After months of teasing, on April 3 staff of the Securities and Exchange Commission (“SEC”) issued a long-awaited Framework for “Investment Contract” Analysis of Digital Assets. The Framework provides further guidance under the SEC’s Howey test as to whether digital assets constitute securities under federal law.
The Framework focuses in particular on whether a digital asset leads to “reasonable expectation of profits derived from efforts of others.” This inquiry turns on whether a promoter, sponsor or other third party (each an “active participant” or “AP”) provides essential managerial efforts that affect the success of the enterprise.
In tackling the thorny problem of when a utility token ceases to be considered a security, the Framework provides a number of factors to analyze. Specifically, the Framework counsels that when reevaluating the status of a digital asset previously sold as a security at the time of later offers or sales, one should look to factors such as:
- Whether or not the efforts of an AP, including any successor AP, continue to be important to the value of an investment in the digital asset.
- Whether the network on which the digital asset is to function operates in such a manner that purchasers would no longer reasonably expect an AP to carry out essential managerial or entrepreneurial efforts.
- Whether the efforts of an AP are no longer affecting the enterprise’s success.
- Whether holders are then able to use the digital asset for its intended functionality, such as to acquire goods and services on or through the network or platform.
- Whether any economic benefit that may be derived from appreciation in the value of the digital asset is incidental to obtaining the right to use it for its intended functionality.
Other factors in the utility token analysis include:
- Purchasers of the digital asset no longer reasonably expect that continued development efforts of an AP will be a key factor for determining the value of the digital asset.
- The value of the digital asset has shown a direct and stable correlation to the value of the good or service for which it may be exchanged or redeemed.
- The trading volume for the digital asset corresponds to the level of demand for the good or service for which it may be exchanged or redeemed.
- No AP has access to material, non-public information or could otherwise be deemed to hold material inside information about the digital asset.
The Framework also lists a number of other factors to consider in determining whether a digital asset has a primarily consumptive purpose that is also likely to mitigate its status as a security. Examples cited include whether the distributed ledger network and digital asset are fully developed and operational, and whether holders of the digital asset are immediately able to use it for its intended functionality on the network. In a related action, the SEC staff issued a no-action letter concurring that tokens for prepaid on-demand air charter services were not securities for purposes of federal law, based largely on their consumptive purpose.