The most recent guidance published by the Securities and Exchange Commission (SEC) goes even further to reinforce the importance of the concept of the “investment contract” and the Howey Test when determining if a digital asset is a security.
The SEC relies heavily upon the Howey Test to determine if, in fact, an investment contract exists in digital assets such as an Initial Coin Offering (ICO). At the heart of Howey is the twofold question whether in the offering there has been an investment of money in a common enterprise and whether there is a reasonable expectation of profit from the efforts of others. If an offering is found to have met these criteria, then an investment contract is deemed to exist.
In its guidance, the SEC broke down its thoughts on its application of Howey to digital assets:
- The Investment of Money: this criterion is typically satisfied in an offer and sale of a digital asset because the asset is purchased or otherwise acquired in exchange for value, whether in the form of fiat currency, another digital asset, or other types of consideration;
- A Common Enterprise: the SEC notes that courts have found the existence of a common enterprise a “distinct element of an investment contract.” Most U.S. federal courts have defined this as a situation where individuals are found to have pooled their money with the goal of making an investment; and,
- A Reasonable Expectation of Profit from the Efforts of Others: The SEC noted that to meet this requirement, 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 through the efforts of a third party. The SEC defines the third party – whether they be a sponsor, promoter, or group of third parties – as Active Participants (AP). It’s important to note that price appreciation resulting solely from external market forces (such as inflation or economic trends) impacting the supply and demand for an underlying asset is not usually considered “profit” under Howey.
- In asking whether the purchaser is relying upon the others, questions raised by the SEC include: does the purchaser reasonably expect to rely upon the AP’s efforts? Are these efforts what the regulator terms “undeniably significant?” Does the AP further develop the digital asset as to enhance its value? Does the AP have a lead, central or managerial role? Does the AP have the ability through capital appreciation of the digital asset?
- In determining whether a reasonable expectation of profit exists, the SEC asks a number of questions, including: does the digital asset gives the holder rights to share in the enterprise’s income or profits or to realize a gain from capital appreciation of the digital asset? Is the asset tradable on a secondary market or platform? Is there a reasonable expectation that purchasers would expect the AP’s efforts to result in capital appreciation? Is the asset being offered broadly to purchasers rather than those who may have a need for it based on a strict network application?
In this guidance, besides Howey, the SEC notes that there are other considerations present when determining whether there is an investment contract present in a digital asset. Federal courts in the United States, will look to economic realities of the transaction when determining if a reasonable expectation of a profit exists. The regulator also notes that certain characteristics of a digital asset, such as the operational status of the distributed ledger network and/or digital asset, and whether the digital asset’s creation and structure is designed for strictly for its user needs rather than broader capital appreciation, can mean it is less likely that the Howey criteria will be met.
The Framework for “Investment Contract” Analysis of Digital Assets can be found on the website of the Securities and Exchange Commission.
For more information, please call Barbara Hendrickson at BAX Securities Law (416) 601 -1004.
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