Important note: While I have read both of the releases discussed below in full, the following still represents a “first take”, and in any case, does not constitute legal advice.
Yesterday was a big day in blockchain legal news, as the SEC put out two releases (combined here) that arguably constitute the biggest advances in token-sale securities law policy since the DAO Report in 2017.
The two releases were a “Framework for ‘Investment Contract’ Analysis of Digital Assets” by the SEC’s new FinHub (providing a guide for determining if a proposed token sale is a security), and a no-action letter (NAL) granted to TurnKey Jet, Inc., for its sale of non-security tokens (i.e., “utility tokens”).
These releases do represent a major categorical step forward, as the SEC is showing it wants to “move the needle” in this area and be of use to entrepreneurs attempting to develop in the space, and because the SEC has not previously granted any blockchain-related no-action letter requests (and I am aware that many have been submitted since 2017). It is particularly good that the SEC is signaling that they will look at specific projects and give a “yes or no” regulatory coverage answer (presuming the request is formulated clearly and there aren’t too many unknowns, and of course, subject to the SEC’s workload).
However, when looking at the details, the degree of advancement is quite modest, as the substance of the releases doesn’t add much to the state of thinking of counsel working actively in the space (if my experience is typical).
Taking the two releases in turn, starting with the Framework:
1. The Digital Asset Framework
The framework represents an incremental step forward in the process of determining whether a token is a security in that it makes explicit various points mentioned in SEC staff speeches over the past 1-2 years, and considerations close followers in the industry had been hypothesizing about, but it’s not revolutionary. Mainly this is because, even while introducing some “new” useful factors to the analysis and formalizing some prior proposed ones, it introduces a lot of implicit uncertainty about the weighting of factors. Indeed, the FinHub staff explicitly disclaim any binding or specific aspect of the analysis (from footnote 1):
This framework represents the views of the Strategic Hub for Innovation and Financial Technology (“FinHub,” the “Staff,” or “we”) of the Securities and Exchange Commission (the “Commission”). It is not a rule, regulation, or statement of the Commission, and the Commission has neither approved nor disapproved its content.
and footnote 4:
It is not an exhaustive treatment of the legal and regulatory issues relevant to conducting an analysis of whether a product is a security, including an investment contract analysis with respect to digital assets generally. We expect that analysis concerning digital assets as securities may evolve over time as the digital asset market matures. Also, no one factor is necessarily dispositive as to whether or not an investment contract exists.
Thus, despite being the first “end-to-end” compilation of factors by the SEC, it is really still more a tool for it discussion and understanding the SEC’s thinking, rather than providing any sort of determinative yardstick, and thus raises almost as many questions as it answers.
That said, here’s a sample of some of the positive detail of the framework:
Although no one of the following characteristics of use or consumption is necessarily determinative, the stronger their presence, the less likely the Howey test is met:
The distributed ledger network and digital asset are fully developed and operational.
Holders of the digital asset are immediately able to use it for its intended functionality on the network, particularly where there are built-in incentives to encourage such use.
The digital assets’ creation and structure is designed and implemented to meet the needs of its users, rather than to feed speculation as to its value or development of its network. For example, the digital asset can only be used on the network and generally can be held or transferred only in amounts that correspond to a purchaser’s expected use.
Prospects for appreciation in the value of the digital asset are limited. For example, the design of the digital asset provides that its value will remain constant or even degrade over time, and, therefore, a reasonable purchaser would not be expected to hold the digital asset for extended periods as an investment.
Verbiage like that seems almost tailor-made for projects that have very carefully considered how to separate “utility” token sales from “security” aspects and roles, and to take proactive measures to limit unwanted speculative behavior towards tokens (as some of my clients have, including in discussions with the SEC).
A major thematic downside, in my view, was that the SEC reiterated repeatedly points such as that continued “development” of an blockchain network was a factor counting towards a security. I hope that gets clarified more, because a factor like this could be taken to effectively mandate that a blockchain digital service provider can’t keep improving their network/service offering in the usual course, which would place such efforts below standard non-blockchain enterprises.
Other mentioned factors of concern include (where “AP” means the project or associated persons):
The digital asset is transferable or traded on or through a secondary market or platform, or is expected to be in the future.
Purchasers reasonably would expect that an AP’s efforts will result in capital appreciation of the digital asset and therefore be able to earn a return on their purchase.
Purchasers would reasonably expect the AP to undertake efforts to promote its own interests and enhance the value of the network or digital asset, such as where […] AP retains a stake or interest in the digital asset. […] or the AP’s compensation is tied to the price of the digital asset in the secondary market.
