The Securities and Exchange Commission on Wednesday released its long-awaited (and long-promised) “plain English” guidance designed to help determine if initial coin offerings (ICOs) must register as securities.
It’s a vital question, as selling securities requires the seller to register with federal regulators and is subject to substantial regulation, notably limiting sales of the security—i.e. the coins or tokens—to accredited investors rather than the general populace.
The guidance, issued on the SEC’s FinHub, focuses on whether a digital asset passes the so-called “Howey test” created by the U.S. Supreme Court in 1946 to determine if it is an “investment contract.” Such a contract exists when there is “a reasonable expectation of profits to be derived from the efforts of others,” the guidance explains, adding that it is often used by the Commission and the courts to determine if unusual financial instruments are subject to federal securities law.
Several ICO issuers have been sued and given cease-and-desist orders based on the Howey test, and in December 2018, the organizers of the Basis stablecoin project decided to return $133 million to investors including Google Ventures, Bain Capital Ventures, and Andreessen Horowitz after extended talks with the SEC led them to conclude “there would be no way to avoid securities status,” the project organizers said in a letter explaining their decision.
The Howey test has three prongs, the guidance notes: the reliance upon the efforts of others, reasonable expectation of profits, and the somewhat amorphous “other relevant considerations.”
Among the points noted in the reliance upon others section, one good indication is if the ICO promoter (the “active participant”) is responsible for the ongoing development, operation and promotion of the cryptocurrency network, particularly if further development is necessary for the network to function properly. Another is if the active participant controls the creation or issuance of the digital asset (the coins or tokens) or acts to support its price by limiting supply through techniques like buying them back or “burning” them. Owning intellectual property rights to the network or digital asset is also a red flag.
Under “reasonable expectation of profits,” the guidance notes that factors include whether the digital asset is (or is expected to be) transferable or traded on a secondary market like an exchange; if the active participant is able to benefit because it holds some of the digital assets released to the public; or the marketing suggests that ready transferability of the digital assets is a key selling feature.
The “other relevant considerations” section looks at the economic realities of the transaction. One example it gives is that the stronger the ability to use a virtual currency to make payments without first converting it to another digital asset or to fiat currency, the less likely it is to fall under the Howey test.
Each of the three sections also look at how to determine if a digital asset sold as a security should be re-evaluated as a non-security at a later time. For example, if the efforts of the active participant (or a successor) are no longer important to the value of an investment in the digital asset, or if they no longer affect its success.
The guidance comes with a pair of big asterisks, according to the announcement by Bill Hinman, the SEC director of the division of corporation finance, and FinHub head Valerie Szczepanik, the SEC’s senior advisor for digital assets and innovation.
First of all, it is a framework that is “not intended to be an exhaustive overview of the law, but rather, an analytical tool to help market participants assess whether the federal securities laws apply.”
Secondly, and more importantly, it “represents Staff views and is not a rule, regulation, or statement of the Commission,” it reads, adding that like any other Staff guidance, it “is not binding on the Divisions or the Commission.”