2d 53 (1973) (“Turner“). at 299. See In re Tomahawk Exploration LLC, Securities Act Rel. See, e.g., Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (Exchange Act Rel. Whether holders are then able to use the digital asset for its intended functionality, such as to acquire goods and services on or through the network or platform. If the AP provides efforts that are “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise,” and the AP is not merely performing ministerial or routine tasks, then there likely is an investment contract. Use of the Blogs does not create any attorney-client relationship between you and any individual KMK attorney or the firm. In applying the framework … Making or contributing to managerial level business decisions, such as how to deploy funds raised from sales of the digital asset. SEC, Framework for “Investment Contract” Analysis of Digital Assets … Rather, under the Howey test, “form [is] disregarded for substance and the emphasis [is] on economic reality.”  Howey, 328 U.S. at 298. It is not an exhaustive treatment of the legal and regulatory issues relevant to conducting an analysis of whether a product is a security, including an investment contract analysis with respect to digital assets generally. What is the document? The inquiry into whether a purchaser is relying on the efforts of others focuses on two key issues: Although no one of the following characteristics is necessarily determinative, the stronger their presence, the more likely it is that a purchaser of a digital asset is relying on the “efforts of others”: In evaluating whether a digital asset previously sold as a security should be reevaluated at the time of later offers or sales, there would be additional considerations as they relate to the “efforts of others,” including but not limited to: An evaluation of the digital asset should also consider whether there is a reasonable expectation of profits. 1992). For example, take the case of an online retailer with a fully-developed operating business. 1985). A partner in the firm’s Business Representation & Transaction ... As a partner in the firm’s Business Representation & Transactions Group, Allie Westfall’s insight and proven analytical skills help translate the complexities of the often-challenging securities laws. We encourage market participants to seek the advice of securities counsel and engage with the Staff through www.sec.gov/finhub. The information contained within another site that is linked to or from the Blog are beyond the control of the individual blogger or KMK and do not convey approval, support, or any relationship to any site or organization. [4] This framework is intended to be instructive and is based on the Staff’s experiences to date and relevant law and legal precedent. The opportunity may result from appreciation in the value of the digital asset that comes, at least in part, from the operation, promotion, improvement, or other positive developments in the network, particularly if there is a secondary trading market that enables digital asset holders to resell their digital assets and realize gains. The digital asset is offered broadly to potential purchasers as compared to being targeted to expected users of the goods or services or those who have a need for the functionality of the network. As part of a continuing effort to assist those seeking to comply with the U.S. federal securities laws, FinHub is publishing a framework for analyzing whether a digital asset is offered and sold as an … The ready transferability of the digital asset is a key selling feature. 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. [7]  This is true in the case of a corporation, for example, but also may be true for other types of enterprises regardless of their organizational structure or form. The discussion above identifies some of the factors market participants should consider in assessing whether a digital asset is offered or sold as an investment contract and, therefore, is a security. Business Representation & Transactions Group. The U.S. Supreme Court’s Howey case and subsequent case law have found that an “investment contract” exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others. The Strategic Hub for Innovation and Financial Technology ("Staff") of the Securities and Exchanges Commission ("SEC") recently released a Framework for 'Investment Contract' Analysis of Digital Assets ("Framework" or "Document") 1.These are essentially guidelines to assess whether an investment into a digital asset (which, per the document includes any asset … ), cert. A threshold issue is whether the digital asset is a “security” under those laws. Howey found that an “investment contract” exists where there is an investment of money in a common enterprise with a reasonable expectation that profits will be derived from others’ efforts. The AP is able to benefit from its efforts as a result of holding the same class of digital assets as those being distributed to the public. publishing a framework for analyzing whether a digital asset is offered and sold as an investment contract, and, therefore, is a security. As the Commission explained in The DAO Report, “[i]n determining whether an investment contract exists, the investment of ‘money’ need not take the form of cash” and “in spite of Howey‘s reference to an ‘investment of money,’ it is well established that cash is not the only form of contribution or investment that will create an investment contract.” The DAO Report at 11 (citation omitted). [17] See, e.g., Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce Fenner & Smith, 756 F.2d 230 (2d Cir. Restrictions on the transferability of the digital asset are consistent with the asset’s use and not facilitating a speculative market. If you are considering[1] an Initial Coin Offering, sometimes referred to as an “ICO,” or otherwise engaging in the offer, sale, or distribution of a digital asset,[2] you need to consider whether the U.S. federal securities laws