In recent years, following the launch of the Bitcoin network, offers of digital assets have been made to investors in the United States. Historically, the U.S. Securities and Exchange Commission (the “SEC”) has suspiciously viewed and investigated these transactions on the assumption that the offer of digital assets (also known as “tokens”) constituted an offer of securities. On several occasions, the SEC found that those offerings had been conducted in violation of U.S. securities laws.
In the past, the SEC viewed cryptocurrencies like Bitcoin and Ether as non-securities in light of the decentralized nature of their networks, which excluded the existence of a central party whose efforts could be a key factor in the enterprise. On April 3, 2019, the SEC, through its Strategic Hub for Innovation and Financial Technology (the “FinHub”), released a framework (the “Framework”) for analyzing whether a digital asset is a security. In particular, this framework provides guidance on whether a digital asset is an investment contract under Section 2(a)(1) of the U.S. Securities Act of 1933.
The Framework has found application in practice already. On April 3, 2019, the SEC released its first “no-action” letter regarding an offering of tokens, requested by TurnKey Jet, Inc., and on April 11, 2019, Blockstack Token LLC filed a preliminary offering circular under Regulation A of the Securities Act for the offering of tokens of its network.
The discussion below represents an effort to identify the critical points of the latest developments in the US cryptocurrency space, both from a US and Australian perspective.
The SEC’s Framework
The Framework analyzes whether tokens of a network are investment contracts under the U.S. Supreme Court’s test devised in S.E.C. v. W. J. Howey Co., 328 U.S. 293 (1946) (the “Howey test”). Under this test, an investment contract exists if (i) there is an investment of money, (ii) in a common enterprise, (iii) with a reasonable expectation of profits derived from the efforts of third parties. The first two prongs require little analysis as, based on the SEC’s experience, tokens are purchased in exchange for value (investment of money) and investors either share the risks and profits deriving from the development of the network or each of them relies directly on the developer’s success (common enterprise). Thus, the third prong of the Howey test becomes critical.
Reliance on efforts of others
The third parties on whom investors can rely are promoters, sponsors, developers, referred as “Active Participants”. The Active Participant’s efforts can be relied on when they express “control” of the network where tokens are circulated. Whether any Active Participant has control of the network is ultimately determined based on the totality of the circumstances. According to the elements listed in the Framework, however, control can be reasonably assumed to exist if an Active Participant is (i) responsible for the development and improvement of the network and the tokens, (ii) responsible for the management of the network and the circulation of the tokens (such as determining whether and where the tokens will trade); and (iii) not part of a dispersed community but rather has a primary role in the development, improvement and management of the network and the tokens.
Reasonable expectation of profits
The existence of a reasonable expectation of profits under the Howey test is similarly based on the totality of the circumstances. Such expectation, however, can be reasonably assumed if the holders of tokens (i) own rights to participate in the profits of the network or (ii) expect that an Active Participant’s efforts will determine an increase in the value of the tokens marketed as investment, with that value having little (if any) connection with the market price of the goods or services that can be purchased on the network using its native tokens.
Exclusion of the third prong
The structure and purpose of the network and its tokens can neutralize the reasonable expectation of profits. If the network and the tokens are designed and implemented solely to satisfy consumer needs, purchasers of tokens cannot have any reasonable expectation of profits.
Also in this case, the determination of whether a network and its tokens are meant to satisfy consumer needs is based on the totality of the circumstances. It is possible, however, to draw a red line connecting all the factors listed in the Framework. In particular, the satisfaction of consumer needs is likely the object of a network and its tokens if the tokens:
- can be used and redeemed in connection with the purchase of goods and services;
- are not available in disproportionate quantities compared to the amount of goods and services that can be bought for consumption; and
- are not marketed and do not trade as investments.
The SEC “no-action” letter for TurnKey
TurnKey created a digital network where air carrier and air taxi operator services could be purchased and sold. The currency on the network consisted of tokens that could be purchased from TurnKey. The network hosted three different types of participants: (i) consumers, (ii) brokers of air carrier and air taxi operator services and (iii) carriers.
Notably, TurnKey had “control” of the network and its tokens. TurnKey had developed the network, exclusively using its own capital resources . TurnKey had also the exclusive right to issue and remove the tokens. Furthermore, TurnKey defined itself as “Program Manager”.
The SEC granted “no-action” relief because:
- TurnKey had already fully developed the network so that the proceeds from the sale of the tokens could not be used for development purposes;
- the tokens had a 1:1 exchange ratio to US dollars, which greatly minimized the risk of participants trading tokens for speculative purposes, and also created a strong connection between the value of the tokens and the value of the air carrier and air taxi operator services that could be purchased on the network;
- the tokens could be traded only within the network and could be repurchased by TurnKey only at a discount to face value;
- consumers who held tokens did not have any equity interests in TurnKey nor any rights to dividends, distribution rights or voting rights; and
- TurnKey provided no rewards to consumers who purchased tokens and did not market purchase of tokens as an investment.
As a result, no participant could have a reasonable expectations of profits from the purchase and sale of tokens. Despite the strict approach taken by the SEC, the value of holding and using the tokens consisted in the fact that the blockchain technology provided a more efficient payment settlement than the traditional banking system.
Through the TurnKey no-action letter, the SEC implied that no element is determinative in categorizing a digital asset as investment contract under the securities law. Even though an Active Participant has “control” of the network and its tokens, other elements can exclude the application of the securities laws to a digital asset.
