On April 3, 2019, the Securities and Exchange Commission (“SEC”) issued its first no-action letter related to the offering and sale of digital tokens. The beneficiary is TurnKey Jet, Inc. (“TurnKey”) which proposes to offer and sell blockchain-based digital assets in the form of “tokenized” jet cards (“Tokens”).

The no-action letter, which some see as a turning point in the digital asset regulatory space, is unlikely to provide much encouragement to other issuers desiring to offer and sell their tokens without registration. The no-action letter, which is a letter indicating that the SEC staff will not recommend legal action against the requesting entity if the requesting entity complies with the requirements set forth in the letter, provided for a multitude of requirements that TurnKey must comply with that are likely not possible across most token projects. These factors include:

• TurnKey will not use any funds from Token sales to develop their Platform, Network, or App, and each of these will be fully developed and operational at the time any Tokens are sold;
• TurnKey will restrict transfers of Tokens to TurnKey Wallets only, and not to wallets external to the Platform;
• TurnKey will sell Tokens at a price of one USD per Token throughout the life of the Program, and each Token will represent a TurnKey obligation to supply air charter services at a value of one USD per Token;
• If TurnKey offers to repurchase Tokens, it will only do so at a discount to the face value of the Tokens (one USD per Token), absent certain limited circumstances; and
• The Token is marketed in a manner that emphasizes the functionality of the Token, and not the potential for the increase in the market value of the Token.

On the same day, the SEC also released a framework for determining whether a digital asset falls under the definition of a “security.” The SEC’s guidance is derived from the traditional test of what is considered to be a security – the Howey test – as described in our post from June 2018. Notably absent is any mention of the Gary Plastics case that the SEC has previously analyzed in the context of digital assets. Under the Gary Plastics test, a token that provides utility and is not itself a security under the Howey test could nevertheless become a security depending on how the token is packaged and sold. The SEC’s framework focused on the third prong of the Howey test – whether there is a reasonable expectation of profits derived from the efforts of others. While all elements of the Howey test must be satisfied for an instrument to be deemed an “investment contract” and thus a security, the SEC views the last prong as pivotal in understanding the appropriate safeguards to avoid enforcement in connection with the tokenization of digital assets.

The SEC clarified that when a promoter, sponsor, or other third party (or affiliated group of third parties) (each, an “Active Participant”) provides essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts, then this prong of the test is met. Relevant to this inquiry is the “economic reality” of the transaction and “what character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect.”

The SEC noted that the following factors and characteristics are especially relevant in an analysis of whether a digital asset satisfies the third prong of the Howey test is satisfied:

• Reliance on the efforts of others:
  • Whether an Active Participant is responsible for the development, improvement (or enhancement), operation, or promotion of the network, particularly if purchasers of the digital asset expect an Active Participant to be performing or overseeing tasks that are necessary for the network or digital asset to achieve or retain its intended purpose or functionality.
  • Whether an Active Participant creates or supports a market for, or the price of, the digital asset. This can include, for example, an Active Participant that: (1) controls the creation and issuance of the digital asset; or (2) takes other actions to support a market price of the digital asset, such as by limiting supply or ensuring scarcity, through, for example, buybacks, “burning,” or other activities.
• Reasonable expectation of profits:
  • Whether the digital asset gives the holder rights to share in the enterprise’s income or profits or to realize gain from capital appreciation of the digital asset.
  • Whether the digital asset is transferable or traded on or through a secondary market or platform, or is expected to be in the future.
  • Whether the Active Participant has raised an amount of funds in excess of what may be needed to establish a functional network or digital asset.
  • Whether the digital asset is marketed, directly or indirectly, using any of the following:
    • The digital asset is marketed in terms that indicate it is an investment or that the solicited holders are investors.
    • The intended use of the proceeds from the sale of the digital asset is to develop the network or digital asset.
    • The availability of a market for the trading of the digital asset, particularly where the Active Participant implicitly or explicitly promises to create or otherwise support a trading market for the digital asset.
• Other relevant considerations – economic reality of the transaction:
  • Whether the distributed ledger network and digital asset are fully developed and operational.
  • Whether the digital assets’ creation and structure is designed and implemented to meet the needs of its users, rather than to feed speculation as to its value or development of its network. For example, the digital asset can only be used on the network and generally can be held or transferred only in amounts that correspond to a purchaser’s expected use.
  • Whether the digital asset is marketed in a manner that emphasizes the functionality of the digital asset, and not the potential for the increase in market value of the digital asset.
  • With respect to a digital asset referred to as a virtual currency, whether it can immediately be used to make payments in a wide variety of contexts, or acts as a substitute for real (or fiat) currency.
  • With respect to a digital asset that represents rights to a good or service, whether it currently can be redeemed within a developed network or platform to acquire or otherwise use those goods or services.

As we have discussed in our posts from November 2018 and February 2019, the above is drawn from multiple SEC staff statements released over the past year and while helpful to have comprehensive guidance together in one place, the SEC has not provided much new advice for token projects.