June 19, 2018
by Larry E. Bergmann

William Hinman, the Director of the Division of Corporation Finance at the Securities and Exchange Commission, gave a significant speech on June 14 on the subject of determining whether digital assets are securities.[1]

Among other things, he referred in his remarks to the Simple Agreement for Future Tokens, or SAFT.[2]  While declining to debate the SAFT “hypothetical structure,” Hinman stated that, in the context of the discussion in his speech, “it is clear I believe a token once offered in a security offering can, depending on the circumstances, later be offered in a non-securities transaction.”[3] This appears to contemplate token offerings in two phases: first, a token is sold as an investment to raise capital to build a network, where purchasers have “the expectation that the promoters will build their system and investors can earn a return on the instrument – usually by selling their tokens in the secondary market once the promoters create something of value with the proceeds and the value of the digital enterprise increases;” and second, distribution and sale of tokens after the network become “fully functional” and “sufficiently decentralized” (often called “utility tokens”).  Depending on the facts and circumstances, the first phase would be an offering of an investment contract, i.e., a security, but the second phase would not.

Hinman noted one way to reduce the analytical burden:

I believe some industry participants are beginning to realize that, in some circumstances, it might be easier to start a blockchain-based enterprise in a more conventional way.  In other words, conduct the initial funding through a registered or exempt equity or debt offering and, once the network is up and running, distribute or offer blockchain-based tokens or coins to participants who need the functionality the network and the digital assets offer.

That is the process discussed in my recent article, “Updating SAFT: Breaking the Security/Utility Token Conundrum.”[4]  For startups that can afford the costs of conducting a private placement or a Regulation A offering, this type of two-phase process can help reduce the legal uncertainty about the application of the securities laws.  The initial, capital-raising phase, would involve the offer and sale of securities (whether debt, equity, or investment contracts).[5]  When the network, or platform, became fully functional, utility tokens would be distributed to the securities holders, the securities would be extinguished (through a redemption), and thereafter only utility tokens would be extant and sold in the second phase.  This type of process would have benefits for network developers and the SEC, because it would avoid the need to analyze whether the initial phase was a security offering.

If the same token is sold in both phases, however, the problem is how to distinguish the security token from the utility token.  Hinman offers illustrative lists of considerations in making this determination.[6]

Hinman noted that an inquiry into how the asset was being sold and the reasonable expectations of purchasers was central to the analysis in all phases of token offerings.  While he could not be expected to provide guidance on all aspects of digital asset offerings in one speech, he touched upon some facts and circumstances that require further consideration.  For example:

1.            His suggestion that, in a “sufficiently decentralized” network, “purchasers [of tokens] would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts.”  Does this imply that, in order to avoid “security” characterization of the tokens, even when a network is fully functional and decentralized, no one may be expected to take action to improve the network functionality?[7]  Presumably, a company with an established platform could sell utility tokens, earn a profit on the sale of those tokens, and use the profits to improve the platform.[8]  Indeed, platform users may expect that such improvements will be made.

2.            Does the existence of a secondary (trading) market for utility tokens undermine their non-security status?  Does that fact that the tokens may increase in value[9] and some holders may seek to realize that increase in value by selling their tokens necessarily imply that such persons view the tokens as an investment vehicle?[10]  The simple fact that a product such as a utility token might have secondary market value, and that some purchasers may not acquire it solely to use the product should not, in itself, imply that the product is an investment contract.[11] 

Director Hinman’s comment that, in these “exciting legal times,” the SEC staff “stands prepared to provide more formal interpretive or no-action guidance about the proper characterization of a digital asset in a proposed use”[12] demonstrates a welcome commitment to “help promoters of this new technology and their counsel to navigate and comply with the federal securities laws.”

 

[1] W. Hinman, “Digital asset transactions: when Howey met Gary (Plastic),” https://www.sec.gov/news/speech/speech-hinman-061418 (“Hinman”).

[2] Id. n.15.

[3] Id.

[5] No tokens would be issued in this phase; the security would represent a right to acquire tokens when they are first issued.

[6] Hinman refers to examples of an asset (like orange groves, exempt certificates of deposit, and whisky warehouse receipts) that “all by itself is not a security,” but the marketing (or packaging) of the asset can make it a security.  See Hinman, text at footnotes 8, 14.  Hinman suggests that the purchaser’s motivation for purchasing the asset may be relevant to its status as a security. Id. Item 3 in his list of non-exclusive legal analysis factors.  (“Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment?  Have purchasers made representations as to their consumptive, as opposed to their investment, intent?”)  Although a reasonable expectation of profit is an element of the Howey analysis, if a promoter has taken no steps to raise investment expectations in marketing or packaging its product, a person’s personal motivation for making a purchase, whether reasonable or not, may be unknowable to the seller and should be irrelevant.

[7] Hinman suggests that an indicator of a security could arise where 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?” Hinman, Item 3 of his illustrative list of facts and circumstances in a security analysis.

[8] Hinman poses a question in this regard as relevant to the “security” analysis: “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?” Id.  But see SEC, “Guidelines as to the applicability of the Federal securities laws to offers and sales of condominiums or units in a real estate development,” Securities Act Release No. 5347 (January 4, 1973) at 4 (“[A] continuing affiliation between the developers or promoters of a [housing] project and the project by reason of maintenance arrangements does not make the unit a security.”)

[9] The value of tokens can be affected by the entrepreneurial efforts of developers (in all phases), and by the participation of increasing numbers of users of the network.  In his remarks, Hinman referred to “essential managerial or entrepreneurial efforts” as indicative of the presence of a security. In some cases, however, entrepreneurial efforts may enhance the network, but would not be “essential” to its continuing operation.

10] Hinman remarks that purchasers in the capital-raising phase may sell their tokens to realize a return: “Funds are raised with the expectation that the promoters will build their system and investors can earn a return on the instrument – usually by selling their tokens in the secondary market once the promoters create something of value with the proceeds and the value of the digital enterprise increases.”

[11] Numerous examples of non-security products with secondary markets include sneakers, dolls, and baseball cards.

[12] Hinman, text at footnote 15 (citing the SAFT structure as an example).