Why the SEC Thinks Most Tokens Are Securities
When the SEC Thinks a Token Might Stop Being a Security1
August 1, 2018
A common misconception in the cryptocurrency community has been the belief that because a digital cryptocurrency or other crypto asset ("token") is intended to have utility in the future, it is not a security at the time it is issued. That belief reflected a basic misunderstanding of the "Howey test," which is the principal test for analyzing whether most tokens are securities.2 The Howey test looks to the current status of an instrument, not its future promise, in evaluating whether the instrument is a security. Nonetheless, the Howey test at least leaves open the seemingly strange possibility that a token can begin its life as a security, but eventually evolve into a non-security. Recently, a high-ranking Securities and Exchange Commission ("SEC") official not only confirmed that he thought this can happen, but even gave examples of factors that may help in determining when a token that was a security may no longer be a security.
This article provides an overview of why the SEC and its staff ("Staff") consider most tokens to be securities,3 and the circumstances under which the Staff believes some tokens eventually may no longer be securities.4
A. Treatment of Tokens as Securities
1. Why are tokens securities?
The SEC and the Staff take the position that almost all tokens, as they are typically structured, are securities under the Securities Act of 1933 (the "Securities Act") because they meet the definition of an "investment contract."5 Under Section 2(a)(1) of the Securities Act (and similar provisions in the other federal securities laws), the term "security" is defined through a list of instruments that includes, among other things, "investment contracts."6 Although Section 2(a)(1) does not list the terms "tokens" or "coins" or any similar item as a security, the term "investment contract" has been used by the federal courts and the SEC as a catchall for other types of security interests not explicitly encompassed by the list in the Securities Act and the other federal securities laws.7 The SEC has indicated that it views tokens as securities based on an analysis of the tokens as investment contracts under SEC v. W.J. Howey Company8 and subsequent cases.9 In Howey, the Supreme Court found that an instrument meets the definition of an "investment contract" under the Securities Act if it involves "an investment of money in a common enterprise with profits to come solely from the efforts of others."10
In an offering of tokens or DDATs (a "Token Offering"), investors invest money or another form of value in exchange for the right to receive tokens, either immediately or in the future. The instrument may involve a "common enterprise" because (among other reasons) money is pooled and used to finance the development, marketing, and deployment of the issuer's platform, and any success is often common to investors and the issuer.11 Many investors will purchase tokens with the expectation of receiving profits, which are tied to the success or failure of the platform. Token purchasers primarily depend on the issuer's efforts developing, marketing and maintaining the platform for that success. Based on these features of the tokens and how they are typically offered, the SEC has apparently concluded that most (if not all) tokens will be investment contracts and therefore securities.12
2. Is it possible that a company's tokens can transition from securities to non-securities at some point in time?
It is possible that once the value of a token is primarily driven by the token's commercial usage, rather than by the centralized efforts of a token issuer, the token will no longer meet the conditions described in Howey and thus will no longer constitute a security. Precisely when a token transitions to a non-security in these situations is unclear. In general, it is likely that it will occur at some point when the platform is "sufficiently decentralized"13 and the principal driver of a token's value is its commercial usage on one or more mature and operational token platforms (i.e., when there are many users and service providers on the platform and the issuer's efforts developing, marketing, and maintaining the platform are no longer a significant driver of the tokens' value).14 In contrast, as long as a token's value is principally driven by the entrepreneurial or managerial efforts of a centralized source (such as the issuer, affiliates of the issuer, or other identifiable third-party expending managerial efforts), or speculation by other investors, the token will likely remain a security.15
If a token may transition to a non-security, it is also possible that the efforts of the issuer—or a third party, such as a third party responsible for a significant "fork"—can result in a token transitioning back into a security.16 If, for example, the issuer decides to develop a new feature on its platform or provide a significant technological development to the underlying blockchain, the value of the token may return to depending more on the efforts of the issuer than the commercial demand for the underlying good or service.
3. Did the SEC recently change its mind on whether most tokens are securities? (Spoiler alert: No)
In June 2018, the Director of the Division of Corporation Finance, William Hinman, released a statement (the "June 2018 Remarks") outlining certain guiding factors for issuers to consider in determining whether their tokens constitute securities,17 and listed several factors for an issuer to consider in determining both whether a token is a security and when a token that was a security may no longer be a security. Director Hinman also stated that, in his view, Bitcoin and Ether are not securities, although he did not identify the factual characteristics of Bitcoin and Ether that led him to conclude that neither of them are securities.
Anecdotally, it appears that some people in the cryptocurrency community interpreted the June 2018 Remarks as suggesting the SEC had changed its view that most tokens are not securities. A number of people also seem to believe that the SEC may now be amenable to issuing no-action letters to individual token issuers declaring that their tokens are not securities. We think people who take these positions likely are misinterpreting Director Hinman's comments.
