During a speech in San Francisco on June 14, 2018, at the Yahoo! Finance All Markets Summit, William Hinman, director of the Division of Corporation Finance of the Securities and Exchange Commission (SEC), provided some welcome clarity regarding the applicability of the federal securities laws to digital assets and tokens projects (Hinman speech). Hinman’s speech, titled “Digital Asset Transactions: When Howey Met Gary (Plastic),” focused on whether a digital asset offered as a security can, over time, become something other than a security. According to Hinman, the answer to this question is a qualified “yes” when a digital asset is sold only to be used to purchase a good or service available through a network. Hinman also expressed his view that Ether—the cryptocurrency of the Ethereum network—is not a securit and therefore is not subject to the U.S. federal securities laws. Hinman said that, in his view, Bitcoin is not a security either, reinforcing what SEC Chairman Jay Clayton stated in his remarks recently on CNBC and what many who follow virtual currency developments thought was a foregone conclusion. On June 21, 2018, as discussed below, SEC Chairman Jay Clayton gave congressional testimony that provided further support for the SEC staff’s approach as outlined by Hinman.
Hinman’s speech was even more significant to the universe of those who pay close attention to regulators’ views on digital assets, in particular when a digital asset is deemed to be a security.Hinman suggested that in limited circumstances, the SEC believes that blockchain startups can raise money by selling tokens (or agreements for future tokens) as securities before a network is launched (i.e., before it has functionality or utility), but then further sales of these same tokens can be made as nonsecurities once the circumstances surrounding that sale transaction have changed in a manner that no longer constitutes an investment contract.
Hinman discussed certain factors to be considered in assessing whether a digital asset is offered as an investment contract in a securities transaction. In particular, Hinman focused on the fourth prong of the Howey investment contract test (as explained below) and whether the efforts of an identifiable third party—be it a person, an entity, or a coordinated group of actors—drives the expectation of a return. Also noteworthy was Hinman’s comment that the SEC is “happy to help promoters and their counsel work through . . . issues . . . [and] . . . stand[s] prepared to provide more formal interpretive or no-action guidance about the proper characterization of a digital asset in a proposed use.” As in the cases Hinman discussed, this summary focuses on an analysis under the Securities Act of 1933 and the Securities Exchange Act of 1934. Note that based on context, an analysis under the Investment Company Act of 1940 and the Investment Advisers Act of 1940 may have different results, as may analysis under state laws, due to different definitions or interpretations.
Key Components of Hinman’s Speech
Digital Asset: Product vs. Security. Hinman began by describing promoters selling tokens or coins to raise money to develop networks on which the digital assets will operate, rather than selling shares, issuing notes, or obtaining bank financing. In many cases, the economic substance is the same as a conventional securities offering—funds are raised with the expectation that the promoters will build their system, and investors can earn a return on the instrument. In such cases, Hinman said that it would be “easy to apply” the longstanding “investment contract” test from the 1946 U.S. Supreme Court’s decision in SEC v. W.J. Howey Co. (Howey test): (1) an investment of money, (2) in a common enterprise, (3) with a reasonable expectation of profits, (4) to be derived from the entrepreneurial or managerial efforts of others.
Hinman next focused on the specific facts of the Howey case, which involved a hotel operator, Howey, selling interests in a nearby citrus grove coupled with a service contract obligating the hotel operator to harvest and market the oranges on the purchaser’s behalf. Howey unsuccessfully claimed it was selling real estate rather than securities. Hinman highlighted that although the transaction in Howey was recorded as a real estate sale, it also included a service contract to cultivate and harvest the oranges, which meant that the investors were relying on the efforts of Howey for a return. Hinman emphasized that regardless of whether something is called a “token” or a “coin,” the analysis turns on how an asset is sold, which may cause investors to have a reasonable expectation of profits based on the efforts of others.
Just as in Howey, Hinman stressed, tokens and coins are often touted as assets that have a use in their own right, coupled with a promise that the assets will be cultivated in a way that will cause them to grow in value to be sold later at a profit. In addition, as in Howey—where interests in the grove were sold to hotel guests who were passive investors, not farmers—tokens and coins typically are sold to a wide audience rather than to persons who are likely to use them on the network.
Gary Plastic. As the title of his speech signals, Hinman analogized certain sales of tokens to the facts in Gary Plastic Packaging v. Merrill Lynch, in which the court held that a transaction may be subject to the securities laws, even if the underlying instrument would not be a security, based on the manner of their sale and the promises associated with such sale. In Gary Plastic, the court found that despite the fact that conventional certificates of deposit (CD) issued by a bank are not securities, they were securities in that instance because they were sold in a manner that satisfied the Howey test. The CDs were sold through a program organized by Merrill Lynch that promised retail investors it would maintain a secondary market for the CDs. The court found that the CDs represented a joint effort by the issuers of the CDs and Merrill Lynch, and that the CDs were investment contracts because investors expected to receive profits through the extra services provided by Merrill Lynch.
Applying the same reasoning to tokens, Hinman stated that although tokens themselves (which are, after all, “simply code”) may not be securities, “how [tokens are] being sold and the reasonable expectations of purchasers” are central to the securities law determination. Therefore, in the context of a token sale that resembles the sale of a security, the application of the securities laws is appropriate because such laws’ disclosure requirements (among other protections) are necessary to mitigate the information asymmetry between promoters and investors.
Mutability: From Security to Utility Tokens. Hinman explained that a digital asset transaction may no longer represent a security offering, i.e., an investment contract, if, in addition to the token or coin lacking other security-like features, the network on which the token or coin is to function is sufficiently decentralized—where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts. Moreover, Hinman added, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede, and as a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult and less meaningful.
Ether and Bitcoin. Hinman expressed his view that sales of Ether are not securities transactions, stating: “Based on my understanding of the present state of Ether, the Ethereum network, and its decentralized structure, current offers and sales of Ether are not securities transactions.” Hinman also said that, in his view, Bitcoin also is not a security because network participants are not reliant upon the efforts of a central third party. Hinman stated:
I do 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, perhaps from inception. Applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value.
Hinman cautioned that the analysis of whether something is a security is not static and does not strictly inhere to the instrument, specifically noting that even digital assets with utility that function solely as a medium of exchange in a decentralized network could be packaged and sold as an investment strategy that can be a security.
Director Hinman reiterated that although the token or coin by itself is not a security, the packaging and sale of such token or coin could bring it within the purview of the securities laws.
Token Sales. Hinman provided additional context to Chairman Clayton’s prior remarks in which the chairman noted that an overwhelming number of the token sales he has seen likely qualify as securities offerings under the Howey test. Hinman reiterated that merely calling the token a “utility token” does not give it the substance needed to avoid being a security. He focused on the concepts of full decentralization and consumptive intent of the purchasers as two important factors, but noted that a broader facts-and-circumstances analysis is required.
In what appears to be the SEC’s nod to token pre-sale agreements, such as the SAFT (simple agreement for future tokens) or SAFE-T (simple agreement for equity or tokens), where tokens are issued as securities to accredited investors pursuant to the private offering regime of Regulation D, Hinman noted the possibility of structuring a blockchain-based enterprise with funding through token pre-sale agreements without necessarily affecting the ability of the token to be sold later as a nonsecurity.