- What is a Security?
- What is an Investment Contract (i.e. Howey Test)?
- Fourth Prong of Howey Test - Efforts of Others
- Decentralization, Consumptive Purpose and Priming Purchasers' Expectations
Many blockchain networks use, or intend to use, cryptographic tokens ("tokens" or "digital assets") for various purposes. These purposes include an incentive for network participants to contribute computing power to the network; or to gain access to certain goods, services or other network functionality. Some promoters of such a network sell tokens, or the right to receive tokens once the network has launched. They then use the sales proceeds to finance development and maintenance of the networks.
The U.S. Securities and Exchange Commission (SEC) has determined that many of the token offerings and sales over the past few years have been in violation of federal securities laws. In some cases, the SEC has taken action against the promoters of the offerings.
Refer to the following Orders under the Order Instituting Cease-and-Desist Proceedings Pursuant to [1, Section 8A]:
- Making Findings, and Imposing a Cease-and-Desist Order against Munchee Inc. (the Munchee Order);
- Making Findings, and Imposing Penalties and a Cease-and-Desist Order against CarrierEQ, Inc., D/B/A/ Airfox (the Airfox Order);
- Making Findings, and Imposing Penalties and a Cease-and-Desist Order against Paragon Coin, Inc. (the Paragon Order); and
- Making Findings, and Imposing a Cease-and-Desist Order against GladiusNetwork LLC (the Gladius Order).
In each case, the SEC's decision to take action has been underpinned by its determination that the digital assets that were offered and sold were securities pursuant to Section 2(a)(1) of the Securities Act of 1933 - the "Securities Act" or "Act" . Under [1, Section 5], it is generally unlawful for any person, directly or indirectly, to offer or sell a security without complying with the registration requirement of Section 5, unless the securities offering qualifies for an exemption from registration.
The sanctions for a violation of [1, Section 5] can be significant. They include a preliminary and permanent injunction; rescission; disgorgement; prejudgment interest; and civil money penalties. It is important that those seeking to promote token offerings and sales do so only after ensuring that the tokens to be sold are not securities under , or that the offering, if it involves securities, complies with [1, Section 5], or otherwise qualifies for an exemption from registration thereunder.
While the Securities Act ; relevant case law and administrative proceedings; as well as guidance and statements of the SEC and its officials shed much light on many of the considerations involved in an analysis of whether a given digital asset is a security, the facts and circumstances relating to each token, token offering and sale are typically quite unique. Many who seek to undertake token offerings and sales struggle to achieve clarity regarding whether such offerings and sales must be registered under , or have to fit within an exemption from the Act's registration requirements. As a result, there is significant regulatory uncertainty surrounding the offering and sale of tokens.
The Commission recognizes the need for more guidance in this area and continues to assist those seeking to achieve a greater understanding of whether the U.S. federal securities laws apply to the offer or sale of a particular digital asset. This report:
Reviews  (the "Framework", which was recently published by the SEC's Strategic Hub for Innovation and Financial Technology, along with previous statements by William Hinman, the Director of the SEC's Division of Corporation Finance. Note: "The Framework" represents the views of SEC Staff. It is not a rule, regulation or statement of the SEC, and it is not binding on the Divisions of the SEC or the SEC itself.
Explains how  is indicative of the SEC's approach to applying the investment contract test laid out in  to digital assets. The SEC adopted this test, commonly referred to as the Howey test , and has applied the test in subsequent actions involving digital assets.f1 Note: [3, Section 21(a)] authorizes the SEC to investigate violations of the federal securities laws and, in its discretion, to "publish information concerning any such violations". The Report does not constitute an adjudication of any fact or issue, nor does it make any findings of violations by any individual or entity.
In particular, this report examines some of the SEC Staff's statements relating to the fourth prong of the Howey test, i.e. the "efforts of others", and discusses factors for promoters of token offerings to consider when assessing whether a token purchaser may have a reasonable expectation of earning profits from the significant efforts of others. It should be noted that this report is in no way intended to constitute or be relied upon as legal advice, or to substitute for obtaining competent legal advice from an experienced attorney.
Section 2(a)(1) of the Securities Act  defines a security as follows:
The term "security" means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a "security", or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.
