Ii Application Of Howey To Digital Assets
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 are securities transactions. As noted above, under the Howey test, 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. Whether a particular digital asset at the time of its offer or sale satisfies the Howey test depends on the specific facts and circumstances. We address each of the elements of the Howey test below.
Framework For Investment Contract Analysis Of Digital Assets
LL.M. Columbia University School of Law and Lawyer Universidad de Nacional de Córdoba.
On July 25, 2017 the Securities and Exchange Commission of the United States issued an investigative report %20separado%20Eng.doc#_ftn1″ rel=”nofollow”> ) asserting that digital assets issued in the context of an initial coin offering , using blockchain technology, may be securities and therefore subject to the agencys jurisdiction.
Although most ICOs are conducted using blockchain technology, there are other digital assets not using such technology .
The legal framework applicable to ICOs based on blockchain technology should be also pertinent to such other ICOs as well.
As per the DAO Report, a digital asset would be deemed a security if it were an investment contract as per the Howey test.
The Howey test is a test created by the Supreme Court of the United States for determining whether certain transactions qualify as “investment contracts.”
If so, then, those transactions are considered securities and therefore subject to certain disclosure and registration requirements.
A transaction meets the Howey test if it is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others
On the same day the SEC issued the DAO Report, it also released an investor bulletin detailing its position on ICOs, following the criterion set forth in the DAO Report.
A) The Investment of Money
The Guideline In Action: Turnkey’s Sec No
When an entity or individual is unsure whether a certain actionmay violate U.S. federal securities law, a “no-action”letter may be requested from the relevant regulating division ofthe SEC.
On April 2, 2019, TurnKey Jet, Inc., which provides interstateair charter services as a licensed U.S. air carrier and air taxioperator, submitted a request for a no-action letter to the Division ofCorporation Finance of the SEC 2 . TurnKey proposed to offer andsell its digital assets through a private blockchain network.TurnKey proposed to sell its digital assets at a price of U.S.$1.00per digital asset throughout the life of its digital asset program.Purchasers of TurnKey’s digital assets could redeem the digitalassets for air charter services. TurnKey would require purchasersto sign an agreement in which purchasers represented, warranted andacknowledged, among other things, that they are not acquiring thedigital assets as an investment and they have no expectation ofeconomic benefit or profit from the digital assets.
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Sec Issues Framework For Investment Contract Analysis Of Digital Assets
On April 3, 2019, the Strategic Hub for Innovation and Financial Technology known as FinHub of the U.S. Securities and Exchange Commission published a Framework for Investment Contract Analysis of Digital Assets to provide additional guidance to market participants in determining whether a digital asset meets the definition of an investment contract, and thus, is a security under U.S. federal securities laws. A digital asset is defined in the Guideline as an asset that is issued and transferred using distributed ledger or blockchain technology, including, but not limited to, so-called virtual currencies, coins and tokens.
The Guideline is not a rule, regulation or statement of the SEC, nor is it an exhaustive treatment of the legal and regulatory issues relevant to conducting an analysis of whether a digital asset is an investment contract, and thus, a security under U.S. federal securities laws. FinHub expects that the analysis concerning digital assets as securities in the U.S. may evolve over time as the digital asset market matures.
The Guideline builds upon SEC Director William Hinman`s widely followed speech on token offerings at the Yahoo Financial Summit in June, 2018 and provides a framework for analyzing whether a digital asset has the characteristics of an investment contract in the U.S. and focuses on the third and fourth elements of the Howey test.
Sec Finhubs Digital Asset Framework: A Guide For Issuers And Secondary Trading Markets
On April 3, the U.S. Securities and Exchange Commission s Strategic Hub for Innovation and Financial Technology released its much-anticipated guidance, the Framework for Investment Contract Analysis of Digital Assets , regarding its views on factors to consider in applying the Howey test to digital assets. In conjunction with the Framework, the SECs Division of Corporation Finance published its first no-action letter in connection with the sale of digital assets, providing relief to TurnKey Jet, Inc., for its proposed token sale.