These are very broad and open-ended, and the SEC did not make clear to what extent disclaimers might be adequate to dispel such expectations or notions of purchasers (as generally), or whether technical measures would be required, or whether it would require active preventative measures or outright prohibitions of related conduct or features to avoid any of these factors rendering a token sale a security.
An overriding legal concern is that — while it seems reasonable to introduce “new” legal factors in a sector as novel as blockchain — many of the SEC’s suggested factors are not traditional securities law analysis factors, and have little to no basis in statute or case law, so it’s not clear how well they will hold up (but for now, those that don’t plan on challenging them in court have to treat them with the same deference as traditional factors).
Of course, as the SEC said, no one factor is dispositive, but no weighting was provided — explicitly. This is the sort of lingering ambiguity that makes it clear that even with such a “Framework”, at this stage, token sellers will still be left with no option but to request a NAL in every single case of “utility” token sale.
Finally, here’s an example of a specific non-security token example given by the SEC in the Framework that is, in my view, quite a bit less helpful than at first glance:
… Digital assets with these types of use or consumption characteristics are less likely to be investment contracts. For example, take the case of an online retailer with a fully-developed operating business. The retailer creates a digital asset to be used by consumers to purchase products only on the retailer’s network, offers the digital asset for sale in exchange for real currency, and the digital asset is redeemable for products commensurately priced in that real currency. The retailer continues to market its products to its existing customer base, advertises its digital asset payment method as part of those efforts, and may “reward” customers with digital assets based on product purchases. Upon receipt of the digital asset, consumers immediately are able to purchase products on the network using the digital asset. The digital assets are not transferable; rather, consumers can only use them to purchase products from the retailer or sell them back to the retailer at a discount to the original purchase price. Under these facts, the digital asset would not be an investment contract.
This seems good at first blush, but all the SEC is doing here is describing an internal loyalty points system with blockchain factors stripped out. But not only does such eliminate most of the innovative elements we have questions about, this is answering a question that really wasn’t asked — which is “are loyalty points systems with no transfers permitted securities.” The operative question is more like: “to what extent can you add blockchain transferability to a consumer points system without the digital asset becoming a security?”
Unfortunately, until some of the avowedly-helpful factors that the SEC introduced and reiterated in this Framework receive something closer to a bright-line (or really any line) rule, most of the uncertainty in the space bearing on the “security vs. utility” question will remain (and even worse, the introduction of new factors to “watch out for” might have a chilling effect). That is because — as the guidance repeatedly makes clear — the final determination integrating all of the factors is just an overall balancing analysis. In other words, until there is more on-point legislation or judicial opinion, it is simply about the comfort level of the SEC. And that is not a terribly comfortable place for most entrepreneurs to be.
2. The TurnKey Jet NAL
It represents great progress that the SEC has now granted a NAL to a token seller — and even better that it is for a “utility” token.
However, it is my sense after going through the TurnKey Jet NAL request and response that it was actually a very limited-scope NAL. In essence, it just requests no enforcement action for a locked-in points platform that happens to be based on a blockchain instead of some other shared database technology (amongst the private network partners). True, it also has the attributes of (1) a 1-1 token “soft peg” to USD, and (2) a “secondary market” whereby users can resell tokens to each other on the platform, so it goes a little beyond most (but not all) proprietary consumer points systems. However, because the “lock-in” is rather extensive, namely:
- tokens cannot be removed from the private network’s wallets (to say nothing of being listed on 3rd party exchanges)
- tokens may only be re-purchased by the company at a discount
- tokens will correspond to literal USD balance on deposit
- token proceeds will not be used for any development or for general purposes (i.e., “overhead” or otherwise)
it’s not clear how much this advances regulatory clarity for a wide swathe of the utility token sector. Importantly, the SEC explicitly hit on all of the above limiting points in their NAL response, showing that they “cared” about them quite significantly.
Thus, I find this to be a “conservative” grant on the part of the SEC — they are doing little more than assenting to a closed consumer points system that happens to be implemented with blockchain. They arguably have to do that, because of the “economic reality” dictum of securities law. Still, such a conservative move as a first step on the NAL front is probably to be expected, and isn’t much of a surprise.
Indeed, the biggest point of substantive regulatory progress the NAL represents may be that it validates that something like a non-security “stablecoin” — at least in the utility token (rather than financial product) context — can be a non-security.
In sum, the SEC releases yesterday are more of a “small step” than “a giant leap”, which raise the question of what the next big foray of the SEC in the token space will be — and likely more immediately, what will become of Kik’s Wells Notice response and prospective litigation with the SEC. The latter will inevitably answer some of the factor-“dividing line” questions implicated by the releases and discussed above.