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Regulation

A closer look at the SEC’s newly issued token investment framework

Quick Take

  • The SEC has published new guidance for digital asset sales
  • The Block pulled some interesting snippets from the guidance

The U.S. Securities and Exchange Commission’s Strategic Hub for Innovation and Financial Technology (FinHub) just published a framework for analyzing whether digital assets offered and sold are securities.

According to the SEC, “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.”

As to whether a particular digital asset satisfies the Howey test during its sale/offering, the following prongs have to be examined:

  • The Investment of Money, which satisfies the Howey test if the digital asset is “purchased or otherwise acquired in exchange for value”
  • Common Enterprise, which satisfies the Howey test if there is a “common enterprise” as a distinct element of an investment contract.
  • Reasonable Expectation of Profits Derived from Efforts of Others, which satisfies the Howey test if “a purchaser has a reasonable expectation of profits (or other financial returns) derived from the efforts of others.” This specific prong becomes more relevant if the purchaser of the asset should “reasonably expect to rely on the efforts of an Active Participant” to determine the failure or success of the enterprise

To determine whether the purchaser is relying on the efforts of an Active Participant (AP), the following characteristics have to be examined:

  • “An Active Participant is responsible for the development, improvement (or enhancement), operation, or promotion of the network.” An example of this is if the network or the digital asset is still in development or not fully functional during the token sale. A purchaser in this scenario would “reasonably expect an AP to further develop the functionality of the network or digital asset.”
  • “There are essential tasks or responsibilities performed and expected to be performed by an AP, rather than an unaffiliated, dispersed community of network users,” or decentralized network.
  • An AP creates or supports a market for the digital asset, which includes controlling the creation and issuance of the asset and taking action to support the price of the asset.
  • “An AP has a lead or central role in the direction of the ongoing development of the network or the digital asset, which includes the AP playing a leading role in “deciding governance issues, code updates, or how third parties participate in the validation of transactions that occur with respect to the digital asset.”
  • “An AP has a continuing managerial role in making decisions about or exercising judgment concerning the network or the characteristics or rights [of] the digital asset.” This includes compensating those providing service to the network, determining where the asset will trade, determining who receives additional assets, and making other managerial decisions that would “directly or indirectly impact the success of the network or the value of the digital asset generally.”
  • “Purchasers would reasonably expect the AP to undertake efforts to promote its own interests and enhance the value.”

When determining whether a digital asset previously sold as a security should be reevaluated at a later time, the framework offers some considerations:

  • “Whether or not the efforts of an AP, including any successor AP, continue to be important to the value of an investment in the digital asset.”
  • Whether the network the digital asset is functioning has reached a point where the purchasers “would no longer reasonably expect an AP to carry out essential managerial or entrepreneurial efforts.”
  • Whether the efforts of an AP are no longer affecting the enterprise’s success.

While the following characteristics do not necessarily determine that a digital asset is not a security, according to the SEC, “the stronger their presence, the less likely the Howey test is met:”

  • “The distributed ledger network and digital asset are fully developed and operational.”
  • The holders of the digital asset can immediately use it for its intended functionality
  • The digital asset 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.” 
  • “Prospects for appreciation in the value of the digital asset are limited.” 
  • The asset can “immediately be used to make payments in a wide variety of contexts, or acts as a substitute for real (or fiat) currency” and “can be redeemed within a developed network or platform to acquire or otherwise use those goods or services.”
  • 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.
  • The digital asset is marketed to emphasize the functionality of the digital asset, not the potential increase of its market value.
  • “Potential purchasers have the ability to use the network and use (or have used) the digital asset for its intended functionality.”
  • “Restrictions on the transferability of the digital asset are consistent with the asset’s use and not facilitating a speculative market.”
  • “If the AP facilitates the creation of a secondary market, transfers of the digital asset may only be made by and among users of the platform.”