A Moment of Clarity for the SEC’s Regulation of Cryptocurrencies
There is a certain irony in the fact that the legal principles that currently govern the regulatory treatment of cryptocurrencies draw primarily from a 1946 case dealing with investment contracts in Florida orange groves. However, to experienced observers, the outcome should not be particularly surprising: SEC Director William H. Hinman’s remarks on June 14, 2018, at the Yahoo Finance All Markets Summit: Crypto, titled “Digital Asset Transactions: When Howey Met Gary (Plastic)” included arguably the SEC’s most important guidance to date on the regulatory approach to sales of digital assets. A transcript of Director Hinman’s speech may be found here.
Director Hinman’s remarks helped address the question of whether a digital asset that would have constituted a security at issuance can eventually transition into something other than a security for purposes of federal securities regulations. He provided a useful list of criteria to help determine when that transition may occur, focusing primarily on the economic substance of the transactions involved and whether the digital assets have become sufficiently decentralized that their value no longer depends on the entrepreneurial efforts of a person or group.
Perhaps most significantly, Director Hinman’s focus on the eventual “decentralization” of cryptocurrencies, such that the problem of informational asymmetry—a critical factor in the enforcement of securities laws—that may be present during initial coin offerings (ICOs) eventually dissipates, appears to be a recognition of the unique characteristics of this new, decentralized technology by a top regulator.
To understand the importance of Director Hinman’s comments, it is first necessary to have some basic background on some of the guidance courts and the SEC have provided prior to this point. Readers who are already familiar with this material should feel free to skip ahead.
A brief primer on the SEC’s treatment of cryptocurrencies and ICOs prior to Director Hinman’s remarks on June 14, 2018
One of the most fraught questions in recent securities jurisprudence has been whether sales of cryptocurrencies offered in ICOs should be regulated as if they were securities being offered in a traditional securities offering. The Securities Act of 1933, somewhat unhelpfully, defines “security” to include “an investment contract,” and courts have been left to figure out what that was supposed to mean. As briefly noted above, the landmark case Securities and Exchange Commission v. W. J. Howey Co., 328 U.S. 293 (1946) dealt with sales of interests in citrus groves and an argument that because the investors were purchasing real estate, the interests being sold were not securities subject to federal securities regulation.
Just to lay out the facts in Howey a little more clearly, the seller in that case owned large tracts of orange groves in Florida and held onto half of that land as the outright owner. The seller then offered tracts for sale from the remaining portion but offered (and heavily promoted) an optional lease-back of the land whereby Howey would manage the land to the exclusion of the buyer, who would have no right to possession of the tract. It was the lease-back contracts that caused the arrangement to be treated as a security.
In determining that the interests did indeed constitute securities, the Court’s decision gave rise to a set of principles, known among securities practitioners as the “Howey test,” that have been used ever since to determine whether an investment arrangement constitutes a security that is subject to regulation under federal securities laws. The fundamental principal from the Howey test relevant to our current discussion can be summarized as follows: An investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others will be deemed an investment contract and therefor a security subject to regulation under the Securities Act.
The advent of cryptocurrencies and ICOs has raised new questions not squarely addressed by previous regulatory pronouncements and has led to a significant amount of speculation as to the likely approach that regulators will take when applying existing regulatory principles to these new innovations. To date, investors have piled billions of dollars into ICOs, and these offerings have been structured in a variety of different ways, each with varying degrees of risk tolerance in their attempts to avoid classification as securities under the Howey test.
Two particularly notable examples of this phenomenon for purposes of the present report have been “utility tokens” and Simple Agreements for Future Tokens (SAFTs).
An ICO is essentially a pre-sale of a cryptocurrency or token that is intended (eventually) to be used as the “coin of the realm” for a particular decentralized economic “ecosystem,” before that ecosystem is built, in order to fund development. These tokens that are intended to eventually have functional value have been called utility tokens.
Proponents of utility tokens typically argued that because they represented future (or sometimes immediate) access to a specific product or service rather than a portion of a company’s earnings like a traditional equity security, they were not subject to regulation under federal securities laws. In December 2017, SEC Chairman Jay Clayton issued a public statement cautioning investors that attempts to highlight utility characteristics of tokens risked elevating form over substance and that the ultimate regulatory analysis will be based on the facts and circumstances of a given situation rather than its label as a “utility” or “currency” token.
To illustrate this point, Chairman Clayton noted that a token sold for participation in a book-of-the-month club may be an efficient means of funding book purchases for the club’s use and may not implicate securities laws, but a token for construction of publishing houses with still-nonexistent authors, books and distribution networks presents a different situation, particularly where promoters of such an offering emphasize the potential for secondary-market trading or other means of profiting from the increase in the value of the tokens from the efforts of others.
