The SEC’s Division of Corporation Finance issued both its "Framework for 'Investment Contract' Analysis of Digital Assets" and a no-action letter relating to a blockchain-based consumptive token on April 3, 2019. While the Division’s guidance breaks little new ground, it does provide some additional insights into the staff’s views on token mutability and signals a willingness to engage on questions relating to consumptive/utility tokens.
The Framework is intended to be a “plain English” description of how the SEC staff applies the so-called Howey test to determine if a digital asset is a security, specifically, an investment contract, under the federal securities laws. According to the Division, a digital asset is an investment contract under the Howey test if it involves “the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.” The Division notes that the sale of a digital asset typically involves the investment of money – fiat currency or another digital asset – in a common enterprise. “[T]he 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.”
The Framework lists a number of characteristics whose presence tends to indicate that the purchaser of a digital assets is relying on the “efforts of others.” No single characteristic is necessarily determinative of reliance on the efforts of others, however. Those characteristics include the following, among others: a third party is responsible for the development, improvement, operation or promotion of the network; third party support of a market for, or price of, the digital asset by, for example limiting supply or otherwise creating scarcity of the asset; a third party has a continuing managerial role in the ongoing development of the network or the digital asset; and purchasers would expect the third party to promote its own interests by, for example, retaining interests in the digital assets.
Similarly, the Framework lists a number of characteristics whose presence tends to indicate that the purchaser of a digital asset has a reasonable expectation of profit. No single characteristic is necessarily determinative of a reasonable expectation of profit, however. Those characteristics include the following, among others: the digital asset gives the holder rights to the enterprises income or profits, or to realize gain from the asset’s capital appreciation; the digital asset is traded on a secondary market; the digital asset is offered broadly to potential purchasers, rather than targeted to expected users of the network; little apparent correlation exists between the purchase/offering price of the digital asset and the market price of the particular goods/services that can be acquired in exchange for the digital asset; little apparent correlation exists between quantities the digital asset trades in and the amount of the underlying goods/services a typical consumer would purchase; the third party raises funds in excess of what may be needed to establish a functional network; and the digital asset is marketed as an investment and the transferability of the digital asset is a key selling feature.
The Framework also addresses the concept of “mutability” (although it is not referred to as such) whereby a digital asset previously sold as a security may later be offered and sold as an asset that is not a security. The Division states that in considering whether a digital asset previously sold as a security should be reevaluated at the time of later offers or sales, the issuer would have additional considerations as they relate to the “efforts of others” and a “reasonable expectation of profit.” Those considerations would include, among others, whether the relevant third party’s efforts continue to be important to the enterprise’s success and to the value of an investment in the digital asset; the value of the digital asset has shown a direct and stable correlation to the value of the goods and services that may be acquired; the digital asset can be used for its intended functionality; and third parties do not have access to material, non-public information about the digital asset. The Framework thus suggests that once a platform is fully developed, a digital asset can be used to purchase goods and services, and if the value of the digital asset is directly correlated to the value of the goods and services acquired, a digital asset previously sold as a security could be sold as a non-security for consumptive purposes.
Consistent with prior statements and positions, the Division notes that the Howey test is likely not met, i.e., the digital asset would not be a security, if the platform is fully operational when the digital asset is sold (and likewise fully operational); the digital assets can be used immediately for their intended function; the digital asset is designed and implemented to meet the needs of its users; and the digital asset is unlikely to appreciate in value. Conversely, the digital asset is more likely to be considered a security if offered or sold before the platform is fully operational, particularly if the proceeds of the offering or sale are intended to be used to complete the platform.
The TurnKey Jet, Inc. No-Action Letter
On the same date that it issued the Framework, the Division issued the TurnKey Jet, Inc. no-action letter permitting TurnKey Jet, Inc. (“TKJ”), an airplane charter company, to issue a pre-paid token that would permit token holders to purchase air charter services from TKJ and other charter services with the token without registering the token under either Securities Act of 1933 or the Securities Exchange Act of 1934. In granting TKJ relief, the Division noted that funds from token sales would not be used to develop the token platform; the tokens would be usable immediately to purchase air charter services; the tokens would be held only in TKJ wallets; the tokens would be sold at a price of one dollar per token; any token repurchases would be at a discount to the face value of the token; and the token would be marketed to emphasize its functionality, not the potential for increase in value. The Division’s letter thus permits TKJ to issue a consumptive/utility token.
While the TKJ letter is a welcome step forward, neither it nor the framework addresses whether and under what circumstances a consumptive/utility token sold for use on a functional platform could be traded on a secondary market, including a market on which the token issuer actively sought listing. Although the Framework in particular suggests issuing a token and promising secondary market trading of that token pushes the token toward classification as a security under the Howey test, some issuers anticipate that they will (1) issue tokens to miners as compensation for their support of the issuer’s platform, and those miners may want to sell all or some portion of those tokens to users of the relevant platform; and (2) allow the secondary market to set the price of the goods or services offered on their platforms. To assist in the continued development of utility token ecosystems, the staff of the Division, as well as other SEC staff, should provide guidance on if, and subject to what criteria, secondary market trading of utility tokens would be permissible.
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