First, Director Hinman suggested that factors issuers should consider in determining whether their tokens are securities include, among others, whether the issuer or its affiliates (together with, as applicable, any members of the founding, management or development teams, (the "Sponsoring Parties")):
- Play a significant role in the development and maintenance of the tokens and their potential to increase in value;
- Have retained a stake or other interest in the tokens so that the Sponsoring Parties have financial incentives to increase the value of the tokens (and whether purchasers of the tokens reasonably believe the Sponsoring Parties will undertake these efforts);
- Raise an amount of funds in excess of the amount needed to make the platform fully functional (and may also promise that any excess funds raised will be used to support the value of the tokens or to increase the value of the platform or may continue to expend funds from the proceeds of any Token Offering or operations of the platform for those purposes); or
- Market and sell the tokens to the general public rather than to potential users of the platform.18
These factors, of course, are not meant to replace the Howey test; they are meant, we believe, to help further the Howey analysis (even Director Hinman cannot overrule the Supreme Court's Howey decision). The first two factors, for example, go to the prong of the Howey analysis focusing on whether token purchasers are relying on the efforts of the Sponsoring Parties. The third factor also goes to this prong of the Howey analysis. The fact that a Sponsoring Party raises sufficient money to continue supporting the platform for some time after the initial issuance of the tokens suggests that purchasers of those tokens reasonably are or may be relying on the continuing efforts of one or more of the Sponsoring Parties to maintain, market, support and develop the platform.
The fourth factor, which looks to whether the tokens are marketed and sold to the general public rather than to potential users of the platform, goes to the prong of the Howey analysis focusing on whether purchasers are buying the tokens with an expectation of profits. If the tokens are principally purchased by people who want to use the tokens for commercial purposes on the platform, there is a reasonable argument that these people are not purchasing the tokens with an expectation of profits. As Director Hinman points out, however, a broad-based sale such as a public offering suggests that many purchasers are buying tokens with a speculative, investment intent—or an expectation of profits—rather than with the intent to use the tokens for commercial purposes.
As Director Hinman said, these factors are not the only factors. Indeed, these factors go only to two of the four prongs of Howey. More importantly, the Howey test still stands, and the question a token issuer must ask is whether its tokens are securities under Howey, not under the four non-exclusive factors set forth by Director Hinman.
Second, Director Hinman also listed certain factors that are helpful indications of when a token that was a security may no longer be a security.19 These factors include, among others, whether:
- Creation of the tokens is commensurate with meeting the needs of users of the platform rather than for feeding speculation;
- Independent actors are setting the price of the tokens or if the Sponsoring Parties are supporting or influencing secondary trading in the tokens;
- The primary motivation for purchasing the tokens is for personal use or consumption rather than investment, and the purchaser has made representations that they intend to personally use or consume the tokens (in addition, Sponsoring Parties should consider whether the number of tokens purchased by a user correlates to the number of tokens needed for personal use or consumption on the platform);
- The tokens are distributed in a way that meets users' needs (e.g., the tokens can be held or transferred only in amounts that correspond to a purchaser's expected use and the tokens have built-in incentives for users to use the tokens on the platform rather than hold the tokens for investment purposes);
- The tokens are held by a diverse user base rather than concentrated in the hands of a few token holders that can exert influence over the platform; and
- The platform is fully functioning rather than still in development.20
In our view, it is unlikely that many tokens could meet the factors set forth by Director Hinman prior to the time there is a public offering of the tokens. Among other reasons, it may be difficult for independent actors to set the price of tokens and for the related platform to be fully functioning prior to the time there are publicly offered and freely transferable tokens that can be used on the platform.21 We also are cautious because of all the tokens the SEC and the Staff have examined, to date the Staff has indicated it believes only two tokens—Bitcoin and Ether—are not securities.22 Both of these tokens, of course, have many years of trading and operational history.
Third, although Director Hinman did not discuss the availability of no-action relief to individual token issuers, we are aware that a number of participants in the cryptocurrency community are hopeful that they can receive no-action letters to the effect that their tokens are not securities. While we cannot rule out the possibility of some type of no-action relief, especially for truly unusual tokens or platforms or for groups of tokens and platforms meeting specified criteria, we think it is unlikely that the Staff will begin issuing no-action letters to many individual token issuers.
As previously discussed, the Staff appears to continue to view most tokens as securities, and therefore the Staff is likely to disagree with most requests for no-action relief. In addition, it appears that among the factors that the Staff would look at in deciding whether a particular token is or is not a security are those that Director Hinman discussed, and it is not clear that many token issuers in the United States currently have the type of data necessary to show that some of those factors weigh in favor of a non-securities determination. More generally, the Staff likely is concerned that it lacks the resources to deal with the potential torrent of no-action letter requests it would get from token issuers if the Staff started considering and granting these requests on an issuer-by-issuer basis.