apply. Also, no one factor is necessarily dispositive as to whether or not an investment contract exists. We address each of the elements of the Howey test below. Further, the lack of monetary consideration for digital assets, such as those distributed via a so-called “air drop,” does not mean that the investment of money prong is not satisfied; therefore, an airdrop may constitute a sale or distribution of securities. For example, purchasers may reasonably rely on an AP for liquidity, such as where the AP has arranged, or promised to arrange for, the trading of the digital asset on a secondary market or platform. There are essential tasks or responsibilities performed and expected to be performed by an AP, rather than an unaffiliated, dispersed community of network users (commonly known as a “decentralized” network). This means that it is possible to pay for goods or services with the digital asset without first having to convert it to another digital asset or real currency. The trading volume for the digital asset corresponds to the level of demand for the good or service for which it may be exchanged or redeemed. [10]  In evaluating digital assets, we have found that a “common enterprise” typically exists.[11]. SEC FinHub Publishes Framework for Investment Contract Analysis of Digital Assets 04.08.19 On April 3, 2019, the Strategic Hub for Innovation and Financial Technology (“FinHub”) released a framework for … 81207) (July 25, 2017) (“The DAO Report“); William Hinman, Digital Asset Transactions: When Howey Met Gary (Plastic), Remarks at the Yahoo Finance All Markets Summit: Crypto (June 14, 2018), available at https://www.sec.gov/news/speech/speech-hinman-061418. Potential purchasers have the ability to use the network and use (or have used) the digital asset for its intended functionality. Purchasers of the digital asset no longer reasonably expect that continued development efforts of an AP will be a key factor for determining the value of the digital asset. Making other managerial judgements or decisions that will directly or indirectly impact the success of the network or the value of the digital asset generally. 10530 (Aug. 14, 2018) (issuance of tokens under a so-called “bounty program” constituted an offer and sale of securities because the issuer provided tokens to investors in exchange for services designed to advance the issuer’s economic interests and foster a trading market for its securities). In a so-called “airdrop,” a digital asset is distributed to holders of another digital asset, typically to promote its circulation. On April 3, 2019, the SEC released Staff Guidance titled “Framework for ‘Investment Contract’ Analysis of Digital Assets,” which applies the factors set forth in SEC v. W.J. We expect that analysis concerning digital assets as securities may evolve over time as the digital asset market matures. In these instances, purchasers would reasonably expect the AP to undertake efforts to promote its own interests and enhance the value of the network or digital asset. Whether a particular digital asset at the time of its offer or sale satisfies the Howey test depends on the specific facts and circumstances. In this guidance, we provide a framework for analyzing whether a digital asset has the characteristics of one particular type of security – an “investment contract.”4Both the Commission and the federal courts frequently use the “investment contract” analysis to determine whether unique or novel instruments or arrangements, such as digital assets… An AP is responsible for the development, improvement (or enhancement), operation, or promotion of the network. The digital asset is available in increments that correlate with a consumptive intent versus an investment or speculative purpose. [10] In order to satisfy the “common enterprise” aspect of the Howey test, federal courts require that there be either “horizontal commonality” or “vertical commonality.”  See Revak v. SEC Realty Corp., 18 F.3d. No. The focus of his practice is corporate, securities, and financing law, where he has extensive experience in mergers, acquisitions and ... Mark Reuter advocates for business clients in transactions, proceedings and conflicts regulated by federal and state securities laws and stock exchange rules. The Securities and Exchange Commission (SEC) has published a statement on the “Framework for ‘Investment Contract’ Analysis of Digital Assets” The public statement announcing the … The promise (implied or explicit) to build a business or operation as opposed to delivering currently available goods or services for use on an existing network. The Framework emphasizes that it is only a guideline for analyzing whether the digital asset represents an investment contract, and that no single factor is determinative. [16] We recognize that holders of digital assets may put forth some effort in the operations of the network, but those efforts do not negate the fact that the holders of digital assets are relying on the efforts of the AP. Whether the network on which the digital asset is to function operates in such a manner that purchasers would no longer reasonably expect an AP to carry out essential managerial or entrepreneurial efforts. The Framework only briefly addresses the “investment of money” element, indicating that offering and sale of digital assets are typically satisfied because the asset is exchanged for value … No AP has access to material, non-public information or could otherwise be deemed to hold material inside information about the digital asset. [12] Howey, 328 U.S. at 298. Last week, the US Securities and Exchange Commission (SEC) through its strategic hub for financial innovation, FinHub, published a framework for analyzing whether a digital asset will be treated as a security under the oft cited Howey test. The digital asset is offered and purchased in quantities indicative of investment intent instead of quantities indicative of a user of the network. In this guidance, we provide a framework for analyzing whether a digital asset is an investment contract and whether offers and sales of a digital asset … To the extent these facts are present, the compensated individuals can be expected to take steps to build the value of the digital asset. 