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Are tokens securities or not?

Are digital tokens issued by blockchain companies securities under U.S. law? Much of the industry, including several prominent law firms, has taken the position that they are not. The Securities and Exchange Commission (SEC) has consistently stated that many or even most are securities. 
It recently issued a framework that laid out a host of criteria that will guide the agency’s analysis.  With the framework and its first blockchain no-action letter, the SEC has now articulated three scenarios where a digital token may not be a security: 1) if the token is merely a store of value like bitcoin; 2) pursuant to its no action letter, if the token exists in essentially a closed system designed for consumptive use only and has a fixed value pegged to the dollar; or 3) where the “efforts of others” prong from the Howey test is not met. The framework focuses mostly on the third case.
We will review the framework, and suggest a way to strengthen the SEC’s standard to clarify how a digital token could transition to a non-security, even if it is initially issued as a security. We believe that if a clear and workable regime is not adopted soon, the United States risks being left behind in the race to unlock blockchain’s transformative potential.

What constitutes a security? 

The Supreme Court considered how to define a security in 1946 in SEC vs. Howey. There, hotel guests were given the chance to purchase strips of an orange grove after the hotel’s owners entered into a bundle of contracts granting the guests a right to profits from the processing of the oranges through the owners’ managerial efforts. 
The Court determined that the hotel guests were investing in a security, holding that a security is not defined by what the issuer happens to call it, but rather by the facts and circumstances surrounding the transaction.  The Court’s test of a security is to ask whether there is 1) an investment of money into 2) a common enterprise with 3) an expectation of profit on behalf of the investors (the hotel guests) 4) from the efforts of the promoters (the hotel owners).

The SEC’s framework

Until now, Howey has been the North Star, as neither Congress nor the SEC has made any definitive law on the topic. But on April 4, the SEC’s Strategic Hub for Innovation and Financial Technology (FinHub) issued the aforementioned framework, the Commission’s most comprehensive guidance to date. To be sure, the framework does not constitute binding authority. But it is full of indicators of how, at least conceptually, the Commission is considering the question of whether to regulate cryptocurrencies as securities.
The SEC predictably stayed within the Howey model. The framework dispenses with the first two prongs, arguing that in any initial coin offering, there is an investment of money and a common enterprise. The key inquiry becomes whether there was a reasonable expectation of profit that is derived from the efforts of others.
The SEC emphasizes that this is an objective inquiry, focused on several characteristics to determine whether there was an expectation of profit. The first issue is whether there is reliance on the efforts of others. Key questions are:
  • Are those efforts the undeniably significant ones that determine the success or failure of the enterprise?
  • Is the expectation that these “active participants” will be overseeing the tasks necessary for the digital asset to achieve its intended purpose or functionality?
  • Does the offer or attempt to control the market value by limiting supply or ensuring scarcity?
All of these questions answered in the affirmative would be further indication that the promoters or issuers are taking an active role and not leaving the fate of the token to a decentralized network, leading to the conclusion that the asset or token is a security.

A workable solution

Embedded in FinHub’s framework is the rather explicit admission that it is possible for a digital token to be so widely employed on a decentralized blockchain solution that the token itself no longer derives its value from the efforts of the original issuer. The inherent logic is that there must come a point where a digital token that may have started out as a security ceases to be a security. But despite the lengthy discussion of how to determine if a token is a security, the SEC’s framework is inadequate in identifying what is necessary to make that transition.
The standard we propose to determine when this change takes place is as follows:  when a digital token has substantial value created by something or someone other than the issuer, and where that value is independently sustainable, the token ceases to be a security and becomes a commodity.
Why substantial? We do not believe it would be practical for a court to determine when, say, a majority of a digital token’s value derives from the efforts of the issuer. Substantial allows for an important determination, but one that is not formalistic. As time goes by and the standard is applied, more definitive indicators of value will emerge.
Why sustainable? If the efforts of the entrepreneur were to be withdrawn from the blockchain solution, and without such effort the value at whatever level currently would disappear, then the token is still dependent upon the efforts of the issuer, even if the value of the token would be substantial without the entrepreneurs present. We believe both elements —substantial and sustainable —should be present for the efforts of others prong of Howey to fail and a digital token to become a commodity.

Conclusion

FinHub’s framework is a helpful first step in providing clarity to stakeholders in the blockchain universe.  Legislation or formal rulemaking, however, would be more helpful. And where the framework is lacking, we feel our substantial and sustainable language could fill in the gaps to provide an even more coherent standard.
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