For everyone not living under a rock for the past few years, Bitcoin has now become a household term. We have watched as the value of Bitcoin rose to astronomical heights, fell dramatically, and now appears to be on the rise again. As interest in Bitcoin and other cryptocurrencies has grown, so too has an interest in “initial coin offerings” or ICOs. ICOs are public offers of digital tokens that a business sells in order to raise money from investors. Typically, digital tokens are marketed as representing some right to a specific product or service (as opposed to, say, equity in a business or an interest in an actual currency).
Many cryptocurrency enthusiasts have written at length on various public forums about why ICOs are something other than securities and are therefore not subject to the rigorous registration requirements of the Securities Act and state Blue Sky Laws. Often, those making this argument point to the Howey test, which is derived from an oft-cited U.S. Supreme Court decision in which the Court decided what constitutes an “investment contract” and thus a security, subject to federal securities regulations.
Those taking the position that widely-promoted ICOs are not securities have, generally speaking, not fared so well. The SEC has taken aggressive enforcement actions against issuers of ICOs who do not comply with securities regulations. The SEC has also been VERY vocal in warning investors about the risks of investing in ICOS.
Nevertheless, there seems to be a persistent attitude that the SEC will eventually come around to realizing digital tokens are the next great thing, and that the SEC should step aside to enable the digital token marketplace to operate without regulatory interference.
Today the SEC issued guidance that should again cause issuers of ICO’s to hesitate before assuming securities regulations do not apply. That said, the guidance should also prove helpful to those who want to do an ICO with a thorough understanding of the guideposts surrounding what is, and is not, a security.
As a reminder, an “investment contract” exists under the Howey test if there is: 1) an investment of money 2) in a common enterprise 3) with the expectation of profits 4) derived solely from the efforts of others.
Below are a few highlights from the SEC’s Framework regarding the applicability of the Howey test to a digital token:
Regarding the Form of a Digital Token:
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 (which includes secondary market sales).
Regarding the first prong of the Howey test:
The first prong of the Howey test is typically satisfied in an offer and sale of a digital asset because the digital asset is purchased or otherwise acquired in exchange for value, whether in the form of real (or fiat) currency, another digital asset, or other type of consideration.
Regarding the second prong of the Howey test:
Courts generally have analyzed a "common enterprise" as a distinct element of an investment contract. In evaluating digital assets, we have found that a "common enterprise" typically exists.
Regarding the third prong of the Howey test:
Price appreciation resulting solely from external market forces (such as general inflationary trends or the economy) impacting the supply and demand for an underlying asset generally is not considered "profit" under the Howey test. [However,] The more the following characteristics are present, the more likely it is that there is a reasonable expectation of profit:
Regarding the fourth prong of the Howey test:
A purchaser may expect to realize a return through participating in distributions or through other methods of realizing appreciation on the asset, such as selling at a gain in a secondary market. When a promoter, sponsor, or other third party (or affiliated group of third parties) (each, an "Active Participant" or "AP") provides essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts, then this prong of the test is met. Relevant to this inquiry is the "economic reality" of the transaction and "what character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect."
Regarding when the Howey test may NOT apply:
Perhaps most helpful, the SEC guidance included several factors that, when present, may suggest that the Howey test is not met, and thus securities regulations do not apply. Among those factors:
Before conducting an ICO, assume its an investment contract, then try to convince yourself otherwise.
When doing the self-convincing, rely on the SEC's Guidance, not what you read on a cryptocurrency blog.
If you can't convince yourself the ICO is not a security, raise money the old fashioned way: via an offering that is registered or exempt under federal and state securities laws.
And of course, when in doubt, call an attorney.
Brian Edstrom is a Shareholder and Attorney at Avisen Legal, P.A. He brings to Avisen clients the ability to “speak regulator,” having spent several years working for federal and state regulators in Washington D.C. and Saint Paul, MN before entering private practice. Brian assists clients in all aspects of working with securities regulators, whether it be to obtain a license or registration, prepare for an audit, or respond to an enforcement investigation. Brian also regularly advises clients on their general business needs, particularly surrounding raising money through securities offerings.