SEC Grants No-Action Relief for Initial Coin Offering

Investment Management Update

Date: April 09, 2019

Key Notes:

  • No-action relief granted for offer and sale of tokens without registration as a security
  • FinHub releases framework for analyzing the offer and sale of digital assets under the Howey test

On April 3rd, 2019, the U.S. Securities and Exchange Commission’s (SEC or Commission) Strategic Hub for Innovation and Financial Technology (FinHub), which launched in October 2018, published a framework for analyzing whether a digital asset is offered and sold as an investment contract, and, therefore, is a security. Its statement on the framework of an “investment contract” coincides with the Division of Corporation Finance (Division) issuing a response to a no-action request, indicating that the Division will not recommend enforcement action to the Commission if the digital asset described in the request is offered or sold without registration under the U.S. federal securities law.

The no-action letter issued to TurnKey Jet, Inc. (TKJ) outlines certain facts dispositive to the Division’s statement that it would not recommend enforcement if TKJ offers and sells its tokens without registration and sets forth a very narrow definition of a token which is not an investment contract/security (sometimes referred to as a “utility token”):

  • “TKJ will not use any funds from Token sales to develop the TKJ Platform, Network, or App, and each of these will be fully developed and operational at the time any Tokens are sold;
  • The Tokens will be immediately usable for their intended functionality (purchasing air charter services) at the time they are sold;
  • TKJ will restrict transfers of Tokens to TKJ Wallets only, and not to wallets external to the Platform;
  • TKJ will sell Tokens at a price of one USD per Token throughout the life of the Program, and each Token will represent a TKJ obligation to supply air charter services at a value of one USD per Token;
  • If TKJ offers to repurchase Tokens, it will only do so at a discount to the face value of the Tokens (one USD per Token) that the holder seeks to resell to TKJ, unless a court within the United States orders TKJ to liquidate the Tokens; and
  • The Token is marketed in a manner that emphasizes the functionality of the Token, and not the potential for the increase in the market value of the Token.”

While this fact pattern includes several conditions, the issuance of this first no-action letter in the space is significant, and we expect additional no-action requests to be addressed by the Division.

To assist market participants, FinHub issued the framework, which, alongside the TKJ no action letter, is intended to be an analytical tool to help assess whether the federal securities laws apply to the offer, sale or resale of a particular digital asset.

FinHub starts the framework by confirming that the “Howey test” outlined in the U.S. Supreme Court’s Howey case[1] and subsequent case law remain the applicable standard to determine whether the sale of such digital assets constitutes the sale of securities. Most typically, FinHub expects the digital asset would fall into the category of an “investment contract,” which 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. The framework explores aspects of digital asset transactions and provides valuable guidance under each prong of the Howey test for analyzing such transactions, noting, “the focus of the Howey analysis is not only on the form and terms of the instrument itself (in this case, the digital asset) but also on the circumstances surrounding the digital asset and the manner in which it is offered, sold, or resold.”

Not surprisingly, the analysis presented suggests that most digital asset transactions do implicate federal securities laws. However, the guidance suggests that even though the initial sale of a digital asset may constitute the sale of an investment contract, the character of such digital asset or resale transaction may change over time due to intervening facts and circumstances. Along these lines, the framework contains different or additional points for consideration with respect to the “efforts of others” and “reasonable expectation of profits.” This opens the door for an initial securities offering of a token that later may not be treated as a security.

The framework also includes several “consumption” characteristics (consistent with TKJ), the presence of which make it “less likely the Howey test is met”:

  • “The distributed ledger network and digital asset are fully developed and operational.
  • Holders of the digital asset are immediately able to use it for its intended functionality on the network …
  • The digital assets’ creation and structure is designed and implemented to meet the needs of its users ...
  • Prospects for appreciation in the value of the digital asset are limited.
  • With respect to a digital asset referred to as a virtual currency, it can immediately be used to make payments in a wide variety of contexts, or acts as a substitute for real (or fiat) currency …
  • With respect to a digital asset that represents rights to a good or service, it currently can be redeemed within a developed network or platform to acquire or otherwise use those goods or services …
  • Any economic benefit that may be derived from appreciation in the value of the digital asset is incidental to obtaining the right to use it for its intended functionality.
  • The digital asset is marketed in a manner that emphasizes the functionality of the digital asset …
  • Restrictions on the transferability of the digital asset are consistent with the asset’s use and not facilitating a speculative market.
  • If the AP [active participant] facilitates the creation of a secondary market, transfers of the digital asset may only be made by and among users of the platform.”

While this guidance represents staff views and is not a rule, regulation or statement of the Commission, you can request a fintech-related meeting with SEC staff or view other publications at https://www.sec.gov/finhub.

FOR MORE INFORMATION

For more information, please contact:

Cassandra W. Borchers
513.352.6632
Cassandra.Borchers@ThompsonHine.com

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[1] SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (“Howey”). See also United Housing Found., Inc. v. Forman, 421 U.S. 837 (1975) (“Forman”); Tcherepnin v. Knight, 389 U.S. 332 (1967) (“Tcherepnin”); SEC v. C. M. Joiner Leasing Corp., 320 U.S. 344 (1943) (“Joiner”).