While this framework … See discussion of “Other Relevant Considerations.”. 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. 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. Playing a leading role in the validation or confirmation of transactions on the network, or in some other way having responsibility for the ongoing security of the network. 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 new framework provides an in-depth description of how the SEC uses a measure called the Howey Test to determine whether a given asset qualifies as a type of security called an … The AP continues to expend funds from proceeds or operations to enhance the functionality or value of the network or digital asset. The first prong of the Howey test is typically satisfied in an offer and sale of a digital asset because the digital asset is purchased or otherwise acquired in exchange for value, whether in the form of real (or fiat) currency, another digital asset, or other type of consideration. In applying the framework … 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. An AP is responsible for the development, improvement (or enhancement), operation, or promotion of the network. 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. 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). All rights reserved. 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”. When a promoter, sponsor, or other third party (or affiliated group of third parties) (each, an “Active Participant” or “AP”) provides essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts, then this prong of the test is met. Determining who will receive additional digital assets and under what conditions. Ascertaining the status of digital asset as an investment contract and as a security will now be easier courtesy of the framework published on 3 April by the United States Securities and Exchange Commission (SEC) titled ‘Framework for ‘Investment Contract’ Analysis of Digital Assets’. [3]  The term “security” includes an “investment contract,” as well as other instruments such as stocks, bonds, and transferable shares. The digital asset is available in increments that correlate with a consumptive intent versus an investment or speculative purpose. 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. [17] See, e.g., Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce Fenner & Smith, 756 F.2d 230 (2d Cir. [18]  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. 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. An AP has a continuing managerial role in making decisions about or exercising judgment concerning the network or the characteristics or rights the digital asset represents including, for example: Determining whether and how to compensate persons providing services to the network or to the entity or entities charged with oversight of the network. Making or contributing to managerial level business decisions, such as how to deploy funds raised from sales of the digital asset. 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 i… The Blogs on this website are for educational and informational purposes only. 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. Further, the lack of monetary consideration for digital assets, such as those distributed via a so-called “air drop,” does not mean that the investment of money prong is not satisfied; therefore, an airdrop may constitute a sale or distribution of securities. 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. 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. SEC, Framework for “Investment Contract” Analysis of Digital Assets … Further, this framework does not replace or supersede existing case law, legal requirements, or statements or guidance from the Commission or Staff. 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. 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. 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. 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. For example, purchasers may reasonably rely on an AP for liquidity, such as where the AP has arranged, or promised to arrange for, the trading of the digital asset on a secondary market or platform. 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. 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… With respect to a digital asset that represents rights to a good or service, it currently can be redeemed within a developed network or platform to acquire or otherwise use those goods or services. Although no one of the following characteristics of use or consumption is necessarily determinative, the stronger their presence, the less likely the Howey test is met: Digital assets with these types of use or consumption characteristics are less likely to be investment contracts. We encourage market participants to seek the advice of securities counsel and engage with the Staff through www.sec.gov/finhub. [11] 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. 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… [10] In order to satisfy the “common enterprise” aspect of the Howey test, federal courts require that there be either “horizontal commonality” or “vertical commonality.”  See Revak v. SEC Realty Corp., 18 F.3d. See In re Tomahawk Exploration LLC, Securities Act Rel. [7]  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. The Framework only briefly addresses the “investment of money” element, indicating that offering and sale of digital assets are typically satisfied because the asset is exchanged for value … 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). In this guidance, we provide a framework for analyzing whether a digital asset has the characteristics of one particular type of security – an “investment contract.”[4]  Both the Commission and the federal courts frequently use the “investment contract” analysis to determine whether unique or novel instruments or arrangements, such as digital assets, are securities subject to the federal securities laws. It also identifies some of the factors to be considered in determining whether and when a digital asset may no longer be a security. 10530 (Aug. 14, 2018) (issuance of tokens under a so-called “bounty program” constituted an offer and sale of securities because the issuer provided tokens to investors in exchange for services designed to advance the issuer’s economic interests and foster a trading market for its securities). Rather, under the Howey test, “form [is] disregarded for substance and the emphasis [is] on economic reality.”  Howey, 328 U.S. at 298. . [4] This framework is intended to be instructive and is based on the Staff’s experiences to date and relevant law and legal precedent. For example, the digital asset can only be used on the network and generally can be held or transferred only in amounts that correspond to a purchaser’s expected use. What is material depends upon the nature and structure of the issuer’s particular network and circumstances. The Framework states that an investment in a digital asset would usually constitute an investment in a common enterprise because “ the fortunes of digital asset purchasers have been … [1] 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”). 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 … 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 trading volume for the digital asset corresponds to the level of demand for the good or service for which it may be exchanged or redeemed. [16] 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. Whether the efforts of an AP are no longer affecting the enterprise’s success. A threshold issue is whether the digital asset is a “security” under those laws. [15] In this guidance, we are using the term “network” broadly to encompass the various elements that comprise a digital asset’s network, enterprise, platform, or application. 488, 496 n.13 (Apr. . Therefore, issuers and other persons and entities engaged in the marketing, offer, sale, resale, or distribution of any digital asset will need to analyze the relevant transactions to determine if the federal securities laws apply. In particular, an AP plays a lead or central 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. 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. No AP has access to material, non-public information or could otherwise be deemed to hold material inside information about the digital asset. The Framework emphasizes that it is only a guideline for analyzing whether the digital asset represents an investment contract, and that no single factor is determinative.

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