On April 3, 2019, the U.S. Securities and Exchange Commission (the “SEC“) released guidance outlining whether a digital asset is a security, and thus subject to scope of federal securities laws (the “Framework“). This guidance was introduced to assist participants in the digital asset space with determining whether federal securities laws are applicable to the offering and sale of such assets. The application of securities laws to digital assets will increase obligatory disclosure requirements and compliance costs for issuers in this space.
Although this guidance was issued within the context of the U.S. securities laws, the discussion surrounding legislation of digital assets crosses jurisdictional boundaries. The Canadian Securities Administrators (the “CSA“) and the Investment Industry Regulatory Organization of Canada (“IIROC“) recently published a joint consultation paper on the topic, seeking input from members of the fintech community, including market participants and other stakeholders, on tailoring regulatory requirements to digital assets.
What is a digital asset, exactly?
The SEC defined a digital asset in this context as follows:
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.”
While the terms distributed ledger and blockchain technology are often synonymously, there are nuances between these two technologies. Distributed ledger technology is a decentralized database whereby data is distributed on different devices which come together to create the full database. Blockchain technology is a subset of distributed ledger technology, which uses an algorithm to reach consensus on the distributed ledger. Essentially, blockchain is a form of distributed ledger technology, but distributed ledger technology is not a form of blockchain technology. These technologies are at the forefront of financial technologies because their decentralized nature and encryption help provide security benefits and protect against data augmentation.
And, what is a security?
The SEC exists to protect investors, to maintain fair, orderly, and efficient capital markets, and to facilitate capital formation. To fulfill its mandate, it enforces certain rules and regulations against capital market participants; to issuers, promoters, and investors in the securities market. This is where the problem of what is a security presents itself.
The definition of a security under the U.S. Securities Act of 1933 includes stock, notes, bonds, and a number of other forms of securities including “investment contracts”. But what did this mean? In 1946, the U.S. Supreme Court found itself tasked with deciding this question, and held that real estate contracts in citrus groves to be securities. Specifically, the Court introduced a test for defining whether the real estate contracts in this scenario constituted an “investment contract.” The test is “whether the scheme involves an (i) investment of money (ii) in a common enterprise (iii) with profits to come (iv) solely from the efforts of others” (the “Howey Test“).
Why does it all matter?
This Framework is notable because of the impact it will have on the application of securities laws to digital assets, including virtual currencies. Rather than waiting for a case to bring the intersection of virtual currencies and securities legislation under a legal lens, the SEC distributed this Framework to advise persons considering an initial coin offering of their rights and obligations under U.S. federal securities laws. The factors for analysis provided under the Framework are neither exhaustive nor determinative. Rather, they provide assistance to market participants regarding the offering and sale of digital assets.
The Framework applied the Howey Test set out above to digital assets, outlining which requirements needed to be satisfied for securities laws to apply. The first portion of this test is “the investment of money”. This requirement is typically satisfied through the purchase of digital assets in exchange for value, be it fiat currency or another digital asset. The SEC also found that the second requirement, requiring a “common enterprise” was typically satisfied in the market of digital assets.
The final two prongs of the Howey Test set out the most complications for analyzing digital assets under federal securities laws: where there is a “reasonable expectation of profits derived from the efforts of others”. The inquiry into the third prong, a reasonable expectation of profits, focuses on whether the digital assets experience capital appreciation or a participation in earnings. Appreciation owing solely to external market forces such as inflation or the economy is insufficient. Rather, the following characteristics help determine whether there is a reasonable expectation of profit:
- the digital asset gives the asset-holder rights to realize capital appreciation gains, or a right to share in the earnings of the enterprise;
- the digital asset is transferrable or expected to be in the future;
- the asset is offered broadly to potential purchasers, in quantities indicative of investment intent;
- economic benefit may be derived from appreciation in the value of the digital asset. Incidental to the right to use the asset for its intended function; and
- other contributing factors as set out in the Framework.
The final prong of the Howey Test, the reliance on the efforts of others, analyzes whether the purchase of assets expects to rely on the efforts of a promotor, sponsor or other affiliated third party (“Active Participants“), and whether these Active Participants’ efforts significantly affect the failure or success of the enterprise (SEC v Glenn W Turner Enter, Inc. 474 F.2d 476, 482 (9th Cir.)). The SEC set out the following factors which, while not determinative, contribute to the likelihood that a purchaser of digital assets is relying on the “efforts of others”:
- Active Participants are responsible for the development, improvement, operation, or promotion of the network;
- Active Participants perform essential tasks, rather than an unaffiliated community of decentralized network users;
- Active Participants create and support a market for, or the price of, the digital asset; and
- other contributing factors as set out in the Framework.
Application of the Framework
The SEC recently applied this analysis towards the digital assets issued by TurnKey Jet, Inc., a jet-leasing business that wishes to issue digital tokens as a part of its membership program. These digital tokens will then be used by members to charter private jets. The SEC applied these factors in issuing a no-action letter, noting that the Division of Corporation Finance would not recommend enforcement actions to the Commissioner so long as the company does not use funds from token sales to develop its network, these tokens are immediately usable for their intended purpose at the time of sale, the tokens will not be transferrable to persons external to the platform, and the token is marketed in a manner that emphasizes its functionality rather than the potential for increase in the market value of the token.
Takeaways for Business
While the SEC guidance is not directly applicable to Canadian companies whose activities are not regulated by the SEC (and was issued within the context of the U.S. securities laws), the framework set is nonetheless helpful by providing a way to think about digital assets. Companies participating in the market for digital assets should seek advice on whether securities laws will be applicable to their activities. Securities laws may require registration of the asset, registration of companies involved in the offering or selling process, and obligatory disclosures among other requirements. While the SEC Framework only applies with regards to federal securities laws within the U.S., it is likely that such analyses will influence approaches in other jurisdictions.
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