Although this no-action letter is a favorable outcome for TurnKey, we believe that the restrictions imposed on issue, trading, and redemption of the network tokens are fairly uncommon and are unlikely to be attractive to most token projects.
The “Blockstack” Regulation A offering
Blockstack’s network had some similar features to the network that TurnKey had devised. Blockstack had “control” of its network and tokens because it was the only participant who could develop and manage the network and control the issue of tokens. Moreover, tokens served a commercial purpose as they could be used as currency to purchase the services the network offered, specifically applications such as Graphite, which is a decentralized alternative to Google Docs.
Despite these similarities, however, there is a stark difference which tilted the SEC’s analysis in favor of viewing Blockstack’s tokens as investment “securities” and so required the filing of an offering circular with the SEC:
- Blockstack was still in the process of developing the network and planned to use the offer proceeds for that purpose;
- the tokens offered are freely tradeable on a registered exchange or alternative trading system (and so outside of their native network);
- Blockstack committed to have the tokens listed for trading when such exchange or alternative system is approved by the Financial Industry Regulatory Authority; and
- rewards are granted for crypto mining activities.
These elements imply that the purchase of tokens can have a speculative flavor and thus that the tokens are an investment. As a result, token purchasers can have a reasonable expectation of profits.
Blockstack’s offering circular provides a practical example of tokens that are securities and thus should be registered with the SEC under the Securities Act if offered to the public. More interestingly, the application of the securities law, consistent with the Framework, is also driven by Blockstack’s intent to offer the tokens for trading on a registered exchange and alternative trading system, which is an intent to offer the tokens for a speculative purpose, even though such exchange and alternative trading system do not currently exist.
It should also be noted that Blockstack’s offering circular introduced a type of security that can be treated as “flexible” over time. The offering circular, consistent with the Framework, disclosed that the tokens offered as securities may not be securities in the future if the characteristics of the network and/or the tokens change. What this means is that the protection of the securities law could disappear post-investment.
If Blockstack’s offering circular is declared “effective”, Regulation A can become the go-to avenue for offerings of tokens (up to US$50 million in one year) because
- under Regulation A, offerings can be made to any investors, regardless of their degree of sophistication; and
- securities sold under Regulation A are not “restricted” and thus are freely tradeable after purchase from the issuer.
For smaller token offers, including those which are clearly securities under US law, this is of interest because, in contrast with the traditional registration statement for an equity IPO, an issuer pursuing an offer of securities under Regulation A will benefit from:
- an expedited SEC review process; and
- lighter disclosure requirements.
Regulation A, however, applies only to a specific type of issuer. In particular, Regulation A is available only to issuers incorporated in the United States or Canada with their principal place of business in the United States or Canada.
Relevance of new SEC Framework to interpretation of Australian securities laws
The SEC takes a different approach from securities regulators in many other countries, including Australia. Whereas other regulators look to classify tokens as (broadly) securities, utility tokens or payment tokens, the SEC starts by taking an expansive view of what a security token is. This leads to tokens that may, in other jurisdictions, be classified as utility tokens being considered as securities by the SEC. For example, common features of a utility token such as tradability, centralised development of the network, centralised issuance of tokens, and the ability to acquire tokens for speculative investment, could all lead to classification as a security in the United States.
In Australia, the comparable concept to the US “investment contract” under the Howey test is a managed investment scheme (“MIS”). Like the Howey test, the definition of a MIS has three main elements. These are (i) a contribution of money or value, (ii) the contributions are pooled, or used for a common enterprise, to produce financial benefits, and (iii) contributors do not have day-to-day control of operations. The “common enterprise to produce financial benefits” element is similar to the Howey test element that there be “a reasonable expectation of profits derived from the efforts of third parties”.
The SEC takes the clear view that if token buyers expect that the price or value of their tokens will increase due to the activities of promoters or others, then this satisfies the test for an expectation of profits. For example, raising funds to develop a network or operations, or selling tokens on the basis that they will be listed on an exchange, are factors considered in the Framework. As seen in the TurnKey example above, the issuer went to great lengths to eliminate the possibility of token holders seeking to profit by selling their tokens.
Will Australian regulators interpret the MIS test of “producing financial benefits” in the same way, where a utility token does not otherwise give any right to profits or capital of the business? Or will this be the start of a wider divergence of regulatory approach between the SEC and other regulators?
The Framework is the first step by the SEC to remove the clouds of uncertainty regarding the criteria that make a digital asset a “security” under US law. Certainly, it is a commendable effort. The Framework, however, provides a totality of the circumstances approach that may leave market participants doubtful about what elements listed in the Framework are “heavier” than others. In this respect, the TurnKey no-action letter and Blockstack’s offering circular clarify one point. “Control” of the network and its tokens is not alone determinative.
There is a general consensus among practitioners that the application of the criteria listed in the TurnKey no-action letter could provide a very narrow escape from the application of the securities law, something that is viewed as potentially stifling the development of blockchain technology. However, Regulation A could strike the right balance between protection of the public and promotion of the development of blockchain technology.
The Framework, however, remains silent on other key issues. For example, how can brokers and investment advisers who hold clients’ assets satisfy the custody rules? How can auditors comply with the securities law in connection with offerings of tokens? Can a digital platform trade securities and non-securities? Unfortunately, today these questions have no answers. Further guidance on these issues will be needed.