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. See TSC Industries v. Northway, 426 U.S. 438, 449 (1976) (a fact is material “if there is a substantial likelihood that a reasonable shareholder would consider it important” in making an investment decision or if it “would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available” to the shareholder). [21] See Forman, 421 U.S. at 852-53 (where a purchaser is not “‘attracted solely by the prospects of a return’ on his investment . When a promoter, sponsor, or other third party (or affiliated group of third parties) (each, an “Active Participant” or “AP”) 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. It is not a rule, regulation, or statement of the Commission, and the Commission has neither approved nor disapproved its content. If it is characterized as a virtual currency, the digital asset actually operates as a store of value that can be saved, retrieved, and exchanged for something of value at a later time. Purchasers would reasonably expect the AP to undertake efforts to promote its own interests and enhance the value of the network or digital asset, such as where: The AP has the ability to realize capital appreciation from the value of the digital asset. Any economic benefit that may be derived from appreciation in the value of the digital asset is incidental to obtaining the right to use it for its intended functionality. The value of the digital asset has shown a direct and stable correlation to the value of the good or service for which it may be exchanged or redeemed. This also can be the case where the digital asset gives the holder rights to dividends or distributions. The Framework states that an investment in a digital asset would usually constitute an investment in a common enterprise because “ the fortunes of digital asset purchasers have been … Usually, the main issue in analyzing a digital asset under the Howey test is whether a purchaser has a reasonable expectation of profits (or other financial returns) derived from the efforts of others. On April 3, 2019, the SEC attempted to provide clarity by releasing a “Framework for ‘Investment Contract’ Analysis of Digital Assets,” 2× 2. Howey found that an “investment contract” exists where there is an investment of money in a common enterprise with a reasonable expectation that profits will be derived from others’ efforts. When It Comes to Analyzing Utility Tokens, the SEC Staff’s “Framework for ‘Investment Contract’ Analysis of Digital Assets” May Be the Emperor Without Clothes (Or, Sometimes an Orange Is Just an Orange) … See discussion of “Other Relevant Considerations.”. A digital asset should be analyzed to determine whether it has the characteristics of any product that meets the definition of “security” under the federal securities laws. Prospects for appreciation in the value of the digital asset are limited. With respect to a digital asset referred to as a virtual currency, it can immediately be used to make payments in a wide variety of contexts, or acts as a substitute for real (or fiat) currency. The Blogs do not constitute legal advice and are not a substitute for legal advice from a licensed attorney in your state. This particularly would be the case where an AP promises further developmental efforts in order for the digital asset to attain or grow in value. [6]  The focus of the Howey analysis is not only on the form and terms of the instrument itself (in this case, the digital asset) but also on the circumstances surrounding the digital asset and the manner in which it is offered, sold, or resold (which includes secondary market sales). The AP owns or controls ownership of intellectual property rights of the network or digital asset, directly or indirectly. An AP has a continuing managerial role in making decisions about or exercising judgment concerning the network or the characteristics or rights the digital asset represents including, for example: Determining whether and how to compensate persons providing services to the network or to the entity or entities charged with oversight of the network. On April 3, 2019, the Strategic Hub for Innovation and Financial Technology – known as “FinHub” – of the U.S. Securities and Exchange Commission (the “SEC”) published a “Framework for ‘Investment Contract’ Analysis of Digital Assets” (the “Guideline”) to provide additional guidance to market participants in determining whether a “digital asset… 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. The potential profitability of the operations of the network, or the potential appreciation in the value of the digital asset, is emphasized in marketing or other promotional materials. The framework is not intended to be an exhaustive overview of … . 1994) (discussing horizontal commonality as “the tying of each individual investor’s fortunes to the fortunes of the other investors by the pooling of assets, usually combined with the pro-rata distribution of profits” and two variants of vertical commonality, which focus “on the relationship between the promoter and the body of investors”). Among the information that must be disclosed is information relating to the essential managerial efforts that affect the success of the enterprise. Determining whether and where the digital asset will trade. The availability of a market for the trading of the digital asset, particularly where the AP implicitly or explicitly promises to create or otherwise support a trading market for the digital asset. [1] This framework represents the views of the Strategic Hub for Innovation and Financial Technology (“FinHub,” the “Staff,” or “we”) of the Securities and Exchange Commission (the “Commission”). Howey Co., 328 U.S. 293 (1946), to determine whether a digital asset … 