In Plain English: SEC Publishes Guidance on Tokens as Securities
The U.S. Securities and Exchange Commission (SEC) has published an investment contract framework for digital assets, which is intended to give crypto companies guidance as to whether a cryptocurrency is a security. It’s the first major culminating work of the SEC’s FinHub initiative, a strategic group the commission launched in October 2018 to liaise with fintech and cryptocurrency companies and work toward more substantial regulatory guidance.
This concrete framework comes after years of guidance by enforcement, wherein the SEC prosecuted ICO operators and token companies after their token sales to make examples of the more egregious and unscrupulous opportunists who took advantage of the 2016-2017 bull run.
With the new 13-page framework, cryptocurrency companies will now have a clear touchstone for testing whether or not the SEC would qualify an asset that they offer as a security. But, like SEC enforcement that has targeted ICO orchestrators and broker/dealers in the past, the guidance is not confined to token projects alone — it’s also applicable to crypto exchanges, custody organizations, hedge funds, marketing firms and “other professional services.”
“As financial technologies, methods of capital formation, and market structures continue to evolve, market participants should be aware that they may be conducting activities that fall within our jurisdiction,” according to an SEC press release on the new report. “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.”
The Thick of It
So when will a cryptocurrency offering be considered a security?
The document kicks off with reference to the Howey Test, a litmus test for what defines an investment contract that was established by a 1946 Supreme Court decision. Notably, the test looks not only at the asset being offered or sold but how it is offered or sold. This implies most saliently to ICOs, as the SEC has been keen to remind investors and entrepreneurs for years now, including its insistence that simply calling something a “utility token” doesn’t exculpate it from a security status.
“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,” according to the guidance. “Whether a particular digital asset at the time of its offer or sale satisfies the Howey test depends on the specific facts and circumstances.”
The document then goes on to identify the three primary conditions that constitute an investment contract, namely: that money/value is invested (whether as fiat or crypto), that a “common enterprise” is present (i.e., that some central entity offers the contract and shares a common interest with its purchasers) and that there’s an expectation of profit or return.
As the first two are pretty cut and dry (and the document states that, in its experience, the SEC believes most token sales satisfy these two criteria), the framework unpacks the specific conditions and nuances of the third point pretty thoroughly.
Basically, the document states that a token or sale is at risk of being deemed a security if its purchasers rely on the efforts of an “active participant” (i.e., a centralized entity) and if there is a “reasonable expectation of profit.” In essence, if a manager, company or some centralized entity directs the development of a cryptocurrency and is primarily responsible for its success, then it’s a security. By extension, if token holders expect the active participant to accelerate price through its managerial efforts — and if the active participant makes a promise of ownership in the project/prospect of gain and, to put it bluntly, shills the project to stimulate price appreciation — then it’s a security.
To the SEC, token price appreciation does not equate profit under the Howey Test, because price appreciation for a speculative asset comes from market forces instead of actual company operations and revenue flow.
With all of this in mind, the document confirmed what the SEC has already said when it cleared Bitcoin and Ethereum from securities status. Essentially, if a project is sufficiently decentralized, has a clear working product and the value of its token is tied to utility and not expectation of profit, then it’s not a security.