While blockchain network tokens (as well as a wide variety of other instruments) are not explicitly included in the definition of "security" under the Act, courts have abstracted the common elements of an "investment contract", which is included in the definition of "security" under Section 2(a)(1) (and Section 3(a)(10) of the Exchange Act of 1934, which is contained in ), to establish a "flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits" [3, paragraph 299].
Accordingly, a determination of whether an instrument not specifically enumerated under Section 2(a)(1) of the Act may be deemed to be a security that implicates the federal securities laws must include an analysis of whether it is an investment contract under Howey.
Howey (and its progeny) established the framework of a four-part test to determine whether an instrument is an investment contract and therefore a security subject to the U.S. federal securities laws. Howey provides that an investment contract exists if there is:
- an investment of money;
- into a common enterprise;
- with a reasonable expectation of profits;
- derived from the entrepreneurial or managerial efforts of others.
For an instrument to be an investment contract, each element of the Howey test must be met. If any element of the test is not met, the instrument is not an investment contract.
While the "efforts of others" prong of the Howey test is, at some level, no more important in an application of Howey than any of the other prongs, it is frequently the prong on which the most uncertainty hangs. The "efforts of others" is often the focus when it comes to public blockchain networks. This is because the decentralization of control that many such projects seek to foster prompts the following question: do the kind and degree of the existing decentralization mean that any expectation of profits token purchasers may have does not come from the efforts of others for purposes of Howey? The determination that token purchasers reasonably expected profits to come from the efforts of a centralized (or at least coordinated) person or group has been central in the SEC's findings that the tokens were securities in each of the recent SEC enforcement actions relating to token offerings and sales.f1
On 14 June 2018, Hinman delivered a speechf2 addressing whether "a digital asset that was originally offered in a securities offering [can] ever later be sold in a manner that does not constitute an offering of a security", and noted two cases where he believed this was indeed possible:
"where there is no longer any central enterprise being invested in", e.g. purchases of the digital assets related to a decentralized enterprise or network; and
"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", e.g. purchases of digital assets for a consumptive purpose.
He posed a set of six questions directly related to the application of the "efforts of others" prong of the Howey test to offerings and sales of digital assets:
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 posed a separate set of seven questions exploring "contractual or technical ways to structure digital assets so they function more like a consumer item and less like a security").
Hinman noted that these questions are useful to consider when assessing the facts and circumstances surrounding offerings and sales of digital assets to determine "whether a third party - be it a person, entity or coordinated group of actors - drives the expectation of a return". If such a party does drive an expectation of a return on a purchased digital asset, i.e. priming purchasers' expectations, there is a greater likelihood that the asset will be deemed to be an investment contract and therefore a security.
In the Framework , the SEC Staff similarly focuses attention on whether a purchaser of a digital asset has a reasonable expectation of profits derived from the efforts of others. These three themes: decentralization, consumptive purpose and priming purchasers' expectations, provide useful context for much of its discussion. The following offers for consideration select implications of the Framework's  guidance and Hinman's speech, as industry participants seek a greater understanding of whether or not a digital asset is a security.
The Framework  reinforces that the degree and nature of a promoter's involvement will have a bearing on the Howey analysis. The facts and circumstances relating to a promoter are key. If a promoter does not play a significant role in the "development, improvement (or enhancement), operation, or promotion of the network" [2, Section 3] underlying the tokens, it cuts against finding the "efforts of others" prong has been met. A promoter may seek to play a more limited role in these areas. Or, along similar lines, influence over the "essential tasks and responsibilities" of the network may be widely dispersed, i.e. decentralized, among many unaffiliated network stakeholders so that there is no identifiable "person or group" that continues to play a significant role, especially as compared to the role that the dispersed stakeholders play [2, Section 4]f3.
The SEC has placed particular attention on promoter efforts to impact a token's supply and/or demand and has also focused on a promoter's efforts to use the proceeds from a token offering to create an ecosystem that will drive demand for the tokens once the network is functional.f1 Further, the SEC has singled out promoter efforts to maintain a token's price by intervening in the buying and selling of tokens, separate from developing and maintaining the underlying network.
Further, the SEC's Senior Advisor for Digital Assets, Valerie Szczepanik, noted promoter efforts in this area may implicate U.S. securities law, recently stating she has "seen stablecoins that purport to control price through some kind of pricing mechanism… controlled through supply and demand in some way to keep the price within a certain band", and "[W]here there is one central party controlling the price fluctuation over time, [that] might be getting into the land of securities" .
