On June 14th, 2018, at the Yahoo! Finance All Markets Summit, the SEC’s Director of the Corporate Finance Division, William Hinman, made a “speech heard ’round the world” — best known for its bombshell conclusion that Ether coin (or “ETH”, of the Ethereum blockchain network) should not be considered a security [1]. While this sort of speech is (surprisingly, to most) not an official pronouncement of the SEC [2], the blockchain world nonetheless breathed a sigh of relief, as the fate of a huge swathe of the sector could be in legal peril if present, day-to-day transactions involving Ether were deemed unlawful, and Director Hinman is the head of the SEC division responsible for making such determinations proactively. Direct to point, Hinman stated:
… putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions. And, as with Bitcoin, applying the disclosure regime of the federal securities laws to current transactions in Ether would seem to add little value. Over time, there may be other sufficiently decentralized networks and systems where regulating the tokens or coins that function on them as securities may not be required. And of course there will continue to be systems that rely on central actors whose efforts are a key to the success of the enterprise. In those cases, application of the securities laws protects the investors who purchase the tokens or coins.
That statement is pretty clear regarding Ether, and the market’s jubilation on that particular aspect is likely justified. Indeed, Hinman also stated:
… this also points the way to when a digital asset transaction may no longer represent a security offering. If the network on which the token or coin is to function is sufficiently decentralized – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts – the assets may not represent an investment contract. Moreover, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede. As a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful.
which fairly-directly addresses the separate, but related burning question of whether transition from a security (token) to non-security status is really possible — and does so in the affirmative.
However, look a little beyond the Ether-specific application of these remarks, and additional, thorny questions quickly arise.
For one, Hinman seems to hinge the Ethereum de facto determination on the fact that Ethereum is (now) “decentralized;” even generalizing this criterion, where he says “there may be other sufficiently decentralized networks and systems where regulating the tokens or coins that function on them as securities may not be required” and “where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts ,” and, conversely, that “systems that rely on central actors whose efforts are a key to the success of the enterprise” are protected by “application of the securities laws.”
These portions of Hinman’s remarks did not seem to stir many feathers in the blockchain nest, likely because the blockchain world is “all about” decentralization of social and entrepreneurial functions (preferably, as “disruptively” as possible).
However, from a securities law perspective, the remarks are somewhat unorthodox, because “decentralization” does not exist as concept in the existing main body of law. Now, new criteria are not entirely alarming when taking into account that so much about blockchain and ICOs is new, and intuition has it that the decentralization aspect should factor into the legal analysis somehow — but then the questions become: (1) is such a neologism really appropriate, and (2) if so, is it being delineated and applied correctly?
There are already hints of trouble in blockchain-land in attempting to make use of the “Hinman criteria” (as preliminarily sketched thus far) — i.e., cries have already gone up that “if Ether is not a security, shouldn’t Ripple also not be?”; or “if Ether is not a security because it is sufficiently-decentralized, shouldn’t Ripple, conversely, be a security, because it is not?”
And, more generally, what is sufficiently decentralized, anyways, for the purposes of “not being a security”?
These sorts of concerns in light of the state of extreme diversity of the blockchain ecosystem lead us to question whether the SEC might be headed down the wrong path if intending to weigh decentralization of blockchain tokens/coins qua securities in a manner embodied by Hinman‘s June 14th remarks.
Specifically, the expressed concern is the extent to which a centralized group or body is managing or controlling the network and its development, i.e., exerting “managerial or entrepreneurial efforts” that predominate over other activities in the network.
However, that is not what we take “managerial or entrepreneurial efforts” to mean in the broad body of securities law: it is evidently less of a determinative factor or characterization of the nature of the overall regulated-investment relationship than a dicta providing a broad qualitative descriptor of the sort of things promoters of a venture are doing when investors entrust capital with them to bring a venture to first fruition.
Indeed, the term “managerial or entrepreneurial efforts” didn’t appear in the touchstone SEC vs. W.J. Howey case (“Howey”) [3] — it actually appeared first in United Housing Found., Inc. v. Forman [4] (to be discussed below). In Howey, rather, the court stated (emphasis added):
Thus all the elements of a profit-seeking business venture are present here. The investors provide the capital and share in the earnings and profits; the promoters manage, control and operate the enterprise. It follows that the arrangements whereby the investors’ interests are made manifest involve investment contracts, regardless of the legal terminology in which such contracts are clothed. [5]
The first bolded passage parallels Hinman’s emphasis. However, it appears to us that the stress on “making the investor’s interests manifest” in the second bolded passage has been lost in Hinman’s focus on decentralization of the “management, control” and/or “operation.” I.e., it seems that a critical part of the investment contract-securities determination should be (and has always been) whether promises made to investors by contract have been made manifest. In other words, whether the initial, commercially-viable version of the project or enterprise has been delivered.
