In his June 6, 2018, interview with CNBC, Securities and Exchange Commission (“SEC”) Chairman Jay Clayton further clarified the regulatory landscape around cryptocurrencies, blockchain technology and initial coin offerings, nothing that the SEC would not support changing the traditional definition of a security to take into account this new technology: “Where I give you my money and you go off and make a venture … and in return for me giving you my money, you say, ‘You know what, I’m going to give you a return.’ That is a security, and we regulate that. We regulate the offering of that security, and we regulate the trading of that security.”
Clayton did, however, reinforce the notion that cryptocurrencies acting as currencies used for carrying out transactions, Bitcoin for example, will not be regulated by the SEC. He went on to explain where a cryptocurrency could be a replacement for sovereign currency – “replace the dollar, the yen, the euro with bitcoin” – that cryptocurrency is not a security. When asked whether altcoins, such as Ripple and Ether, are securities, Clayton declined to comment and again referenced the traditional definition of a security. He also was asked how the securities laws apply when a project starts out by selling tokens that are securities, but then become decentralized with no leadership; he also declined to answer that question.
William Hinman, SEC Director of the Division of Corporation Finance, on the other hand, did address such a question. Speaking at the Yahoo Finance All Markets Summit on June 14, 2018, he reiterated the position that the SEC is not going to soften its attitude toward regulating such economic transactions, and confirmed that the traditional test of what is considered to be a security, set out by the U.S. Supreme Court in SEC v. Howey (often referred to as the “Howey test”) is here to stay. He did, however, provide more of a framework on how this definition gets applied to the digital asset industry than we have so far seen. He emphasized that the circumstances surrounding the digital asset – the “economic reality” – should be the focus of what constitutes an offering of a security.
Without actually mentioning the word “SAFT,” (standing for “Simple Agreement for Future Tokens”), Hinman addressed the common SAFT scenario where issuers are raising money to develop the platform and the networks on which the digital assets will operate and selling tokens or coins to facilitate this fundraising, rather than using more traditional methods of fundraising (i.e. selling shares, issuing notes, etc.). While the manner of fundraising is dissimilar, the economic substance is no different than a traditional securities offering. He noted, “[w]hen we see that kind of economic transaction, it is easy to apply the Supreme Court’s ‘investment contract’ test first announced in SEC v. Howey” and that at this initial stage where the very viability of the platform is still uncertain, “the purchase of a token looks a lot like a bet on the success of the enterprise and not the purchase of something used to exchange for goods or services on the network.”
He went on to explain that the tokens themselves are not strictly speaking securities, but it is instead the manner in which these tokens are sold that determines whether they are securities. The key element here is how such token is being sold and the reasonable expectations of purchasers. The success of the platform is heavily dependent, at least in the initial stages, on the efforts of a third party, “so learning material information about the third party … is a prerequisite to making an informed investment decision.”
But what happens once the success of the platform or network no longer turns on the efforts of such a third party or where it may even be impossible to identify an issuer or such a third party to make the required disclosures? This is where Hinman sees applying the disclosure regime of the federal securities law does not make a lot of sense. If the network is “sufficiently decentralized – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts – the assets may not represent an investment contract.” He analogized this to Bitcoin today, explaining how it would add little value to attempt to apply the federal securities disclosure regime to the offer and resale of Bitcoin. He also shared his view that based on his current understanding of the Ethereum network, offers and sales of Ether also would not be considered securities. This is not to say, however, that anything that touches Bitcoin or Ether is not a security. He discussed the situation where if someone were to put Bitcoin in a fund or trust and sell interests in such a fund or trust, that fund or trust would be a security.
Hinman also set forth a list of helpful, instructive questions that someone should consider when analyzing whether a sale of digital assets is offered as an investment contract which would be considered to be an offering of securities under the U.S. securities laws:
- 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 that 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?
While Hinman’s remarks are not the official view of the SEC, Commissioner Clayton gave testimony June 21, 2018, before the Committee on Financial Services of the U.S. House of Representatives where he noted Hinman’s framework is “the approach staff takes to evaluate whether a digital asset is a security.” Despite Clayton’s interview and Hinman’s remarks, it still is yet to be seen whether the SEC will bring actions against issuers of initial coin offerings, virtual currency exchanges, and the like where fraud is not being alleged. However, Clayton’s and Hinman’s recent remarks both point to the SEC’s reliance on the classic definition of a security, and demonstrate that it is unlikely, at least in the initial stages of a digital asset project, that the U.S. federal securities laws would not apply.