In contrast to the kinds of efforts that meet Howey's fourth prong, to the extent that a token's value is driven by market forces (supply and demand conditions), it suggests that the value of the token is attributable to factors other than the promoter's efforts. This is assuming that the promoter does not put some mechanism in place to manage token supply or demand in order to maintain a token's price.
In addition, decentralization of control calls into question whether the application of the Securities Act  makes sense to begin with. A main purpose of  is to ensure that securities issuers "tell the public the truth about their businesses, the securities they are selling, and the risks involved in investing" . Typically, the issuer of a security plays a key role in the success of the enterprise. Investors rely on the experience, judgment and skill of the enterprise's management team and board of directors to drive profits. The disclosure requirements of  focus primarily on issuers of securities. A decentralized network, where no central person or entity plays a key role, however, challenges both identification of a party who should be subject to the disclosure obligations of , and the information expected to be disclosed. Indeed, speaking about Bitcoin, Hinman acknowledged as much, stating he "[does] not see a central third party whose efforts are a key determining factor in the enterprise. The network on which Bitcoin functions is operational and appears to have been decentralized for some time. Applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value". Decentralization ultimately invokes consideration of whether application of  truly serves its purpose. as well as the practical realities of how doing so would even work.
Token purchasers who plan to use their tokens to access a network's functionality typically are not speculating that the tokens will increase in value. The finding that a token was offered to potential purchasers in a manner inconsistent with a consumptive purpose has been a factor in several of the SEC's recent orders, for example:
From paragraph 18 of the Munchee Order [1, Section 8A]: "[The] marketing did not use the Munchee App or otherwise specifically target current users of the Munchee App to promote how purchasing MUN tokens might let them qualify for higher tiers and bigger payments on future reviews... Instead, Munchee and its agents promoted the MUN token offering in forums aimed at people interested in investing in Bitcoin and other digital assets").
From paragraph 16 of the Airfox Order [1, Section 8A]: "AirFox primarily aimed its promotional efforts for the initial coin offering at digital token investors rather than anticipated users of AirTokens").
Accordingly, a promoter may seek to limit the offering and sale of tokens to prospective network users. A promoter may also seek to ensure that, in both its content and intended audience, the marketing, and other communication related to the token offering, is consistent with consumption being the reason for purchasing tokens. The SEC Staff has indicated that the argument that purchasers are acquiring tokens for consumption will be stronger once the network is functional and tokens can actually be used to purchase goods or access services through the network.
Reference [2, Section 9] states that it is less likely the Howey test is met if various characteristics are present, including "[h]olders of the digital asset are immediately able to use it for its intended functionality on the network").
Paragraph 7 of the Airfox Order [1, Section 8A] states "The terms of AirFox's initial coin offering purported to require purchasers to agree that they were buying AirTokens for their utility as a medium of exchange for mobile airtime, and not as an investment or a security. At the time of the ICO, this functionality was not available… Despite the reference to AirTokens as a medium of exchange, at the time of the ICO, investors purchased AirTokens based upon anticipation that the value of the tokens would rise through AirFox's future managerial and entrepreneurial efforts."
Promoters may also consider whether "restrictions on the transferability of the digital asset are consistent with the asset's use and not facilitating a speculative market" [2, Section 10].
The SEC has given much attention to whether token purchasers were led to expect that the promoter would make efforts to increase token value. In this respect, in bringing enforcement actions, the SEC has highlighted statements made by promoters that specifically tout the opportunity to profit from purchasing a token.
For example, from paragraph 17 of the Munchee Order [1, Section 8A]:
Munchee made public statements or endorsed other people's public statements that touted the opportunity to profit. For example… Munchee created a public posting on Facebook, linked to a third-party YouTube video, and wrote '199% GAINS on MUN token at ICO price! Sign up for PRE‑SALE NOW!' The linked video featured a person who said 'Today we are going to talk about Munchee. Munchee is a crazy ICO… Pretty much, if you get into it early enough, you'll probably most likely get a return on it.' This person… 'speculate[d]' that a \$1,000 investment could create a $94,000 return.
Promotional statements explaining that tokens would be listed on digital asset exchanges for secondary trading also draw attention. Refer to the following examples.