It is not clear how decentralization of management, control or operation has any relevance after this point: dozens of times a day, all of us make use of commercial services that are managed, controlled or operated by a single entity, without this arrangement constituting “a security” or otherwise invoking securities regulation (indeed, they aren’t even un-regulated — they are the purview of state consumer protection agencies and the Federal Trade Commission). Thus, it isn’t clear how simply recasting such relationships into “token form” could render them “investment contracts” for securities law purposes. At least, that outcome seems like it could not possibly be the desired result.
To illustrate the looming paradox here, consider other commonplace arrangements that do not strike one as (or are typically considered not to be) a regulated securities “investment contract” arrangement:
- A Microsoft Office 365 subscription (whereby continued access, ongoing updates, and cloud services are provided exclusively by one company, Microsoft);
- A subscription to any software-as-a-service (“SaaS”) delivered entirely by a cloud services company (with no decentralization);
- More conceptually, a coin-op (or internal credit-based) laundromat under service contract from the company that built it, financed originally by selling to investors pre-paid laundry “tokens” (or house credits) (A hypothetical scenario from SEC Chairman Clayton’s recent public remarks [6]).
In any of these scenarios, clearly, the arrangement prior to delivery of the initial commercial service is one of a regulated securities investment. But after first viability and public release of the service, it seems evident that this status should be reversed, and new, or even continued contracts, or the transaction of “tokens” or “house credits,” should be treated as commercial services sales in lieu of regulated securities issuances.
That proposition per se (i.e., evolving from security-investment to utility-purchase) seems significantly less controversial after Hinman’s remarks. But why, then, should it matter whether the provision of the commercial service is “decentralized” after that point? It is in none of the above examples.
We contend that the ultimate standard for deeming blockchain token sales to be regulated sales of securities should instead involve how decentralized the efforts of producing the initial commercially-viable version of the blockchain network (and associated services) are, with respect to those who invested by buying tokens. That is, the proper concern is whether those individuals are protected members of the investing public, or are instead sophisticated co-venturers (i.e., better associated with the venture/promoter group itself), and hence, are not protected as being on the “other side” of an investment contract which is subject to the “information asymmetries” Hinman mentions.
A further, (ostensibly) confounding aspect of the blockchain token-sale/ICO/utility token situation is that the arrangement may evolve from one of clear passive investment to one of direct use by the same original purchaser (indeed, in the blockchain case, often ultimately involving functional use of the actual instrument of sale itself, i.e. the blockchain token).
But, this situation of some fluidity between the two roles turns out to not be unprecedented in securities law and practice.
For example, SEC Notice 33-5347 [7] (which is actually cited by Hinman in his June 14th written remarks) deals with the question of when real-estate contracts are securities versus non-securities. This is germane to the present discussion because you can either profit from real estate (i.e., passively, with other parties managing the arrangement) , or live in it (i.e., glean utility), and the status of the sale contract (or lease) as a security depends on the details. Relevantly, Notice 33-5347 states (emphasis here):
If the condominiums are not offered and sold with emphasis on the economic benefits to the purchaser to be derived from the managerial efforts of others, and assuming that no plan to avoid the registration requirements of the Securities Act is involved, an owner of a condominium unit may, after purchasing his unit, enter into a non-pooled rental arrangement with an agent not designated or required to be used as a condition to the purchase, whether or not such agent is affiliated with the offeror, without causing a sale of a security to be involved in the sale of the unit. Further, a continuing affiliation between the developers or promoters of a project and the project by reason of maintenance arrangements does not make the unit a security. [8]
The first bolded segment supports the argument that a “consumptive” purpose in acquiring a token can override hallmarks of a (passive) investment contract (even if, as in this example, the contract’s “maturing” into a security was also a possibility), to end up with a “utility”-type transaction (here, the vending of real estate for direct use/enjoyment). So “going from security to utility” is not as legally “revolutionary” as might be assumed at first blush.