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. Under these facts, the digital asset would not be an investment contract. Determining who will receive additional digital assets and under what conditions. The new framework provides an in-depth description of how the SEC uses a measure called the Howey Test to determine whether a given asset qualifies as a type of security called an … There is little apparent correlation between the purchase/offering price of the digital asset and the market price of the particular goods or services that can be acquired in exchange for the digital asset. This requirement for disclosure furthers the federal securities laws’ goal of providing investors with the information necessary to make informed investment decisions. [but] is motivated by a desire to use or consume the item purchased  . There is little apparent correlation between quantities the digital asset typically trades in (or the amounts that purchasers typically purchase) and the amount of the underlying goods or services a typical consumer would purchase for use or consumption. Holders of the digital asset are immediately able to use it for its intended functionality on the network, particularly where there are built-in incentives to encourage such use. 81, 87-88 (2d Cir. Although no one of the following characteristics of use or consumption is necessarily determinative, the stronger their presence, the less likely the Howey test is met: Digital assets with these types of use or consumption characteristics are less likely to be investment contracts. © Copyright 2021, The Trustees of Columbia University in the City of New York. The Framework provides additional and more detailed guidance than has otherwise been made public for analyzing whether a digital asset is offered and sold as an investment contract under the so-called Howey test, and it reiterates and enhances the previous guidance given in a June 2018 speech on this topic by SEC Director of Corporation Finance … [6] Whether a contract, scheme, or transaction is an investment contract is a matter of federal, not state, law and does not turn on whether there is a formal contract between parties. In particular, an AP plays a lead or central role in deciding governance issues, code updates, or how third parties participate in the validation of transactions that occur with respect to the digital asset. Framework for “Investment Contract” Analysis of Digital Assets. . Purchasers reasonably would expect that an AP’s efforts will result in capital appreciation of the digital asset and therefore be able to earn a return on their purchase. The registration provisions require persons to disclose certain information to investors, and that information must be complete and not materially misleading. [18]  Price appreciation resulting solely from external market forces (such as general inflationary trends or the economy) impacting the supply and demand for an underlying asset generally is not considered “profit” under the Howey test. Allie’s counsel ... Chris Brinkman practices in the firm's Business Representation & Transactions Group with a concentration in venture capital/private equity, start-ups & growth companies, securities, and mergers and acquisitions. With respect to a digital asset that represents rights to a good or service, it currently can be redeemed within a developed network or platform to acquire or otherwise use those goods or services. [7] Issuers of digital assets, like all issuers, must provide full and fair disclosure of material information consistent with the requirements of the federal securities laws. See SEC v. Int’l Loan Network, Inc., 968 F.2d 1304, 1307 (D.C. Cir. Profits can be, among other things, capital appreciation resulting from the development of the initial investment or business enterprise or a participation in earnings resulting from the use of purchasers’ funds. Third, the SEC considers other relevant considerations, including whether the digital asset is fully developed and operational and whether there would be an appreciation in value incidental to the asset obtaining its intended functionality. The second piece of guidance came in the form of a “Framework for ‘Investment Contract’ Analysis of Digital Assets” that is intended to serve as “an analytical tool to help market participants … Statement on “Framework for ‘Investment Contract’ Analysis of Digital Assets” Framework for “Investment Contract” Analysis of Digital Assets Turnkey Jet No-Action Letter SEC staff advises on … [5] SEC v. W.J. [19] Situations where the digital asset is exchangeable or redeemable solely for goods or services within the network or on a platform, and may not otherwise be transferred or sold, may more likely be a payment for a good or service in which the purchaser is motivated to use or consume the digital asset. [15] In this guidance, we are using the term “network” broadly to encompass the various elements that comprise a digital asset’s network, enterprise, platform, or application. For example, the design of the digital asset provides that its value will remain constant or even degrade over time, and, therefore, a reasonable purchaser would not be expected to hold the digital asset for extended periods as an investment. The first prong of the Howey test is typically satisfied in an offer and sale of a digital asset because the digital asset is purchased or otherwise acquired in exchange for value, whether in the form of real (or fiat) currency, another digital asset, or other type of consideration. Whether any economic benefit that may be derived from appreciation in the value of the digital asset is incidental to obtaining the right to use it for its intended functionality. Therefore, issuers and other persons and entities engaged in the marketing, offer, sale, resale, or distribution of any digital asset will need to analyze the relevant transactions to determine if the federal securities laws apply. 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