From paragraph 13 of the Munchee Order [1, Section 8A]: Munchee stated it would work to ensure that MUN holders would be able to sell their MUN tokens on secondary markets, saying that "Munchee will ensure that MUN token is available on a number of exchanges in varying jurisdictions to ensure that this is an option for all token-holders.");
From paragraph 22 of the Gladius Order [1, Section 8A]: During and following the offering, Gladius attempted to make GLA Tokens available for trading on major digital asset trading platforms. On Gladius Web Pages, Gladius principals and agents stated that "[w]e've been approached by some of the largest exchanges, they're very interested," and represented that the GLA Token would be available to trade on 'major' trading platforms after the ICO.
From [2, page 5], which states that it is more likely that there is a reasonable expectation of profit if various characteristics are present, including if the digital asset is marketed using "[t]he availability of a market for the trading of the digital asset, particularly where the [promoter] implicitly or explicitly promises to create or otherwise support a trading market for the digital asset".
Secondary trading on exchanges provides token holders an alternative to using the token on the network and, especially when facilitated and highlighted by the promoter, can support a finding of investment intent for token purchasers, i.e. buying with an eye on reselling for a profit instead of consuming goods or services through the network.
The Framework [2, Section 6] states that it is more likely there is a reasonable expectation of profit if various characteristics are present, including if "the digital asset is offered broadly to potential purchasers as compared to being targeted to expected users of the goods or services or those who have a need for the functionality of the network", and/or "[t]he digital asset is offered and purchased in quantities indicative of investment intent instead of quantities indicative of a user of the network".
The Framework  also notes that purchasers may have an expectation that the promoter will "undertake efforts to promote its own interests and enhance the value of the network or digital assets" [2, Section 5]. Token purchasers who are not aware of the promoter's interest in the network's success, such as through the promoter having retained a stake in the tokens, should not have any reason to expect the promoter to undertake any efforts to drive token value in order to increase its own profits.
Parties seeking to undertake offerings and sales of tokens in compliance with U.S. securities laws may look to the various actions and statements of the SEC for guidance as to whether the token is a security under the Act. As tokens are not specifically enumerated under the definition of "security", the analysis hinges on the application of the Howey test to determine if the token is an "investment contract" under the Act, and therefore a security. The decentralization of control many public blockchain projects seek to foster places Howey's "efforts of others" prong as a key area of focus. Questions regarding the application of this prong generally relate to:
- decentralization of the enterprise underlying the tokens;
- consumptive purpose of token purchasers; and
- whether token purchasers were led to have an expectation that the promoter would take efforts to drive token value.
This report has offered insight into some of the factors that promoters of token offerings may consider in assessing whether the kind and degree of decentralization that exists means that any expectation of profits token purchasers may have does not come from the efforts of others. It is also indicative of the SEC's approach to evaluating the offer and sale of digital assets.
f1: For examples, refer to paragraph 32 of the Munchee Order and
paragraph 21 of the Airfox Order and accompanying text.
Paragraph 32 of Munchee Order: "MUN token purchasers had a reasonable expectation of profits from their investment in the Munchee enterprise. The proceeds of the MUN token offering were intended to be used by Munchee to build an "ecosystem" that would create demand for MUN tokens and make MUN tokens more valuable".
Paragraph 21 of Airfox Order: "AirFox told investors that the company would improve the AirFox App, add new functionality, enter into agreements with third-party telecommunication companies, and take other steps to encourage the use of AirTokens and foster the growth of the ecosystem. Investors reasonably expected they would profit from the success of AirFox's efforts to grow the ecosystem and the concomitant rise in the value of AirTokens".
f3: Reference [2, Section 4] states that it is more likely that the purchaser of a digital asset is relying on the efforts of others if various characteristics are present. This includes "[t]here are essential tasks or responsibilities performed and expected to be performed by [a promoter], rather than an unaffiliated, dispersed community of network users".
 "Framework for 'Investment Contract' Analysis of Digital Assets" [online]. Available: https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets>. Date accessed: 2019‑03‑10.
 "SEC v. W. J. Howey Co., 328 U.S. 293 (1946)" [online]. Available: https://en.wikipedia.org/wiki/SEC_v._W._J._Howey_Co.). Date accessed: 2019‑04‑05.
 Guillermo Jimenez, SEC's Crypto Czar: "Stablecoins might be Violating Securities Laws", Decrypt (2019) [online]. Available: https://decryptmedia.com/5940/secs-crypto-czar-stablecoins-might-be-violating-securities-laws. Date accessed: 2019‑03‑19.