On April 3, 2019, the Strategic Hub for Innovation and Financial Technology (“FinHub”) released a framework for analyzing the application of U.S. federal securities laws to digital assets (the “Framework”). At the same time, the Division of Corporation Finance (the “Division”) of U.S. Securities and Exchange Commission (the “Commission”) issued a no-action response to an issuer in connection with the proposed offer and sale of a digital asset (the “TKJ Letter”). Together, the Framework and the TKJ Letter offer important insights to persons considering engaging in an initial coin offering (“ICO”) or other transaction to offer, sell or distribute coins, tokens or other digital assets using distributed ledger technology (“DLT”).
What is FinHub?
In late 2018, the Division established FinHub to focus on fintech-related fields. FinHub is, in part, a response to the growing demand of legislators and market participants for the Commission to provide some measure of regulatory guidance in this rapidly developing space. FinHub’s purpose is to facilitate active Commission engagement with innovators, developers and entrepreneurs and serve as an information resource for the Commission’s views and actions in several fintech sectors, including DLT technologies, digital marketplace financing, automated investment advice and artificial intelligence.
What is the Framework?
The Framework is FinHub’s first attempt to provide guidance on the application of U.S. federal securities laws to digital assets, specifically the question of whether digital assets such as utility tokens and coins are, in fact, securities. The Framework does not alter, replace or supersede existing laws, rules, regulations or prior Commission statements and was not approved by the Commission. Rather, it represents FinHub’s position and, like other Commission staff guidance, is not binding on the Commission or its Divisions. In short, the framework is best viewed as an analytical tool to help market participants assess whether federal securities laws may apply to the offer, sale or distribution of digital assets, to raise relevant legal and regulatory issues, and to stimulate further discussion and engagement with the Commission.
In substance, the Framework does not stray from prior Commission statements and guidance on the subject, building on 70 years of precedent following the U.S. Supreme Court’s Howey test. It probes whether a digital asset is offered and sold as an “investment contract” and, therefore, falls within the definition of a “security” for purposes of U.S. federal securities laws. As many market participants know, the Howey test is broad. Under Howey, an investment contract exists when there is:
- the investment of money
- in a common enterprise
- with a reasonable expectation of profits to be derived from the efforts of others.
All three elements of the Howey test must be satisfied before an instrument will be deemed an investment contract. In almost all instances with respect to digital assets, the first two elements of the Howey test are satisfied. Consequently, the Framework’s focus comes down to an objective analysis of Howey’s third prong: whether the purchaser of a digital asset has a reasonable expectation of profits (or other financial returns) derived from the efforts of others.
Because of the traditionally broad application of the Howey test and the wide variety of characteristics of digital assets (including the details of their offering, sale and distribution), a detailed facts-and-circumstances analysis is important. For this reason, the Framework breaks down Howey’s third prong into multiple inquiries regarding:
- the purchaser’s reliance on others, including questions such as whether the issuer or promoter of the digital asset is developing or improving the related network, platform or technology in a way that is necessary for the asset to achieve or maintain its intended purpose or functionality;
- what constitutes a reasonable expectation of profits, including questions such as whether the digital asset gives holders rights to share in the enterprise’s profits or is expected to be tradable in a secondary market, and
- other relevant considerations that look to the economic reality of the transaction, including questions such as whether the digital asset can be immediately used for its intended functionality and whether the digital asset has limited prospects for appreciation in value.
These inquiries are intended to help the market participant determine whether the digital asset will be viewed as a security such that its offer and sale must be registered or exempt from registration under federal securities laws.
What is the TKJ No-action Letter?
In response to a request from TurnKey Jet, Inc. (“TKJ”), the Division also issued the TKJ Letter on April 3, 2019, indicating that it will not recommend enforcement action to the Commission with respect to the unregistered offering and sale of the digital asset described by TKJ in its request for no-action relief. TKJ is a Florida-based interstate air charter service provider that owns and operates business jets. To reduce transaction costs and inefficiencies (including those related to payment settlement and regulatory compliance), TKJ proposed to launch a token membership program and develop a platform (with a digital wallet application) to facilitate sales for air charter services via a private blockchain network accessible to TKJ as well as its customers, brokers, and carriers. Essentially, TKJ wants its customers to be able to buy digital tokens on a proprietary blockchain platform at $1 per token, with each token representing a corresponding obligation of TKJ to provide air charter services at the same value. Once a token enters circulation, a TKJ customer may freely trade or exchange tokens in his or her possession with any other customer, broker or carrier within the network.
Importantly, the Division’s no-action position is predicated on the following conditions:
- TKJ will not use funds from token sales to develop its platform, network or application, all of which will be fully developed and operational before tokens are sold;
- the tokens will be immediately usable at the time they are sold;
- the tokens will not be transferable outside of TKJ’s digital wallet platform;
- the token price and the corresponding value of air charter services TKJ will be obligated to provide for each token both remain at one dollar throughout the life of the program;
- any token repurchase will be at a discount to its face value, unless a U.S. court orders TKJ to liquidate the tokens; and
- tokens will be marketed to emphasize functionality, and not for investment or speculative purposes.
These conditions mirror considerations enumerated in the Framework that, while not necessarily determinative, are indicative of a lower likelihood that the third prong of the Howey test has been satisfied. For this reason, the TKJ Letter is an illustrative companion for market participants using the Framework to gauge whether a digital asset may be a security.
Do these actions really change anything?
In addition to not being new law or Commission-approved guidance, the Framework and TKJ Letter are generally consistent with various statements and guidance that have been put forth previously by the Commission, individual commissioners and Commission staff. Similarly, the conditions emphasized in the TKJ Letter mean that the tokens that the Division does not view as securities under Howey amount to little more than DLT-based airline miles, which have long been offered, sold and transferred (arguably in some ways with less restrictions than TKJ’s tokens) without the need for registration under federal securities laws.
That said, the Framework represents the most thoughtful and deliberate piece on the Howey analysis from Commission staff to date and focuses market participants on specific questions and issues in more detail than before. Perhaps most importantly, these actions tell us that the SEC is engaged on these issues and is making an effort to provide guidance, both generally and with respect to specific cases brought before them. The Framework and TKJ Letter represent important steps in the continuing analysis of the application of U.S. federal securities law to digital assets.
 SEC, Framework for “Investment Contract” Analysis of Digital Assets (Apr. 3, 2019), available at: https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets.
 Turnkey Jet, Inc., SEC No-Action Letter (Apr. 3, 2019), available at: https://www.sec.gov/divisions/corpfin/cf-noaction/2019/turnkey-jet-040219-2a1.htm.
See SEC – FinHub, Engage with FinHub, available at: https://www.sec.gov/finhub.
See SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (“Howey”).
Framework at p. 1 (citing Howey (internal citations and quotations omitted)).
Id. at 2, n.9 and n.10.
See TKJ Incoming Letter to the Division (Apr. 2, 2019), available at: https://www.sec.gov/divisions/corpfin/cf-noaction/2019/turnkey-jet-040219-2a1-incoming.pdf.
See Framework at p. 6.