Finally, at the risk of repetition, SEC Chairman Clayton and the Staff repeatedly have said that in their view most tokens they have seen are securities. Any token issuer that seeks a no-action letter—or indeed any token issuer that seeks to take the position that its tokens are not securities—needs to be able to articulate, under the Howey analysis, why its tokens are sufficiently different from most other tokens to cause its tokens alone to not be securities.
As a result, when a token issuer is designing its tokens, Token Offering and platform, we believe the best approach is to generally assume the tokens are and will be securities for some time, and to develop a strategy to promote a liquid and vibrant token economy on the platform that is fully in compliance with the securities laws.
4. What are the potential consequences if a company does not treat its tokens as securities?
Token issuers that fail to treat their tokens as securities risk being penalized by federal or state regulators or sued individually or collectively by private litigants.23
The SEC has placed market participants on notice not only that many tokens are securities but also that the SEC intends to rigorously enforce federal securities laws.24 The Staff has indicated that it intends to pursue pure registration failures, in addition to cases involving fraudulent conduct.25 To date, the SEC has not brought actions against token issuers for substantive securities law violations not involving fraud (except in the Munchee Order, which did not impose sanctions). Statements by the SEC Staff suggest that they do intend to bring these types of actions in the future.26
To police illegal securities offerings, the SEC or the U.S. Department of Justice may impose civil and/or criminal penalties on issuers or persons that violate federal securities laws. These penalties can include, among others, the imposition of fines, civil monetary penalties and the forced return of illegal gains. In addition, the SEC may also bar or suspend an individual from serving as a corporate officer or director.27
Token issuers that fail to treat tokens as securities also risk state regulatory action. The North American Securities Administrators Association ("NASAA") and several state regulators have announced a significant number of investigations and enforcement activities arising from tokens and/or Token Offerings.28
Private plaintiffs may seek damages against issuers of tokens for the offer and sale of a security in violation of the registration provisions of the Securities Act, which may include punitive damages as well as costs for attorneys' fees.29 A number of private plaintiffs have already filed complaints against token issuers for offering and selling securities in violation of the securities laws.30 Although these actions are currently unresolved, they may give rise to considerable litigation costs and potential civil damages and other penalties.
A token issuer that is subject to regulatory and/or private action may also subsequently be subject to potential treatment as a "bad actor" under the securities laws. This could, among other things, prohibit the issuer from conducting a private offering of its securities (including not only tokens, but other securities) and registering securities in future offerings with the SEC.31
The Ninth Circuit applies a "narrow vertical commonality" test, which requires investors' returns to be linked to the returns of the promoter. See e.g., SEC v. R.G. Reynolds Enters., 952 F.2d 1125, 1130-31 (9th Cir. 1991) (finding narrow vertical commonality satisfies second prong of Howey); SEC v. Glenn W. Turner Enterprises, 474 F.2d 476, 482 n.7 (9th Cir. 1973) ("A common enterprise is one in which the fortunes of the investor are interwoven with and dependent upon the efforts and success of those seeking the investment or of third parties."). A court in the Ninth Circuit might decide that there is no narrow vertical commonality in a Token Offering if, for example, the token issuer has no continuing financial stake in the tokens or the platform.
Finally, the Fifth and Eleventh Circuits apply a "broad vertical commonality" test, which requires investors' returns to be tied to the effectiveness of the promoter. See e.g., SEC v. Koscot Interplanetary, Inc., 497 F.2d 473, 479 (5th Cir. 1974) (deciding that "requisite commonality is evidenced by the fact that the fortunes of all investors are inextricably tied to the" issuer's successful efforts) and SEC v. Unique Fin. Concepts, Inc., 196 F.3d 1195, 1199-200 (11th Cir. 2002) (affirming formulation of common enterprise in Koscot). A court in the Fifth or Eleventh Circuit might decide that there is no broad vertical commonality in a Token Offering, if investors' returns are largely tied to persons other than the token issuer, which might occur on a widely decentralized token platform.
In practice, most tokens are offered and sold throughout the United States and are intended to be used throughout the United States. As a result, a token issuer that decides its tokens are not a security under the common enterprise prong of the Howey test likely would need to conclude that its tokens and platform did not create a common enterprise under any of these three tests.
It is important to note that the Howey test cannot be "passed" based on meeting a numerical threshold from a list of factors with arbitrarily assigned numerical values, and that a token does not immediately lose its status as a security simply because the related platform has become "operational."