denied, 414 U.S. 821, 94 S. Ct. 117, 38 L. Ed. The framework is not intended to be an exhaustive overview of … 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 term “digital asset,” as used in this framework, refers to 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.”. 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. 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. the securities laws do not apply.”). 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. 8, 2004); see also the Commission’s Supplemental Brief at 14 in SEC v. Edwards, 540 U.S. 389 (2004) (on remand to the 11th Circuit).  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. 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.  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”). 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. Jim Kennedy practices in the Business Representation & Transactions Group.  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. 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. Issuers of digital assets should be guided by the regulatory framework and concepts of materiality. 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 … 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. The Role of Institutional Investor Regulation in Restoring a Fair, Sustainable Economy, Short Sellers and Plaintiffs’ Firms: A Symbiotic Ecosystem, ESG, Common Ownership, and Systematic Risk: How They Intersect, Activist Short Selling Today: The Two Sides of the Coin, https://www.sec.gov/news/speech/speech-hinman-061418. The registration provisions require persons to disclose certain information to investors, and that information must be complete and not materially misleading. 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. Second, the SEC examines whether there is a reasonable expectation of profits by looking at several factors, including whether the purchaser has a right to the enterprise’s income or profits and whether there is an ability to trade the asset through a market or platform. Making or contributing to managerial level business decisions, such as how to deploy funds raised from sales of the digital asset. 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. Howey Co., 328 U.S. 293 (1946), to determine whether a digital asset …  See Forman, 421 U.S. at 852-53 (where a purchaser is not “‘attracted solely by the prospects of a return’ on his investment . The AP distributes the digital asset as compensation to management or the AP’s compensation is tied to the price of the digital asset in the secondary market. Further, this framework does not replace or supersede existing case law, legal requirements, or statements or guidance from the Commission or Staff. Rather, the framework provides additional guidance in the areas that the Commission or Staff has previously addressed. The digital asset is marketed, directly or indirectly, using any of the following: The expertise of an AP or its ability to build or grow the value of the network or digital asset. Determining who will receive additional digital assets and under what conditions.  This framework is intended to be instructive and is based on the Staff’s experiences to date and relevant law and legal precedent. 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.  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.  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. 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. In applying the framework … FinHub's framework explains the staff's views on how the "investment contract" analysis… 1992). These factors are not intended to be exhaustive in evaluating whether a digital asset is an investment contract or any other type of security, and no single factor is determinative; rather, we are providing them to assist those engaging in the offer, sale, or distribution of a digital asset, and their counsel, as they consider these issues.  In doing so, the courts also have considered whether the instrument is offered and sold for use or consumption by purchasers.. 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.  SEC v. Glenn W. Turner Enter., Inc., 474 F.2d 476, 482 (9th Cir. The digital asset is transferable or traded on or through a secondary market or platform, or is expected to be in the future. 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.  SEC v. W.J. No.  In evaluating digital assets, we have found that a “common enterprise” typically exists.. Are those efforts “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise,”. The AP continues to expend funds from proceeds or operations to enhance the functionality or value of the network or digital asset. 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. 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. Business Representation & Transactions Group. 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. Whether a particular digital asset at the time of its offer or sale satisfies the Howey test depends on the specific facts and circumstances. 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. In a so-called “airdrop,” a digital asset is distributed to holders of another digital asset, typically to promote its circulation. 1974) (citation and quotation marks omitted). 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 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 Commission, on the other hand, does not require vertical or horizontal commonality per se, nor does it view a “common enterprise” as a distinct element of the term “investment contract.” In re Barkate, 57 S.E.C. The reduction of these information asymmetries through required disclosures protects investors and is one of the primary purposes of the federal securities laws. All rights reserved. The digital asset is marketed in terms that indicate it is an investment or that the solicited holders are investors. 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 …  Based on our experiences to date, investments in digital assets have constituted investments in a common enterprise because the fortunes of digital asset purchasers have been linked to each other or to the success of the promoter’s efforts. 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. 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. 