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SEC’s Strategic Hub for Innovation and Financial Technology Releases a Clarification of the Howey Test Application to Digital Assets

On April 3, The United States Securities and Exchange Commission Strategic Hub for Innovation and Financial Technology (“FinHub”), that aims to facilitate government`s engagement with innovators, developers, and entrepreneurs, released a Statement on “Framework for ‘Investment Contract’ Analysis of Digital Assets” to provide an explanation on the applicability of the investment contract regulations to digital assets.

What is an Investment Contract?

Under the Securities Act of 1933, an investments contract is a type of security. It was defined by the Supreme Court in SEC v. W.J. Howey Co., 328 U.S. 293 (1946) by a well-known formula:

“the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others”.

First applied to the citrus grove offers, it has been widely used ever since, blockchain assets included, when it was initially invoked in the DAO Report in 2017.

FinHub stresses that the Howey test applies not only to the instrument itself, but to the circumstances surrounding the digital asset and the manner in which it is offered, sold, or resold (which includes secondary market sales). Thus, the framework is designed to be applied not only for the token legal analysis, but also for distribution, sale, marketing, holding, provision of professional advice and other services.

The Investment of Money

This part of the Howey test is satisfied if an 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.

However, lack of monetary consideration does not mean that this criteria will not be satisfied (e.g. with “bounty” or “air-drop” programs): "sale" or "sell" under the securities legislation includes every contract of sale or disposition of a security or interest in a security for value – a gift is a "sale" when the purpose of the "gift" is to advance the issuer's economic objectives rather than to make a gift for simple reasons of generosity (re Joe Loofbourrow), as it is the case with these programs.

The same approach was applied to tokens in re Tomahawk Exploration LLC, where an offer of tokens constituted an offer of securities because the company provided tokens to investors in exchange for services designed to advance its economic interests and foster a trading market for its securities.

The Investment is in a Common Enterprise

Either a horizontal, or vertical commonality is to be present in regards to the virtual asset.

Horizontal commonality ties the fortunes of each investor in a pool of investors to the success of the overall venture. In an enterprise marked by vertical commonality, the investors' fortunes do not rise and fall together (Revak v. SEC Realty Corp., 18 F.3d. 81, 87-88 (2d Cir. 1994)).

Reasonable Expectations of Profit…

There should be an expectation of a valuable return on an investment (Reves v. Ernst & Young, 1494 U.S., 156 (1990)), e.g. capital appreciation resulting or participation in earnings resulting from the use of purchasers' funds, when an investor is attracted solely by the prospects of a return (United Housing Foundation, Inc. v. Forman, 1421 U.S. 837 (1975)).

FinHub also provides a list of characteristics that make this part likely to be satisfied, like a digital asset being transferable or traded on or through a secondary market or platform, or is expected to be in the future

…That Comes from the Efforts of Others

This part comprises of two factors:

  1. The purchaser reasonably expects to rely on the efforts of an active participant;
  2. These efforts are the undeniably significant ones, which affect the failure or success of the enterprise (SEC v. Glenn W. Turner Enter., Inc., 1474 F.2d 476, 1482 (9th Cir.)).

FinHub places great importance on the managerial nature of these efforts, such as development of the network for digital assets, supporting the market, promotion of the network in its interests etc.

It is important to note that the Framework adds additional considerations for later sales of tokens, previously sold as securities – such as whether efforts of an active participant continue to be important to the value of an investment in the digital asset, or whether they are no longer affecting the enterprise's success.

What Happens When the Howey Test is not Met?

If all four parts of the Howey test are not satisfied because the tokens are sold for other purposes, they are very unlikely to fall under the definition of an investment contract.

FinHub lists an extensive list of characteristics, usually associated with virtual currencies (use for payment purposes) and utility tokens (e.g. a representation of a right to a good or service), thereby providing a good alternative to the State of Wyoming House Bill and Utility Token Act, that have set forth similar requirements a while ago on a state level.

Conclusion

In general, Framework for ‘Investment Contracts’ is not a game-changer for blockchain lawyers and businesses: it invokes provisions the market is already accustomed to.

However, detailing of the Framework undoubtedly places it among the best consultations on the legal nature of security tokens. In addition, it does not only take into account legal model of the token itself, but also the way it is marketed, which may in its turn help more companies stay compliant with securities legislation.

Since we have released our Security Token Offering Legal Handbook for Startups, two countries (the U.S. and Hong Kong) provided additional information on security tokens. And with undeniable benefits of issuing securities on blockchain, we should definitely expect more financial regulators to join them.

Be sure to check out our Legal Handbook to know more about Security Token Offerings regulation on a global scale, as well as 10 key takeaways from our discussion panel in Berlin to know about technical peculiarities of issuing security tokens compliant.

Disclaimer: the information in this article is provided for informational purposes only. You should not construe any such information as legal, tax, investment, trading, financial, or other advice.

Nik Kliapets

Legal Counsel at Legal Nodes

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