC may well bring actions relating to digital assets operating in the grayer areas—and this is particularly true given that the SEC has recently bulked up its enforcement personnel.
The Bottom Line
- If your assets can appreciate in value and can be traded on secondary markets, there is an inherent and unavoidable risk that the SEC will view the token as a security that must be registered or issued under an exemption from registration.
- Even if your asset has obvious utility and consumptive value, it may still be a security from the SEC’s perspective.
- Unless you want to be subject to a federal or state investigation or enforcement action, consider that the view of regulators often matters more than the nature of the assets.