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. What is the document? On April 3, 2019, the SEC’s Strategic Hub for Innovation and Financial Technology (“FinHub”) 1 published a framework for analyzing whether a digital asset is offered and sold as an investment contract and, therefore, is a security (the “Framework… Restrictions on the transferability of the digital asset are consistent with the asset’s use and not facilitating a speculative market. See, e.g., Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (Exchange Act Rel. This requirement for disclosure furthers the federal securities laws’ goal of providing investors with the information necessary to make informed investment decisions. It is not a rule, regulation, or statement of the Commission, and the Commission has neither approved nor disapproved its content. An AP has a lead or central role in the direction of the ongoing development of the network or the digital asset. Managerial and entrepreneurial efforts typically are characterized as involving expertise and decision-making that impacts the success of the business or enterprise through the application of skill and judgment. The digital asset is available in increments that correlate with a consumptive intent versus an investment or speculative purpose. The AP owns or controls ownership of intellectual property rights of the network or digital asset, directly or indirectly. The AP monetizes the value of the digital asset, especially where the digital asset has limited functionality. 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. Howey Co. and subsequent case law. Where the network or the digital asset is still in development and the network or digital asset is not fully functional at the time of the offer or sale, purchasers would reasonably expect an AP to further develop the functionality of the network or digital asset (directly or indirectly). What is material depends upon the nature and structure of the issuer’s particular network and circumstances. 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 ready transferability of the digital asset is a key selling feature. The retailer continues to market its products to its existing customer base, advertises its digital asset payment method as part of those efforts, and may “reward” customers with digital assets based on product purchases. 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. Potential purchasers have the ability to use the network and use (or have used) the digital asset for its intended functionality. Determining whether and where the digital asset will trade. On April 3, 2019, the SEC announced the framework it would use to determine whether a digital asset would be considered an “investment contract” in light of the Supreme Court’s ruling in SEC v. W.J. 488, 496 n.13 (Apr. 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). This also can be the case where the digital asset gives the holder rights to dividends or distributions. 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 … publishing a framework for analyzing whether a digital asset is offered and sold as an investment contract, and, therefore, is a security. That a scheme assigns “nominal or limited responsibilities to the [investor] does not negate the existence of an investment contract.” SEC v. Koscot Interplanetary, Inc., 497 F.2d 473, 483 n.15 (5th Cir. The following characteristics are especially relevant in an analysis of whether the third prong of the Howey test is satisfied. The federal securities laws require all offers and sales of securities, including those involving a digital asset, to either be registered under its provisions or to qualify for an exemption from registration.  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. Under these facts, the digital asset would not be an investment contract. 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. We encourage market participants to seek the advice of securities counsel and engage with the Staff through www.sec.gov/finhub. 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. 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. 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. Rather, under the Howey test, “form [is] disregarded for substance and the emphasis [is] on economic reality.” Howey, 328 U.S. at 298. 1985).  The lack of monetary consideration for digital assets, such as those distributed via a so-called “bounty program” does not mean that the investment of money prong is not satisfied. 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. We expect that analysis concerning digital assets as securities may evolve over time as the digital asset market matures.  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. No AP has access to material, non-public information or could otherwise be deemed to hold material inside information about the digital asset. First, in determining whether there is a reliance on the efforts of others, the SEC analyzes whether a purchaser of the assets is reasonably expecting to rely on the efforts of a promoter, sponsor, or other third party and whether such efforts are “essential managerial efforts”. 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. 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… 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. 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. 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. 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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. Upon receipt of the digital asset, consumers immediately are able to purchase products on the network using the digital asset. See also Tcherepnin, 389 U.S. at 336 (“in searching for the meaning and scope of the word ‘security’ in the [Acts], form should be disregarded for substance and the emphasis should be on economic reality.”). 2d 53 (1973) (“Turner“). The new FinHub framework delivers on that announcement, providing a useful analytical tool for assessing whether the federal securities laws apply to the offer or sale of a particular digital asset. See In re Tomahawk Exploration LLC, Securities Act Rel. The more the following characteristics are present, the more likely it is that there is a reasonable expectation of profit: 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 “reasonable expectation of profits,” including but not limited to: When assessing whether there is a reasonable expectation of profit derived from the efforts of others, federal courts look to the economic reality of the transaction. The AP has raised an amount of funds in excess of what may be needed to establish a functional network or digital asset. © Copyright 2021, The Trustees of Columbia University in the City of New York. 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