The second bolded segment harks back to a the marquee question raised by Hinman’s June 14th proposal (as discussed above), and seems to contradict it: here, a continuing “service-type” relationship — managed by the very promoters themselves — has no per se bearing on whether the original transaction contract was a security.
This brings us back to Forman. Hinman in fact cites Forman, for the proposition that whether a sale transaction is a securities-regulated investment contract hinges on the expectation of functional use by the purchasers (“Central to determining whether a security is being sold is how it is being sold and the reasonable expectations of purchasers. When someone buys a housing unit to live in, it is probably not a security.” [9]). Yet, let us trace further. The Forman Supreme Court, in interpreting and applying Howey, stated (emphasis added),
This test, in shorthand form, embodies the essential attributes that run through all of the Court’s decisions defining a security. The touchstone is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. By profits, the Court has meant either capital appreciation resulting from the development of the initial investment, as in Joiner, supra (sale of oil leases conditioned on promoters’ agreement to drill exploratory
well), or a participation in earnings resulting from the use of investors’ funds, as in Tcherepnin v. Knight, supra (dividends on the investment based on savings and loan association’s profits). [10]
This is where that handy phrase “entrepreneurial or managerial efforts” comes from. But notice how the court then bifurcates the application of this criteria into (a) capital appreciation from the development of the initial investment, or (b) participation in earnings. Nowhere present in this rubric is incidental capital appreciation, or any other forms of value gleaned from ongoing entrepreneurial or managerial (or any other sorts of) efforts by the contractual counterparties.
This is all in the context of a discussion of shares giving the right to use housing, i.e., a “utility versus security” discussion, and the above passage immediate precedes the Forman court’s more well-known rule (internal quotes and citations removed and emphasis added):
… when a purchaser is motivated by a desire to or consume the item purchased — to occupy the land or to develop it themselves — the securities laws do not apply. [11]
Immediately at the conclusion of the above passage, the court cites SEC Release No. 33-5347 (discussed above) as support, bringing this discussion neatly full-circle.
So it appears that when the SEC and Supreme Court together last looked at an analogous situation (i.e., a contract that can “mature” into either economic returns or direct “personal use”), they came to much the same conclusion that we have regarding decentralization vis-a-vis continued management/control/servicing. That is, the import of “the degree decentralized” of management has on the securities status of ongoing or even vested purchases is categorically limited; what matters far more is whether people are buying the instruments under a bargain whereby a separate group of promoters promises to turn the buyers’ principal into an ongoing economic return, or from an inchoate idea into a viable commercial product or service. We hope the SEC does not lose sight of that when advancing in this sector.
-AK
Citations
- William Hinman, “Digital Asset Transactions: When Howey Met Gary (Plastic),” Securities Exchange Commission, June 14, 2018 (hereinafter, “Hinman0618”), available at https://www.sec.gov/news/speech/speech-hinman-061418.
- I.e., the first footnote of of the written version of Hinman’s remarks reads: “The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author’s views and does not necessarily reflect those of the Commission, the Commissioners or other members of the staff”; id, Fn 1.
- SEC vs. W.J. Howey, 328 U.S. 293 (1946).
- Id. at at 300.
- United Housing Found., Inc. v. Forman, 421 U.S. 837 (1975).
- The SEC has posted no transcript or official written remarks of these speeches, but see, e.g., Nikhilesh De and Mahishan Gnanaseharan , “SEC Chief Touts Benefits of Crypto Regulation,” CoinDesk.com, Apr 5, 2018 , available at https://www.coindesk.com/sec-chief-not-icos-bad/; or Erin Arvedlund, “SEC chair Clayton promotes ‘harmonizing’ conflicting rules over brokers, advisors,” Philly.com, May 2, 2018, available at http://www.philly.com/philly/news/breaking/sec-chair-clayton-promotes-harmonizing-conflicting-rules-brokers-advisors-20180502.html.
- SEC Notice 33-5347, GUIDELINES AS TO THE APPLICABILITY QF THE FEDERAL SECURITIES LAWS TO OFFERS AND SALES OF CONDOMINIUMS OR UNITS IN A REAL ESTATE DEVELOPMENT, Jan. 4, 1973, available at https://www.sec.gov/rules/
interp/1973/33-5347.pdf. - Id at 4.
- Hinman0618, at citation of fn. 6.
- Forman at 852.
- Id. At 852-853.