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Sec Provides Analytical Tools For Assessing Digital Assets
Agencies often struggle to capture emerging technologies in dusty regulatory frameworks14×14.See, e.g., Andy Pasztor & Robert Wall, Drone Regulators Struggle to Keep Up with the Rapidly Growing Technology, Wall St. J. , Gary Stern, Can Regulators Keep Up with Fintech?, Yale Insights , . and the SEC is no different as it attempts to capture ICOs in the Securities Act and the Exchange Act.15×15. Hester M. Peirce, Commr, SEC, Regulation: A View from Inside the Machine, Remarks at Protecting the Public While Fostering Innovation and Entrepreneurship: First Principles of Optimal Regulation , . These statutes define a security as a commonly traded financial instrument, such as a note, stock, or bond.16×16. 15 U.S.C. §§ 77b, 78c. The definition also broadly includes more variable financial instruments, for instance an investment contract.17×17.Id.
Statement On Framework For Investment Contract’analysis Of Digital Assets
Bill Hinman, Director of Division of Corporation FinanceValerie Szczepanik, Senior Advisor for Digital Assets and Innovation
Blockchain and distributed ledger technology can catalyze a wide range of innovation. We have seen these technologies used to create financial instruments, sometimes in the form of tokens or coins that can provide investment opportunities like those offered through more traditional forms of securities. Depending on the nature of the digital asset, including what rights it purports to convey and how it is offered and sold, it may fall within the definition of a security under the U.S. federal securities laws.
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 investment contract, and, therefore, is a security. The framework is not intended to be an exhaustive overview of the law, but rather, an analytical tool to help market participants assess whether the federal securities laws apply to the offer, sale, or resale of a particular digital asset. Also, the Division of Corporation Finance is issuing a response to a no-action request, indicating that the Division will not recommend enforcement action to the Commission if the digital asset described in the request is offered or sold without registration under the U.S. federal securities laws.
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The Fourth Element: Reliance On The Efforts Of Others
The Guideline also sets out a list of non-exhaustivecharacteristics relevant in an analysis of whether the fourthelement of the “Howey test” a relianceof the efforts of others is satisfied. Although thepresence of any one characteristic is not necessarilydeterminative, the stronger the presence of these characteristics,the more likely it is that a purchaser of a digital asset isrelying on the “efforts of others”. These characteristicsinclude:
- the AP is responsible for developing,improving, operating or promoting the network, particularly ifpurchasers of the digital asset expect the AP to perform or overseetasks that are necessary for the network or digital asset toachieve or retain its intended purpose or functionality
- there are essential tasks orresponsibilities performed or expected to be performed by the AP,rather than by an unaffiliated, dispersed community of networkusers
- the AP has a lead or central role inthe direction of the ongoing development of the network or thedigital asset, particularly in deciding governance issues, codeupdates or how third parties participate in the validation oftransactions that occur with respect to the digital asset and
- the AP has a continuing managerialrole in decision-making concerning the network or thecharacteristics or the rights of the digital asset.
Reasonable Expectation Of Profits Derived From Efforts Of Others
Usually, the main issue in analyzing a digital asset under the Howey test is whether a purchaser has a reasonable expectation of profits derived from the efforts of others. A purchaser may expect to realize a return through participating in distributions or through other methods of realizing appreciation on the asset, such as selling at a gain in a secondary market. When a promoter, sponsor, or other third party 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 inquiry, therefore, is an objective one, focused on the transaction itself and the manner in which the digital asset is offered and sold.
The following characteristics are especially relevant in an analysis of whether the third prong of the Howey test is satisfied.
1. Reliance on the Efforts of Others
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:
2. Reasonable Expectation of Profits
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Reasonable Expectation Of Profits
In examining whether a purchaser would have a reasonable expectation of profits, including capital appreciation resulting from the development of the initial investment or business enterprise, or a participation in earnings resulting from the use of purchaserâs funds, the Framework sets out several characteristics, the relevant characteristics include:
Price appreciation resulting solely from external market forces impacting the supply and demand for an underlying asset generally is not considered “profit” under the Howey test.
In evaluating whether a digital asset previously sold as a security should be reevaluated at the time of later offers or sales, the Framework sets forth additional considerations as they relate to the “reasonable expectation of profits,” including whether or not the value of the digital assets continues to be dependent on the continuing development efforts of an AP and whether the value and trading volume of digital assets correlate to the value of and level of demand for, respectively, the goods and services for which they may be exchanged for or redeemed.
Sec Publishes Framework For Investment Contract Analysis Of Digital Assets And Issues First No
On April 3, 2019, the SECs Strategic Hub for Innovation and Financial Technology published a framework for analyzing whether a digital asset is offered and sold as an investment contract and, therefore, is a security . At the same time, the Division of Corporation Finance issued a no-action response to an aviation company in connection with its proposed offer and sale of blockchain-based digital assets in the form of tokenized jet cards without registration under the U.S. federal securities laws . The Framework and the TKJ Letter provide the latest guidance to market participants to help them assess whether a particular digital asset is a security and, therefore, its offer and sale must be registered under the federal securities laws or qualify for an exemption. Taken together, they confirm that the not a security path for most digital assets will be a very steep one.