Simple Agreements for Future Tokens (SAFTs)
SAFTs are modeled after the Simple Agreement for Future Equity popularized by Y Combinator, and serve a similar function. A SAFT is essentially a contract that grants an investor the right to buy tokens upon the occurrence of a later event. The SAFT itself is an investment contract and is subject to regulation under federal securities laws. The benefit of using SAFTs as opposed to selling utility tokens—according to proponents—is that although the SAFT itself is a security (and designed for sale to accredited investors) the tokens obtained through the SAFT would not necessarily need to be classified as securities under the Howey test. This is because at the time the tokens are actually obtained, they would already be functional consumer products. In other words, if the development efforts are already complete once you obtain the token, then you have arguably eliminated the risk that investors are obtaining them for speculation based on profits derived from the entrepreneurial or managerial efforts of others.
In other words, the position taken by many in the industry is essentially that although tokens issued in expectation of a to-be-completed underlying product or service may be deemed securities, if the actual token is not issued until the underlying product or service is complete, the nature of the instrument has changed, the caterpillar is now a butterfly, and it is not subject to federal securities regulation. That contention set the stage for Director Hinman’s remarks on June 14, 2018.
The SEC’s Guidance to Date
The SEC first weighed in on cryptocurrencies in July 2017 with an investigative report on an early ICO known as The DAO. That report clarified that sales of tokens in connection with that ICO were securities offerings, and that promoters of the ICO should have done so in compliance with U.S. securities laws. The report was followed a day later by an Investor Bulletin on ICOs that emphasized the “facts and circumstances” analysis under the Howey test, and cautioned investors about fraud.
Subsequently, the SEC brought a number of enforcement actions against fraudulent behavior in the ICO market, including RECoin, PlexCoin, AriseBank, and Munchee Inc. In connection with the Munchee case, the SEC stated that “even if MUN tokens had a practical use at the time of the offering, it would not preclude the token from being a security. Determining whether a transaction involves a security does not turn on labelling – such as characterizing an ICO as involving a ‘utility token’ – but instead required an assessment of the ‘economic realities underlying a transaction.’”
In its brief before the federal court hearing the Munchee case, the SEC previewed the position taken by Director Hinman in his recent statements:
First, the appropriate focus is on the economics of the offering, not its label. …. What Defendant promised purchasers at the time of the offer and sale were returns on an investment. But, even if Defendant is to be believed that his intent at the time was eventually to issue tokens to be used as “cryptocurrencies” in a blockchain-based ecosystem, building such an ecosystem would have required Defendant’s efforts before any cryptocurrency could be issued by it or used within it. …. Defendant’s supposed plan that the Tokens would, one day, be useful in that ecosystem that he had not built does not alter the nature of Defendant’s promise to investors. Defendant offered and sold the investment opportunity to profit from his development of that ecosystem. Defendant’s fund-raising effort to obtain capital—even assuming an intention to build that ecosystem—bears all the hallmarks of a securities offering.
Director Hinman’s remarks on June 14, 2018 “Digital Asset Transactions: When Howey Met Gary (Plastic)”
Director Hinman’s remarks at the June 14, 2018, “Yahoo Finance All Markets Summit: Crypto” were squarely addressed at the question of whether a token that constitutes a security at one point in time can eventually become something other than a security.
To begin with (and in keeping with general expectations based on previous SEC guidance), Director Hinman noted that simply labeling a transaction an “ICO” or a sale of a “token” would not, by itself, exempt such an instrument from regulation under federal securities laws. Further, Director Hinman highlighted a point that is often misunderstood by those in the crypto space: It is not the token itself that is a security, but the offering of the asset in a particular manner that may be deemed a securities offering. The sellers of investment interests in orange groves in Howey might well have avoided any securities law implications had they just sold the real estate directly to buyers.
Director Hinman confirmed that questions regarding security status will be dealt with, as always, on a facts and circumstances basis, and he provided a laundry list of useful criteria for investors and practitioners to take into account when evaluating cryptocurrency offerings (more on this below). Importantly, the Director reminded the audience that the Howey test focuses on an expectation of profits derived from the efforts of others, and he pointed out that, as has consistently been the case with novel financial arrangements, the SEC’s evaluation of cryptocurrency offerings will focus on the economic substance rather than the form of the instrument.
Indeed, although the question of whether the product or service underlying the token provides immediate consumptive benefits to the token holder is certainly germane to the question of whether the purchase involves an expectation of profits derived from the efforts of others, that, in and of itself, will not be the end of the inquiry for the SEC. Director Hinman noted that the fruits of the orange groves that were at issue in Howey were also of immediate value to those investors, but the contracts for sale of interests in the groves were nevertheless determined to be securities subject to federal regulation.
Significantly, rather than focusing on the immediate utility of the product or service underlying the digital asset, Director Hinman emphasized the role of decentralization in determining whether an instrument that at one point constituted a security had made the transition into something that no longer would be subject to federal securities regulation. In other words, simply asking whether the underlying product is ready for use is not necessarily sufficient if the value of the product is still subject to the ongoing managerial or entrepreneurial efforts of a specific person or group. Critically, federal securities laws are intended to protect investors from the information asymmetry that exists between investors and promoters.
