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SEC Director, Division of Corporation Finance, Discusses ICOs and Digital Assets
Practical Law Legal Update w-015-2638 (Approx. 5 pages)
SEC Director, Division of Corporation Finance, Discusses ICOs and Digital Assets
by��Practical Law Corporate & Securities
| Published on 14 Jun 2018 • USA (National/Federal) |
Director of the SEC Division of Corporation Finance William Hinman discussed whether a digital asset offered as a security can, over time, become something other than a security.
On June 14, 2018, Director of the SEC Division of Corporation Finance William Hinman, in his remarks at the Yahoo Finance All Markets Summit: Crypto, discussed whether a digital asset offered as a security can, over time, become something other than a security. In particular, he suggested that the key question should not focus not on the digital asset itself, but instead on the circumstances surrounding the digital asset and the manner in which it is sold. He rephrased the question as whether a digital asset that was originally offered in a securities offering can ever be later sold in a manner that does not constitute an offering of a security and posed two responses:
- In cases where the digital asset represents a set of rights that gives the holder a financial interest in an enterprise, the answer should be no. In these cases, calling the transaction an initial coin offering, or "ICO," or a sale of a "token," will not prevent the application of US securities laws.
- In cases where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created, the answer should be a qualified yes.
Director Hinman highlighted that regarding ICOs, strictly speaking, the token or coin or other identifier of the digital information packet is not by itself a security. The digital asset itself is simply code. But the way it is sold (for example, as part of an investment, to non-users, or by promoters to develop the enterprise) can cause it to be a security because the transaction evidences an investment contract. Central to determining whether it is a security is how it is being sold and the reasonable expectations of purchasers. If the network on which the token or coin is to function is sufficiently decentralized (where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts), the digital assets may not represent an investment contract. Following this line of reasoning, Director Hinman stated that based on his understanding of Bitcoin and its network and the present state of Ether and the Ethereum network, none of the offers and resales of Bitcoin or offers and sales of Ether constitute securities transactions.
He also reiterated that simply labeling a digital asset a "utility token" does not turn the asset into something that is not a security. It is the economic substance of the transaction that determines the legal analysis, not the label.
In assessing whether a digital asset is offered as an investment contract and is therefore a security, Director Hinman identified the primary consideration as whether a third party drives the expectation of a return. In his speech, he listed the following questions that should be evaluated in making this determination:
- Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value?
- Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?
- Has 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? 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?
- Are purchasers "investing," that is seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?
- Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?
- Do persons or entities other than the promoter exercise governance rights or meaningful influence?
He also identified several contractual or technical ways to structure the digital assets and the economic transaction so they function more like a consumer item and less like a security:
- Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?
- Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading?
- 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? Are the tokens available in increments that correlate with a consumptive versus investment intent?
- Are the tokens distributed in ways to meet users' needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser's expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?
- Is the asset marketed and distributed to potential users or the general public?
- Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?
- Is the application fully functioning or in early stages of development?
Director Hinman concluded by noting that this list is not intended to be exhaustive and not all of these factors need to be present to establish a case that a token is not being offered as a security. Rather, these lists are meant to prompt thinking by promoters and their counsel, and start a much-needed dialogue with the SEC staff.
For more information on the SEC's recent statements on ICOs, see Legal Updates, SEC Chairman Warns Legal Advisors on ICOs and SEC and CFTC Issue Statements on Cryptocurrencies and Initial Coin Offerings.