SEC Releases Framework for “Investment Contract” Analysis for Cryptocurrencies
The Strategic Hub for Innovation and Financial Technology (“FinHub”) of the Securities and Exchange Commission (“SEC”) released a framework for analyzing whether a contemplated sale of cryptocurrency, or tokens, is an “investment contract.” (FinHub Staff, SEC). The Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”) both include investment contracts in their definition of securities. (15 U.S.C. §§ 77b(a)(1); 78c(a)(10)). If a cryptocurrency meets the requirements of an investment contract, it is a security subject to registration and regulation under the Securities Act and Exchange Act. The framework released by the SEC applies existing legal precedent to the cryptocurrency context. (FinHub Staff, SEC).
The framework analyzes cryptocurrencies under two tests applied by the Supreme Court, inSEC v. W.J. Howey, 328 U.S. 293 (1946) (“Howey”) and United Housing Foundation v. Forman, 421 U.S. 837 (1967) (“Forman”), to determine whether a particular instrument qualifies as an investment contract. Under Howey, an investment contract exists where there is an investment of money in in a common enterprise with a reasonable expectation of profits derived primarily from the efforts of others. (FinHub Staff, SEC). Additionally, as analyzed by the court in Forman, the framework distinguishes between sales for consumption, which are not securities, and sales for investment, which are. (Id.). In analyzing these factors, FinHub provides a list of features that can be weighted together to determine whether a cryptocurrency or an initial coin offering(“ICO”) is a security. (Id.). Additionally, FinHub’s guidance notes that cryptocurrencies should be re-evaluated periodically, as cryptocurrency previously sold as a security may no longer meet the updated definition. (Id.).
The SEC released this guidance in conjunction with a no-action letter requested by TurnKey Jet, Inc. (“TurnKey”), which sought review of the digital tokens the company intended to sell to the public. (Andrew Ramonas, Bloomberg). In its request for a no-action letter, TurnKey described its intention to sell digital tokens without registration with the SEC. (TurnKey No Action Request, SEC). The tokens would be sold by TurnKey on a continuous basis for one dollar per token and would allow purchasers to trade-in the tokens for on-demand charter jet travel. (Id.). Tokens could not be transferred off of TurnKey’s digital platform and, as a result, a secondary market for the tokens would be effectively non-existent. (Id.). Turnkey argued its tokens did not qualify as an investment contract under the Howeyand Formanstandards because the transactions were consumptive in nature and purchasers, contractually, had no expectation of profits from the tokens. (Id.). For these reasons, TurnKey argued it could sell the tokens without the registration required under the Securities Act and Exchange Act. (Id.)
FinHub Staff agreed with TurnKey’s analysis and determined they would not recommend enforcement to the Commission if Turnkey sold its tokens without registration. (TurnKey No Action Letter, SEC). In reaching its conclusion, FinHub Staff highlighted a number of the tokens’ features that, when analyzed together, supported the decision that the tokens were not securities. (Id.). First, Turnkey would not use any of the funds raised through token sales to develop its digital platform, network, or app. (Id.). Second, the tokens are immediately usable for the purchase of charter jet services. (Id.). Third, the transfer of tokens is permitted only between users on TurnKey’s digital platform. (Id.). Fourth, the tokens are sold at a constant price throughout the sales period and represent TurnKey’s obligation to provide charter jet services. (Id.). Fifth, the tokens cannot be re-purchased by TurnKey except by court order or at a discount. (Id.). And sixth, the tokens are advertised to emphasize their functionality – the purchase of air travel – and not as an investment with the potential to increase in value. (Id.). Taken together, the features highlighted by FinHub show that the tokens are consumptive in nature and purchasers of these tokens are not investing in the company or its tokens with an expectation of profit.
In announcing the SEC’s decision, FinHub’s division head noted that the decision on TurnKey’s request was easy because the tokens were clearly not intended to be securities (Andrew Ramonas, Bloomberg). However, more difficult cases are still being considered by the SEC, which still has many gaps to fill in regulating the crypto-marketplace. (Id.) The framework released by FinHub covers more complex transactions, and should be more helpful than TurnKey’s no action letter in helping companies and investors assess other cryptocurrencies and ICOs for security-like features. (Id.). This guidance resolves some of the uncertainty that existed in the cryptocurrency industry over the direction federal regulation would take. (Andrew Ramonas and Ben Bain, Bloomberg). With this added clarity, the industry may be poised to bounce back from its year-long slump. (Id.)