Thus, to the extent the value of a cryptocurrency is reasonably based on the managerial or entrepreneurial efforts of an identifiable person or group, it may be in the public interest for regulators to require compliance with federal securities laws to remedy information asymmetries. However, to the extent that a network has become sufficiently decentralized that such disclosures by any given person or group would not provide an appreciable benefit to investors, such disclosures become less meaningful and the case for regulation under federal securities laws becomes much less compelling.
To illustrate this point, Director Hinman specifically mentioned Bitcoin and Ethereum as examples of cryptocurrencies that had arguably become sufficiently decentralized that applying securities disclosure requirements would be of little value at this stage. While Director Hinman seemed to suggest that Bitcoin may not have been a security even at its inception, he hinted that Ethereum may very well have been a security at the time of the initial fundraising that took place at its creation, but it has likely made the transition to a sufficiently decentralized structure such that current offers and sales do not constitute securities transactions.
Readers should take note, however, that Director Hinman pointed out that even if a cryptocurrency had become sufficiently decentralized so as to no longer warrant classification as a security, if promoters were to attempt to package such currencies and market them as investment strategies, this would likely create a new investment contract that would potentially warrant regulation under federal securities laws.
In determining whether the value of a digital asset is dependent upon the efforts of a third party, Director Hinman outlined an illustrative (not exhaustive) list of facts and circumstances that should form part of the analysis. These are of sufficient value that we have reproduced them in their entirety below and encourage readers to also carefully review the full text of Director Hinman’s remarks.
- 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 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?
Similarly, Director Hinman offered the below criteria as examples of considerations to be taken into account when determining whether a digital asset functions more like a consumer item and less like a security. Again, we have reproduced the Director’s list in its entirety.
- 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?
While one might imagine a situation in which information about orange groves might become so ubiquitous that information asymmetry might vanish even in the analog world as well, there is something uniquely modern and even revolutionary about the introduction of “decentralization” into the securities law analysis of digital assets, especially by a senior official at the SEC. The concept of decentralization is a cornerstone of the wave of digital disruption being ushered in by blockchain and other related technologies, and Director Hinman’s recognition of its relevance here should not be understated: It appears to signal an understanding on the part of regulators that in some important ways we are moving into unchartered waters. As a result, we have to interpret existing laws in ways that take into account both the changing technological environment and the reasons for the laws in the first instance. Interpreting the problem of information asymmetry in the context of decentralized business structures is a good first step in doing just that.
That’s the good news. However, although the new guidance from the SEC is welcome, “decentralization” well may prove to be a high bar. That is, the analysis turns on what would appear to be a subjective determination of the level of decentralization, rather than the more objective test proposed by utility token adherents of whether the underlying product or service is now available (Indeed, as noted above, even when a new token-based project is fully operational, there may be situations where certain sales of those tokens could be deemed a security.). What is decentralized enough?
Here’s another issue: What do regulators do with a marketplace in which some tokens have been sold in a securities offering, and some are not sold until later, when the tokens (arguably) have become decentralized? Again, that’s a situation that arises in the analog world: Even in Howey, some orange grove tracts were sold outright with no lease-back (although because the seller offered both together, the court in that case did not need to address this distinction). The short answer is likely that the SEC could pursue enforcement against the securities offering, resulting in sanctions against the directors, officers and control persons of the “issuer” of the instrument as well as dealers and persons deemed to be “underwriters” of those transactions. The specific actions taken can vary widely, but even in cases not involving an intention to defraud, they can result in substantial fines and civil money penalties, as well as exceedingly high defense costs and, in some cases, bars against individuals from future involvement in public offerings, public companies and certain private placements. However, the SEC would likely not need to do anything about the later sales once “decentralization” occurred; again, it is not the token that is being regulated, it’s the sale itself. After all, Howey was never really about orange juice.
So, what about the SAFT model? If you are a purchaser of tokens in an ICO and your analysis of whether the tokens you obtain through your SAFT constitute securities rests solely on whether the tokens will provide immediate consumptive benefits, you should take another moment to consider the factors recited above from Director Hinman’s remarks. In particular, SAFT investors should consider whether the tokens will have achieved decentralization as opposed to simply providing for immediate consumption and whether the economic reality of the underlying value of the tokens is driven by the potential for immediate consumption or the potential for resale on secondary markets based on the ongoing efforts of an identifiable person or group.
Promoters of the SAFT structure should recognize two critical items. First, securities issued to accredited investors are “restricted securities” within the meaning of the Securities Act, as a result of which they are not eligible for immediate resale. Second, as with any exempt securities offering, the exemption only addresses the issuer/seller’s registration obligation—not the antifraud provisions of the Securities Act or the Securities Exchange Act. Accordingly, readers should take care that, to the extent they are considering participation in such an offering as an issuer/promoter, the obligation to comply with the securities laws remains as it has since Howey: an obligation to register the offering or to perfect an exemption from registration and an obligation to provide disclosure that is adequate to permit the hypothetical “reasonable prudent investor” to evaluate the merits and risks associated with the instrument.