The SEC has applied the investment contract analysis outlined in the U.S. Supreme Courts Howey case to analyze whether a digital asset an asset that is issued and transferred using distributed ledger or blockchain technology, including, but not limited to, so-called virtual currencies, coins and tokens is a security. Under the Howey test, 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.
Reliance on the Efforts of Others
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Reliance On The Efforts Of Others
Whether a purchaser is relying on the efforts of others hinges on two key issues:
- Does the purchaser reasonably expect to rely on the efforts of an AP?
- Are those efforts “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise,” as opposed to efforts that are more ministerial in nature?
Although not necessarily determinative, the Framework sets out a list of factors that make it more likely that a purchaser of a digital asset is relying on the “efforts of others.” These factors center around the AP playing a lead or central role in:
- building out the network4 or the digital asset or its continuing development
- creating or supporting the market for, or the, price of, the digital asset and
- continuously managing the network or the rights of the digital assets, including, but not limited to:
- determining compensation of persons providing direct or indirect services to the network
- making or contributing to decisions on how to deploy funds raised from the sales of digital assets and
- making managerial judgements having a direct or indirect impact on the success of the network or the value of the digital asset.
The 2019 Sec Token Framework Does Not Extend The Statute Of Limitation For Token Class Action Lawsuit Under Recent Sdny Ruling
In 2020, plaintiffs filed a series of class action lawsuits alleging that a number of digital tokens were actually securities and, thus, were illegally issued or traded on exchanges. Accusing a number of issuers and exchanges of violating federal securities laws and state blue sky laws the plaintiffs sought damages in the billions of dollars. Because the tokens were acquired a considerable time before the lawsuits were filed, defendants challenged the timeliness of the securities law claims. Plaintiffs argued that although the lawsuits would have normally been time barred under the statute of limitation that an exemption should be made under something called the discovery rule which can extend the limitations period for newly discovered information. The Plaintiffs contended that the SECs Framework for Investment Contract Analysis of Digital Assets published on April 3, 2019, which states that the SEC views most digital tokens as securities, should be considered newly discovered information. Alternatively, plaintiffs contended, the defendants fraudulently concealed the claims, thus the limitations period did not begin to run until the fraud was revealed.
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Application Of Howey To Digital Assets
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 are securities transactions. As noted above, under the Howey test, 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. Whether a particular digital asset at the time of its offer or sale satisfies the Howey test depends on the specific facts and circumstances. We address each of the elements of the Howey test below.
Why Is It Important
The Document is important because several initial coin offerings have been asked by the SEC tocomply with US securities laws and fulfil the compliancesthereunder, with little clarity on which features imbue tokens withcharacteristics of securities.
That being said, the Document is only instructive and is not aset of rules, regulations or a statement of the SEC and the SECneither approves nor disapproves of it content3.
The Framework fleshes out the three ingredients of the HoweyTest individually. This test was formulated by the US Supreme Courtin SEC v. W.J. Howey Co. 4 in1946. The Howey Test is used to determine whether a contract,scheme or transaction is an ‘investment contract’ underAmerican securities’ laws5. This post crystallises theconsiderations the Staff deems important within each individualingredient of Howey.
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The Guideline In Action: Turnkeys Sec No
When an entity orindividual is unsure whether a certain action may violate federal securitieslaw, a no-action letter may be requested from the relevant regulatingdivision of the SEC.
On April 2, 2019, TurnKey Jet, Inc. , which provides interstate air charter services as a licensed U.S. air carrier and air taxi operator, submitted a request for a no-action letter to the SECs Division of Corporation Finance of the SEC. TurnKey proposed to offer and sell its digital assets through a private blockchain network. TurnKey proposed to sell its digital assets at a price of U.S. $1.00 per digital asset throughout the life of its digital asset program. Purchasers of TurnKeys digital assets could redeem the digital assets for air charter services. TurnKey would require purchasers to sign an agreement in which purchasers represented, warranted and acknowledged, among other things, that they are not acquiring the digital assets as an investment and they have no expectation of economic benefit or profit from the digital assets.
In reaching thisposition, the Division noted, among other things, that: