Category: Regulation

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The SEC’s New Tokenized Securities Venue Exemption: What it is… and Isn’t

On September 17, 2026, the SEC surprised the digital asset world by dropping Release No. 34-106402 (File No. 4-927), granting temporary, conditional exemptive relief that, for the first time, provides purpose-built regulatory treatment to on-chain trading venues for tokenized equities. Two exemptions come out of it: one from the definition of “exchange” in Section 3(a)(1) of the Securities Exchange Act (the “Exchange Act”) for what the release dubs a Tokenized Securities Venue (“TSV”), and a second from the definition of “dealer” in Section 3(a)(5) of the Exchange Act for certain liquidity providers into those venues (“Covered Firms”). Both run from September 17, 2026 through September 17, 2031, and both come with a long list of conditions.

This is a genuinely significant development, and I want to walk through what the SEC’s order actually says and does—before discussing how the scope—and therefore impact—of the order is significantly narrower than the breathless early headlines have suggested.

What the SEC Actually Did

The SEC set out to solve a problem (one of many in the “blockchain markets don’t fit traditional securities markets regulations” category). An automated market maker (“AMM”) from the crypto world—a smart contract that prices assets off the ratio of the two (or more) assets sitting in a liquidity pool—is functionally a trading venue. Under the Rule 3b-16(a) of the Exchange Act, something that brings together the orders of multiple buyers and sellers using “established, non-discretionary methods” is a securities exchange, full stop (“exchange,” as used by the SEC, and in this article, includes traditional national exchanges like NASDAQ and NYSE, as well as private alternative trading systems (“ATSes”)). And an AMM is nothing if not an established, non-discretionary method.  So just get your security token AMM registered as a securities exchange or ATS, right?

Wrong. The trouble is that an AMM cannot easily be an exchange in the Regulation NMS sense (“NMS” comes from “NMS security,” which essentially means securities that can be listed on traditionally-regulated securities exchanges). The SEC spells this out in the order explicitly: an AMM prices off internal pool ratios without reference to external quotations, so it can’t comply with the Rule 611 trade-through requirement; it has no member broker-dealers whose best bids and offers can be collected and attributed under Rule 602(a); and AMM pricing in six-to-eighteen decimal places doesn’t sit comfortably with the minimum pricing increments of Rule 612.  So, attempt to register an AMM as an exchange or ATS, and you’d have to break the system and introduce a slew of off-chain organizational bureaucracy for not purposes other than to comply with the rules written for a world where that bureaucracy was functionally necessary.

So rather than force the square peg into a round hold, the SEC (or the “Commission,” in this post) exempted the peg. A TSV meeting the conditions of the order is not an exchange for Exchange Act purposes, is not required to register under Section 5 or operate as an ATS under Regulation ATS, and—critically—is not a “trading center” or “market center”—so Regulation NMS simply does not reach it.

Under the new order, a TSV is defined as “an organization, association, or group of persons that brings together buyers and sellers of Tokenized NMS Stock” by (1) providing one or more AMM liquidity pools for permissioned participants to interact and agree to trade terms, and (2) setting the standards for who gets access. “Providing” is interpreted functionally: you provide a pool if you designate it as the venue for trading, deploy the AMM smart contract, set or alter pool parameters, set fees, or hold the ability to pause trading. Merely encoding a smart contract to whitelist a pool, as an administrative act, does not by itself make you a TSV.

“Tokenized NMS Stock” means an NMS stock tokenized either by or on behalf of the issuer, or by an unaffiliated third party. It expressly excludes synthetic exposure instruments—tokenized linked securities, tokenized security-based swaps—and excludes rights and warrants. Eligible trading pairs are limited to another Tokenized NMS Stock, a non-security crypto asset (a GENIUS Act payment stablecoin being the obvious case), or a tokenized money market fund, and any such paired asset must be directly paired with a Tokenized NMS Stock to be eligible at all.

The Conditions, in Brief

Here we discuss the main conditions imposed by the order to take advantage of its core exemption:

  1. Public, permissionless infrastructure. The TSV’s smart contracts must be auditable, public, and deployed on a public, permissionless distributed ledger—notwithstanding that the pool itself is permissioned. The Commission expressly notes a permissioned pool can live on a permissionless chain.
  2. U.S. person status, which pulls the venue into full OFAC compliance as a matter of law.  (So, you can’t run one of these offshore!)
  3. A 30-day advance public Notice, in plain English, on the venue’s website, prior to launch, with written notice to the Division of Trading and Markets within one business day, plus revised Notices on defined triggers.  The required contents of that Notice run to roughly thirty enumerated items—governance, permissioning criteria, tokenization processes, fees, off-chain functionality, conflicts, clearance arrangements, systems safeguards. (Additional notice triggers include: five business days for commencing/ceasing a symbol or receiving an issuer objection; twenty calendar days in advance of any material change; quarterly for non-material changes).
  4. Issuer notice and objection, discussed below.
  5. No primary issuance. No initial securities offerings are permitted on a TSV, and all offers and sales must still be registered or exempt under the Securities Act.
  6. Economic equivalence. The TSV must verify that the token confers the same rights and privileges as the underlying class—same economic interest, same dividends, same votes, same liquidation share. Where a third party did the tokenizing, that third party must distribute proxy materials and issuer communications at no cost to the issuer or the shareholders.
  7. Symbol and volume caps, keyed to the National Market System Plan to Address Extraordinary Market Volatility (“LULD Plan”) tiers. Tier 1 (S&P 500, Russell 1000, certain ETPs): 75 symbols, and no more than 0.25% of the prior month’s average daily share volume in each name. Tier 2 (everything else): 250 symbols and 2.5%. Affiliated TSVs aggregate. The first volume breach in a given name incurs no penalty; every one after that forces a three-month pause in that symbol.
  8. Transaction transparency. USD-denominated, machine-readable, freely public trade data—symbol, price, size, time, direction—updated within ten minutes and covering a rolling thirty days, plus pool address, daily pair volume, and end-of-day pool size.
  9. Halt concurrency. Trading stops when the primary listing exchange stops, with immediate participant notice.
  10. No leverage. No borrowing, no hypothecation, no extension of credit to buy on the venue.
  11. No claiming registration or approval, plus an affirmative disclaimer that the venue is not registered.
  12. Books and records kept in the United States, preserved for three years after the relief ends, produced promptly in human-readable and reasonably usable electronic form, with standing consent to Commission examination at any time.

And a final overriding condition on all of it: no one subject to statutory disqualification under Section 3(a)(39) (i.e., the Exchange Act “bad actor” provisions for securities intermediaries) can rely on the exemption, absent SRO or Commission permission.

The Covered Firm Exemption

The second exemption is the quieter, and in some way, the more interesting one. Liquidity providers who commit proprietary capital to an AMM pool are, the Commission says, ordinarily traders rather than dealers. But the moment an LP starts quoting prices to customers, or enters into a committed-capital arrangement with the venue, the dealer/trader line gets uncomfortably blurry—and Section 15(a)(1) is not a statute you want to be guessing about.

So the Commission exempted them, conditionally: proprietary trading only, no customer assets held or custodied, activity confined to pools operating under the TSV Exemption, records of liquid assets and of every liquidity-provision agreement and incentive arrangement, public disclosure of non-registration and of the compensation arrangements, and a notification filing with the Commission. Same statutory-disqualification bar (extended to affiliates), same five-year clock.

Notably, the Commission says the plumbing justifies it: without committed liquidity, “the automated pricing and execution mechanisms of AMMs related to AMM Liquidity Pools cannot operate as designed.” That is a regulator reasoning from granular market structure rather than from category labels, which is very encouraging to see.

What This Exemption Is Not

Here is where I have to throw some cold water on things, because digital asset markets participants who aren’t securities law experts are likely to over-extrapolate from the headlines:

It is not relief for private or early-stage security tokens. This is the big one. The relief is scoped to NMS stock (defined earlier).  This is not simply any security; it is traditionally-listed equities and certain ETPs. Your seed-stage cap table, your real estate-backed RWA token, your crypto project token that is deemed to be a security under a Howey + SEC guidance analysis, your tokenized Reg D or Reg A+ offering, your tokenized LLC units—none of it is Tokenized NMS Stock, and none of it can trade on a TSV.  In other words, no new secondary market access.

But for good measure, the order closes the door from the other side too: no primary issuance; i.e., no initial security token offerings, and no relief from Securities Act registration for any offer or sale whatever.

Startups and community-centric projects therefore get nothing directly usable from this order—not for their own token issuance, and not in the form of a venue where their tokens could trade. The secondary-trading problem for unlisted security tokens, which has been the single biggest practical obstacle in this space for the better part of a decade, remains exactly where it was: ATS registration, Regulation CrowdFunding or a Reg A+ structure with a broker-dealer, or nothing.

It is not carte blanche even for qualifying securities. This deserves emphasis, because the phrase “tokenized stock is now legal to trade” is going to get said a lot, and it isn’t quite right. Where a Tokenized NMS Stock was created by a third party unaffiliated with the issuer—which is the entire wrapper/depositary-style model—the TSV must give the issuer written Issuer Notice, delivered to the principal executive offices listed on the issuer’s Exchange Act cover page, and cannot begin trading for at least 30 calendar days. But, as discussed above, the issuer can object, and that’s the end of that. 

To be sure: this is a notice-and-veto mechanism, not affirmative consent. An issuer that does nothing for 30 days is deemed to have not objected, and trading may proceed. But the practical effect is the same—the issuer holds the power.  Nevertheless, there’s a very real possibility that NMS stock issuers will generally object – except in situations where they are in control, or at least receiving a cut of the action. Anyone modeling a third-party tokenization venue should assume that a meaningful slice of the S&P 500 will say “no,”— and should assume that at least a few will say no loudly.

Layer on the per-name economics and the picture sharpens further. On the Commission’s own 2025 figures—a weighted daily average of roughly 3.0 million shares for Tier 1 names and 1.2 million for Tier 2—a 0.25% Tier 1 cap works out to something on the order of seven thousand shares a day in a typical large-cap name, and 2.5% of Tier 2 to roughly thirty thousand. That is a pilot program, not a market. Which, to be fair, is exactly what the SEC says this exemption is.

It is not a registration, a license, or an endorsement. A TSV operates outside the exchange framework, which means no fair-access obligation and—as the mandated disclaimer must state outright—no Commission review of access denials. The venue can exclude whomever it likes. Anti-fraud and anti-manipulation liability under Section 10(b) and Rule 10b-5 is entirely untouched, as are the Investment Company Act, the Securities Act, and every participant’s own registration and AML/CFT obligations. A broker-dealer trading on a TSV is still a broker-dealer with all that entails; the order says flatly that it “does not apply to nor address the regulatory or registration status of securities activities performed by TSV Participants.” And a registrant that wants to run a TSV must keep the TSV operation separate from its registered activity.

And finally, it is not permanent. The order provides an exemption lasting five years, expressly framed as an interim measure while the Commission considers rulemaking, and expressly modifiable under Section 36 at any time.

Why It Still Matters

Despite the caveats, this is encouraging progress. Look at what the SEC conceded, which is actually quite a lot: that a smart contract can be the venue; that an AMM’s continuous, auditable, on-chain transparency can substitute for—not merely coexist with—pieces of the Regulation NMS apparatus; that self-custody, around-the-clock trading, fractional shares, and near-instantaneous settlement are benefits worth writing an exemption to support; and that liquidity provision into a pool is presumptively trading rather than dealing. That last point, in particular, is a conceptual win that reaches well beyond this order.

More to the point for anyone in the private-markets side of this business: the Commission has explicitly put expansion on the table. Comment question 4 asks, in so many words, whether the TSV Exemption “should be modified to permit a TSV to trade securities other than Tokenized NMS Stock,” and if so, which types. That is not a throw-away. It is the Commission telling the market where the next expansion could be, and inviting it. Question 2 asks whether the relief should be made permanent.

It is, to be sure, a bit deflating for the rest of the security token world that this order does nothing for them directly, seemingly opening the barn door to the large, established players to run out and occupy the field first.  But the SEC starting with the most liquid, most disclosed, most surveilled securities in the market is a rational, stepwise rollout strategy. NMS stock is the “easy case” in many ways: there is a definitive public price to reference, a listing exchange to halt in coordination with, and an Exchange Act reporting regime already supplying the underlying disclosure. If the market can “prove the plumbing” there and generate a few years of transaction data the Commission can examine to gain trust, the argument for extending some version of this to security tokens generally gets a great deal easier to make. The harder questions for private securities—who does the transfer-agent function (is it even needed?), what substitutes for a listing exchange halt, what disclosure baseline applies—are more like engineering questions now, rather than regulatory “blockers.”

What to Do Next

If you are building anything in this space: read the Notice requirements in Section III of the order before you read anything else, because that thirty-item disclosure schedule is the actual compliance burden, and it will shape your architecture more than the exemption itself will.

If you are an issuer of a listed security: someone at your company should decide, in advance and on purpose, what you do when an Issuer Notice shows up. You will have 30 days, and doing nothing is a decision.

And if you are on the digital assets startup or general private-markets side, watching this and feeling left out—comment! File Number 4-927, open on the Commission’s comment page, and question 4 is addressed to you specifically. This SEC has proven that it is listening.

And of course, if you have questions regarding any of the above, or want to discuss your plans with digital assets legal counsel, reach out to us for a chat.

This article is commentary, not legal advice.

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DFS Crypto “Coin Listing” Proposal Represents A Dramatic Expansion of the NY BitLicense

The comments below are in response to the New York DFS’s new proposed Coin Listing Policy Framework (the “Proposal” or the “Framework”) extension to the DFS Part 200 (the “BitLicense”) regulation, released on 12/11/2019 (available here. The DFS has provided only until January 27, 2020 to get comments in to innovation@dfs.ny.gov, so please read the Proposal and this post, and send them your thoughts ASAP).  The proposal consists, in main, of two prongs:

  1. A provision for DFS “listed” coins which will automatically be permitted to be used by BitLicense grantees (“Licensees”).
  2. A provision for self-certification of coins by Licensees which aren’t permitted under prong 1.

Little detail has been provided at this point, so the below comments reflect on the apparent main concepts of the Proposal, as well as interpret its general contextual and explanatory language.

As a reminder, the scope of the BitLicense is coverage only of those engaged in a “virtual currency customer business,” and so, the Proposal would apparently not effect either (a) non-business or (b) non-customer uses of cryptocurrencies (however, it’s worth noting that both limiting concepts could use more clarity in the context of the BitLicense).

  1. Issues with The First Prong.

The first (and main) prong of the Proposal uses the foundational language “list of all coins that are permitted for the Virtual Currency Business Activities of the VC licensees, without the prior approval of DFS.”

However, neither the BitLicense regulation itself nor the language of the Proposal makes it clear whether it will be permitted to utilize coins which aren’t expressly approved by the DFS (or aren’t approved under Prong 2: self-certification).  The alternative interpretation would be that of a “safe habor”: i.e., under which a Licensee could make use of non-approved coins in business, but would potentially receive less regulatory deference for them (or face some statutory limits under the safe harbor; e.g., limits in manner of use, type of customer, or scale).

My belief is that, on the wording of the Proposal, the DFS does intend to entirely prohibit dealings by Licensees in coins not approved under Prong 1 or Prong 2, rather than to create a new safe harbor.

If true, this would be striking, because it would represent a whole new dimension of the BitLicense: a ban on individual (non-approved) coins.  This requirement (which seems material to the BitLicense as a whole) is not spelled out in Part 200, nor, even, in the language of the BitLicense application materials (i.e., the language of the forms – which may typically go beyond the letter of the law, albeit, in a less-binding and more guidance-like capacity).

It appears, then, that ad hoc interactions between Licensees and the DFS regarding permissiveness of activities with respect to specific coins (by understandably-cautious regulated crypto financial companies) has been taken “to the next level” in a regulatory sense with this proposal.

The confusion is compounded by the use of the term “listing” in almost every place in the Proposal –except the one sentence quoted above, which seems to contemplate any type of virtual currency business activity.  The BitLicense itself does not define “listing”.  Thus, it is not clear if the Proposal is intended to encompass public listing activities of Licensees (i.e., by exchanges, such as Coinbase), or any dealings in coins (e.g., private custodial holdings,  private trading, payment processing, participating in a “utility token” ecosystem, etc.).

I believe this apparent quantum leap in the scope of the BitLicense deserves more public attention and scrutiny than it has thus far received.

To illustrate the impact of the regulatory shift, imagine you are a well-meaning crypto project starting up outside the U.S. — let’s say, Estonia.  You “do everything right” in terms of your project team, governance, and financing — and may explicitly follow applicable cryptocurrency or other regulations in your home country of Estonia, as well as potentially on cryptocurrency exchanges in other countries (which may themselves be licensed and have an explicit regulatory status — e.g., as Gibraltar provides).  You may even have what is on it’s face a “security token” – or choose to treat your coin as such, for regulatory certainty.

However, none of that “good citizenship” will result in your coin being listable – or perhaps even commercially-usable (i.e., in a custodial arrangement) by New York BitLicense holders.  This will simply not be possible unless your coin or token is explicitly permitted under the Proposal – either under Prong 1 (DFS listing), or more likely, Prong 2: Licensee self-certification of the coin.

And despite  the availability of Prong 2,   getting certified under it is one-off process, company by company (discussed further in the next section).  There are not a lot of parallels to this situation.  It would be as if every non-public stock had to be re-certified by every broker-dealer or exchange that wished to deal in it – and mind you, many of these crypto tokens will be regulatory securities, just like stocks.  This new Proposal, then, would represent a redundant layer of regulation for such instruments.

As for mainly “unit of exchange” crypto coins, these are more like currencies in view of the forex sector (which counts as its participants banks, speculative trading houses, and forex brokers).  Yet, none of the regulated players in the forex space are required to get approval for every single currency they deal in.

Note that, in both the cases of stocks and foreign currencies, the traded instruments may very well “implode”, despite all assurances, and best hopes. They also might suffer from varying levels of money laundering risk (something explicitly cited as a review factor in the Proposal with respect to crypto coins). But one of the core functions of the market is to “price risk” with respect to all manner of bad outcomes, including that fraud, insolvency, or some other form of risk (i.e., cybersecurity) might lurk within an instrument.

Thus, it is far from clear that a more restrictive, crypto coin-specific regime is appropriate – and such might even hinder the market in its risk-pricing function (which is also a risk-surfacing and mitigating function).

RECOMMENDATIONS:

  • Clarify the permissiveness of non-approved coins under the BitLicense (under either prong of the Proposal)
  • Create (or clarify) a safe harbor for one or both prongs (preferably covering both).
  • Clarify whether the coin use restriction is with respective to public trading listings, or any “virtual currency business” use of a coin.
  • Limit the coin use restriction to public trading listings, or at least, tailor the safe harbor in a manner respecting “public vs. private” use (one might follow securities exemptions/safe harbors in this respect – and for similar reasons).
  • Clarify which factors would trigger the DFS to even review a coin for the general list in the first place, and if under consideration, what the criteria would be (presumably, all the company self-certification criteria, plus some additional ones).
  • Exempt coins which are securities in entirety (with a foreign reciprocation regime).
  • Exempt coins which have any regulated status under any qualifying foreign recognized regulatory regime.
  • Require the DFS to consider coins for listing by any paying applicant, fully subject to administrative and judicial review (just as with the BitLicense itself).
  1. Second Prong Issues

The second set of issues I see is with Prong 2 in specific.  This is the self-certification provision.  The DFS has suggested numerous factors to be examined in a self-certification framework.  Though the factors mentioned are not definitive, at least the DFS plans to release a “model” framework, and certainly, having this means of  coin  approval at all somewhat counterbalances the “bottleneck” that would exist if requiring DFS approval for every single coin.  We can naturally expect that this will be the go-to provision for newer coins that haven’t yet garnered universal attention or acceptance, and therefore would not be under consideration for general listing under Prong 1.

However, the effectiveness of this prong seems limited by its “one-off” status.  I.e., a Licensee that self-certifies a coin hasn’t done anything to make that coin usable by any other Licensee.  So, each Licensee will have to “reinvent the wheel” in onboarding a new coin.

Or, alternatively, the onus will be on the progenitor of the coin to advocate for its self-certification by individual New York Licensees.  It’s not clear why our Estonian (or any other foreign token-issuing) venture should have to be this concerned with individual companies in New York — particularly if they have followed all local  regulations and those of major crypto-coin trading venues.  In a sense, it’s a sort of “non-fungibility” rule for crypto assets that (almost by definition) doesn’t really exist in the broader financial sector — or in a free market property system, for that matter (imagine, e.g., pawn brokers not only having to themselves be licensed, but being required to “certify” every single type of asset they took in).

From the perspective of our Estonian applicant, it’s probably not worth the effort to shepherd their coin through possibly dozens of prospective Licensees.  This will provide a competitive disadvantage to smaller or upstart projects, which will inevitably make New York less competitive.

RECOMMENDATIONS:

  • Make the Prong 2 prohibition a safe harbor (again).
  • Allow self-regulatory organizations to approve coins (this will presumably require some approval process in turn for the SRO – however, crypto SROs are indeed now in existence, such as the Association for Digital Asset Markets,  or ADAM).

III.  General Issues and Comments

  • Non-licensees who can still deal in crypto without a BitLicense under the DFS regulation; e.g., banks.  Apparently, these entities will have a unique advantage under this regime, as it appears they will not have to get coin-specific certifications.

    RECOMMENDATION: Clarify this (and preferably, do not establish this kind of differential treatment).

  • Regulatory Phase-ins. The BitLicense generally has no initial coverage threshold or “phase-in,” i.e., for small businesses or startups.  I view this as one of the most damaging shortcomings of the BitLicense broadly (and know of numerous clients and prospects who have avoided or pulled out of New York entirely because of it).  This has clearly created a preference for larger companies to deal in crypto in New York, and dramatically limited the choices of New York consumers and business.  Now, with coin-specific qualification, the lack of BitLicense phase-ins will be even more damaging.

    RECOMMENDATION: Allow businesses – subject to reasonable phase-in parameters (i.e., such as number of customers or revenue) – to be excluded from the BitLicense entirely, or subject to a general safe harbor.  Coincidentally, one doesn’t need to look far to find reasonably-tailored regulation in this sense effectively covering crypto companies in New York: the New York SHIELD privacy and data security law, which goes into effect in 2020 (indeed, most privacy and data security laws in the U.S. and worldwide phase-in thusly, so they don’t apply from dollar (or customer) number 1, and which would badly squelch commerce and innovation.  And arguably, crypto should have even more generous phase-ins, as most crypto clients make an affirmative choice and “know what they are getting themselves into” — unlike consumers generally using digital services).

  1. CONCLUSION

I am a big fan of the increased securing and professionalization of the crypto sector, of which government regulation is a major (though not the only) part. However, the Proposal, and the BitLicense generally, could use significant fine-tuning to make it more friendly to innovation, including small businesses and startups.  Until this is done, I believe New York is missing out on playing a larger and more constructive role in this important new sector, and this new coin-permitting Proposal (as initially-posed) will make the situation worse rather than better.

 

 

 

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“Decentralized” No More — SEC Drops Proposed Blockchain Test?

Another takeaway of mine from the SEC’s April 3rd releases was noting a striking shift in gears from the SEC.  Namely, there was a conspicuous lack of emphasis on the “degree of decentralization” of blockchain token-issuers as applied to the security-vs-utility analysis of their tokens (I didn’t mention this in my earlier post, to keep it as short as possible).   Despite a focus all through 2018 on decentralization by top SEC officials, “decentralization” was only mentioned once in the SEC’s 4/3 “Digital Asset Framework” — and then only as a secondary factor, barely in passing.

Recall that SEC Director Hinman had proffered an overriding decentralization-based test and elaborated sub-factors related to it in a major June, 2018 speech (in which he famously expressed the view that Ethereum was no longer a security).    Then at Consensus Invest on November 27, 2018, SEC Chair Jay Clayton underscored these factors, using an analogy of tickets sold to Broadway plays as being securities before a show first opens, but not afterwards — because at that point “the situation becomes decentralized” (I was in the audience, among those scratching my head upon hearing this).

“Decentralized Broadway shows” no more, these considerations seem to have now taken a back seat.  (And indeed, what Clayton seems to have really been getting at with the Broadway example was that, after opening, the value of tickets sold is no longer speculative).

I think this is a good turn, despite how compelling the possibilities for decentralization that blockchain enables are.  As I’ve commented before, the element of decentralization isn’t a traditional securities factor, nor does it “map” directly to any of them; thus, to the extent it is relevant, it makes more sense for it to take a secondary role in the overall analysis.

What may be going on here is the SEC recognizing that, to the extent a token-issuing project is (or becomes) little more than open source software (with a similarly open blockchain network or networks), it is clearly not within traditional securities purview.  However, to the extent a project more resembles a speculative enterprise, for which the ultimate “test” is success or failure on business merits and acumen, a more conventional analysis applies.  And such a conventional analysis wouldn’t have much to do with how “decentralized” the project or the promoter group are.

This de facto bifurcation in the analysis is visible not only in the SEC’s “Digital Asset Framework”, but in the TurnKey Jey no-action letter granted on the same day.

TurnKey Jet was operating a tokenomics-based platform that was avowedly not decentralized — TurnKey specifically referenced how it would closely manage and control the platform, only allowing certain commercial partners to participate privately (and in that, even citing antitrust concerns — as if it didn’t truly want to have any partners at all!).

The SEC granted TurnKey’s request to issue tokens without being subject to enforcement, even though it was the exact opposite of decentralized in most respects, because of controls and limitations going to more traditional securities factors (i.e., TurnKey is a completely “closed” platform on a private blockchain, with no ability to “remove” tokens, and no use of token sale proceeds for general development).

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Initial Impressions On The SEC’s Big “Digital Asset Framework” and Token No-Action Letter Releases

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.

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House Financial Services – Monetary Policy and Trade Subcommittee Hearing (7/18/18): “The Future of Money: Digital Currency”

Below is a rough auto-transcript of a hearing held last week entitled “The Future of Money: Digital Currency” (video available at previous link).

The witnesses were:

  • Dr. Rodney J. Garratt, Maxwell C. and Mary Pellish Chair, Professor of Economics, University of California Santa Barbara
  • Dr. Norbert J. Michel, Director, Center for Data Analysis, The Heritage Foundation
  • Dr. Eswar S. Prasad, Nandlal P. Tolani Senior Professor of Trade Policy, Cornell University
  • Mr. Alex J. Pollock, Distinguished Senior Fellow, R Street Institute

We have not yet gone through the hearing record exhaustively and produced a selection of “pull quotes” of interest. However, the transcript with links to the hearing video is reproduced here anyway, as it might be useful to some.  (Watch this space for further excerpts and comments, once we analyze the record fully).

TRANSCRIPT GUIDE  AND ADVISORY:

  • The transcript was produced by a text-to-speech process performed automatically by a third party service outside of our control.
  • KrowneLaw does not vouch for its accuracy; indeed, we guarantee it is inaccurate.
  • As such, each snippet of translated text is linked directly to the point in the video at which it occurs (popup in separate window/tab).   Please use this functionality to confirm exactly what was said in each case.
  • The hearing may cover a wide variety of topics; thus, cryptocurrency/blockchain-related terms have been highlighted to assist in quick location of the relevant passages (this highlighting is by no means exhaustive, however).
  • The breaks in the text coincide roughly with changes in topic/changes in Congressperson leading the questioning.  They do not correspond to changes in speaker; thus, each block usually represents multiple speakers, including those on “opposing sides.”  You must listen to each particular segment in the video to determine who is speaking and to get the full context (and therefore, meaning).

Scroll box with transcript follows:

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House Agricultural Committee Hearing (7/18/18): “Cryptocurrencies: Oversight of New Assets in the Digital Age”

Below is a rough auto-transcript of a hearing held last week entitled “Cryptocurrencies: Oversight of New Assets in the Digital Age” (video available at link).

The witnesses were:

  • Mr. Joshua Fairfield, William Donald Bain Family Professor of Law, Washington and Lee University School of Law, Staunton, VA
  • Ms. Amber Baldet, Co-Founder and CEO, Clovyr, New York, NY
  • Mr. Scott Kupor, Managing Partner, Andreessen Horowitz, Menlo Park, CA
  • Mr. Daniel Gorfine, Director, LabCFTC and Chief Innovation Officer, CFTC, Washington, DC
  • The Honorable Gary Gensler, Senior Lecturer, MIT Sloan School of Management, Brooklandville, MD
  • Mr. Lowell Ness, Managing Partner, Perkins Coie LLP, Palo Alto, CA

Here are a few “pull quotes” and exchanges of interest (this is by no means exhaustive):

    • Rep. Soto (@1:42:08): “I’m more concerned though about being able to avoid money laundering for terrorism, drug trafficking, human trafficking, tax evasion — so I’d love to hear from each of you in one sentence on what we could do to stop money laundering and having Bitcoin and other cryptocurrencies be the choice of terrorists, drug traffickers, and those evading taxes.”

      Mr. Fairfield: “Trust FinCEN to do their job.”

      Ms. Baldet: “Rely on other law enforcement mechanisms that work around strong cryptography — we do not weaken roads to add potholes to them.”

      Mr. Kupor: “Bitcoin is actually the worst tool to money launderer because every transaction is registered and fully recordable so it’s actually law enforcement’s best friend”.

      Mr. Gorfine: “While the technology can be peer-to-peer, most activity takes place through a new type of intermediary where you can apply AML and KYC rules.”

      Mr. Gensler: “On top of that, rigorously require crypto exchanges to register — and you may need to pass a law to do that — but to make sure they register and that all the AML, anti-money laundering and know-your-customer is being done there.”

      Mr. Ness: “The alleged Russian hackers were caught because they used Bitcoin.”

    • Rep. Faso (@1:45:01): “I’m wondering if for the benefit of our viewers at home across the country who are watching this hearing and are trying to understand the impact of the crypto currencies and what the future holds if if perhaps miss Baldet and Mr. Kupor could tell us where you think from a five to ten year view point where this is going to be the role that these currencies are going to have in our economy and how might this affect average consumers — right now it’s the market participants are mostly very sophisticated people do you see this insinuating itself into the broader economy?”

      Mr. Kupor: “Thank you yes so we believe that this really is gonna create a whole new set of of infrastructure on which all kinds of new applications are going to be built — some which we may not even know about today. So if you think about all the benefits we’ve reaped from you know Facebook and Google and all the kind of you know internet properties have been built today.”

      Rep. Faso: “… and negatives …”

      Mr. Kupor: “… and negatives — I think what the beauty of this technology is is it gives us a new set of platforms and again very critically those platforms are not controlled or governed by centralized corporations; they’re controlled and governed by community, and so you can imagine all the utility that we have today but where the consumer actually has ownership of data the consumer has the ability to actually ensure that data is shared in a manner in which they want to be shared and the consumer also can capture the economic rents from use of that data; so we think the opportunity in that respect is endless.”

    • Rep. LaMalfa (@1:51:30): “Would you touch upon what what would look like if that token is determined to be a security?…”

      Mr. Ness: “Yeah I think the issue really comes down to friction and while we can get to a status of free trading securities by registering them, even when you do get to that status there are all sorts of ancillary friction[s] in and around the transfer of a security — you need to have broker dealers involved, and you need to have suitability requirements met and other potential disclosure issues and so forth that are ongoing; and so when we’re talking about trying to create the next generation of decentralized protocol layer kind of apps on top that are all interoperably-interacting with each other and transferring value at the speed of software to deliver a service to a consumer — it may it may be all transparent to the consumer that this is all happening under the hood –but you can’t have fundamentally the transfer of value at the speed of software if it’s a security.

      Rep. LaMalfa: “Please touch on the importance of increasing the access to the speediness of those types of trans transactions — why is that important?

      Mr. Ness: “Well I mean, to get a little philosophical I suppose I mean you know ledger technology is fundamental to Commerce, right, and double-entry accounting was an amazing innovation and ledger technology that, you know, pulled Europe out of the … Dark Ages, and the same thing can happen in in in a amazingly more robust way when we start to literally not just allow parties to trust each other through standard mechanisms of reconciliation, but when we remove the reconciliation or the need for it all together… and that is simply a philosophical point of view I suppose but it goes to this issue that we’re at early stages of this, we don’t know where it’s gonna, go but speed is probably a good thing.

      Mr. Gensler: “Could I just say I’m an optimist I agree with what mr. Ness says, but maybe it’s the MIT in me now, I think that the beneficial ownerships will be able to be tracked in a matter of milliseconds and nanoseconds — not yet, it might take five years — but we’ll get there; technology’s pretty neat how it grows and helps us.”

    • Rep. Davis (@2:01:54): “I want to ask you a quick question sir; based on the way current law is written, it’s not cut and dry whether cryptocurrency should be regulated by the SEC or the CFTC.  If Congress attempts to come up with a workable definition for cryptocurrencies that are more similar to commodities — you know call them as we’ve heard blockchain commodities — what should we be looking at to guide us?”

      Mr. Gorfine: “You know I the one thing I would say is that — and I mentioned this in my opening statement — that it’s important that we’re not hasty in terms of figuring out what the right contours are of applying… securities laws and then the the commodities framework. I do think that the SEC has in due course been providing additional clarity — there was recently Mr. Hinman over at the SEC, gave a well-received speech kind of outlining some of the SEC’s thinking as to how they would apply the securities law framework — and some of the things that I think you’ve heard are factors around decentralization, you know are their expectations of return based on meaningful work of others… Rhese are important elements that — of course are not you know I’m not saying that these are the only elements — but these are some of the things that you start to look at in terms of figuring out well when does it make sense to be applying the securities laws framework that includes things like required disclosures, it requires regulations around you know the offering of securities, and the intermediaries involved in securities, and when does that perhaps not fit the product. So I think that this discussion is ongoing, and I think that in due course, and being thoughtful you’re starting to see additional clarity and uncertainty coming out. But certainly those are some of the factors that we’ve we’ve heard talked about a fair amount.”
      …
      Ms. Baldet: “To tag on to kind of the last question but also the the concern about regulatory framework, you know what I was mentioning is about a need for clarity more so than the, not so much the bright lines that we’re talking about with security versus commodity, as much as more interest in safe harbors for innovators; especially because we’re seeing the market adapt to this in that new disruptors are at an advantage versus incumbent institutions who are waiting for regulatory clarity to engage. And so in a way, in the absence of that, it’s not it’s not necessarily that incumbents are incapable of innovating or they don’t understand the technology, but they have to take a sidelines approach because they have traditional businesses to lose.”
      …
      Rep. Davis: “Well thank you… We want to make sure that we devise a regulatory structure that allows this industry to continue to grow, but allows to us to address many of the law enforcement problems that have been brought up here by many of my colleagues — so I can’t wait to continue to work with you; thanks for your time.”

Again, we have not yet gone through the hearing record exhaustively. However, the transcript with links to the hearing video is reproduced here anyway, as it might be useful to some.  (Watch this space for further excerpts and comments, once we analyze the record fully).

TRANSCRIPT GUIDE  AND ADVISORY:

  • The transcript was produced by a text-to-speech process performed automatically by a third party service outside of our control.
  • KrowneLaw does not vouch for its accuracy; indeed, we guarantee it is inaccurate.
  • As such, each snippet of translated text is linked directly to the point in the video at which it occurs (popup in separate window/tab).   Please use this functionality to confirm exactly what was said in each case.
  • The hearing may cover a wide variety of topics; thus, cryptocurrency/blockchain-related terms have been highlighted to assist in quick location of the relevant passages (this highlighting is by no means exhaustive, however).
  • The breaks in the text coincide roughly with changes in topic/changes in Congressperson leading the questioning.  They do not correspond to changes in speaker; thus, each block usually represents multiple speakers, including those on “opposing sides.”  You must listen to each particular segment in the video to determine who is speaking and to get the full context (and therefore, meaning).

Scroll box with full transcript follows:

Posted on

Doubts Emerge Regarding SEC Director Hinman’s “Decentralization” Token Security-Criteria

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

  1. 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.
  2. 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.
  3. SEC vs. W.J. Howey,  328 U.S. 293 (1946).
  4. Id. at at 300.
  5. United Housing Found., Inc. v. Forman, 421 U.S. 837 (1975).
  6. 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.
  7. 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.
  8. Id at 4.
  9. Hinman0618, at citation of fn. 6.
  10. Forman at 852.
  11. Id. At 852-853.
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House Financial Services Subcommittee Hearing: Cryptocurrencies and Illicit Financing (6/20/18)

Below is a rough auto-transcript of a hearing held yesterday entitled “Illicit Use of Virtual Currency and the Law Enforcement Response”.  The House Financial Services Subcommittee had officials from USCIS (ICE), FinCEN (Treasury) and the Secret Service on the stand, ostensibly to testify on the above-titled topic.  However, due to the contemporaneous border family separation debacle, a large portion of the hearing was pre-empted by this issue, so virtual currencies did not get the full treatment originally expected.   Nevertheless, the transcript with links to the hearing video is reproduced anyway, as it might be useful to some.  (Watch this space for further excerpts and comments, once we analyze this record fully).

TRANSCRIPT GUIDE  AND ADVISORY:

  • The transcript was produced by a text-to-speech process performed automatically by a third party service outside of our control.
  • KrowneLaw does not vouch for its accuracy; indeed, we guarantee it is inaccurate.
  • As such, each snippet of translated text is linked directly to the point in the video at which it occurs (popup in separate window/tab).   Please use this functionality to confirm exactly what was said in each case.
  • The hearing covers a wide variety of topics; thus, cryptocurrency/blockchain-related terms have been highlighted to assist in quick location of the relevant passages (this highlighting is by no means exhaustive, however).
  • The breaks in the text coincide roughly with changes in topic/changes in Congressperson leading the questioning.  They do not correspond to changes in speaker; thus, each block usually represents multiple speakers, including those on “opposing sides.”  You must listen to each particular segment in the video to determine who is speaking and to get the full context (and therefore, meaning).

Scroll box with transcript follows:

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Congress Members Push Back Against SEC; Promise To Introduce Utility Token/SAFT-friendly U.S. Legislation

A routine House Financial Services Committee hearing held on May 16th, 2018, turned eventful when a number of U.S. Congressional representatives sprung “initial coin offering” (ICO-related) questions on SEC officials — most of them from a more positive and supportive perspective than the SEC’s Chairman Jay Clayton has evinced in his comments directed at the ICO sector for most of the past year.

At the hearing, Ms. Avakian  and Mr. Peikin, co-directors of the SEC’s Division of Enforcement, testified for the SEC.

Notable statements and exchanges included (emphasis added):

  • Rep. Sherman (28:21): “I hope you shut it all down” (in reference specifically to ICOs; Sherman goes on to contrast the supposedly-lax SEC treatment of ICOs with a perceived harshness faced by conventional filers merely “misstating a footnote”.)
  • Rep. Maloney (42:30): ” … there [has] been a strong debate about whether a token that is offered as an ICO can be a security when it is first issued to investors and then later evolved into something that is not a security; some people think that once it’s a security it’s always a security and the others think that the token status as a security can change over time. As far as I know this is not a decision that’s been decided by the SEC or the court, so I’d like to ask both of you do you believe it’s possible for a token to start as a security but then evolve to something that is not a security?”
    Ms. Avakian: “I think it’s always going to be a facts and circumstances test as to whether something meets the definition of a security, and if the substance of something changes over time that analysis is going to have to continue to happen — but we really do look at the substance of the transaction, not the name of it, not what it’s called, and look at, you know, does it fit the test for a security…”
    Rep. Maloney: “… have you seen any situations where [a coin going from a security to ‘utility’ status] has actually happened?”
    Mr. Peikin: “I mean we have dozens of investigations that are ongoing and one of the subjects of many of these investigations is evaluating whether or not a particular instrument is or isn’t a security. I don’t think I can speak to… the outcome of those because some of that work is ongoing. A lot of what we’ve seen though in these ICOs obviously looks and… meets the definition of securities.”
  • Rep. Maloney (44:14): “… chairman [Clayton] has stated, and I quote, ‘I believe every ICO I’ve seen is a security’ — do you agree with that statement?”
    Mr. Peikin: “I can’t speak to whether he’s seen the broad… gamut of instruments that our division is is investigating, so I certainly don’t dispute that what he’s seen he he believes is a security; the question… is whether some of the things that we’re looking at now, do they actually meet that definition, and I think… some more needs to be written on that.”
  • Rep. Emmer (01:10:10): “… as I’ve listened today, clearly I must have a different point of view when it comes to some of my colleagues on cryptocurrencies, and I will say that you just testified that these initial coin offerings present real risks to investors — but let’s not forget they also present real opportunities and we’re talking about a technology blockchain technology that has an amazing potential … “
  • Rep. Emmer (01:10:51): “… secretary Clayton has said ‘every initial coin offering is a security’ — that’s not what I heard you say; you’re reviewing these and you’re developing what your view is of the different types of cryptocurrency… problem is, a lot of people up here with white hair without hair or people that have been around for a while don’t even understand what they’re talking about and we worry that too much government could actually kill this thing before it can grow into something that’s very good for our economy…”
  • Rep. Emmer (01:12:46): ” … how does the SEC distinguish between an ICO and the sale of a token for use on a blockchain platform?”
    Ms. Avakian: “That’s always going to be a real facts and circumstances question, and again, we’re gonna take a step back and look at exactly what the substance of that particular transaction or token is not the name of it…”
    Rep. Emmer: “Is that [determination] evolving , because it could be a security, it could be a commodity, it could be a currency — there have to be some delineated lines so that people understand where they’re at and… who has jurisdiction over them, because we want to make sure that they’re continuing to explore the opportunity, and not just going out of business.”
    Ms. Avakian: “Yeah, I think that’s right — and we’ve spoken a lot publicly about it, certainly the Chairman’s spoken a lot publicly about it, you know to the extent something is a pure currency, pure medium of exchange, that’s not a security. I think we’re relying on the experts in the marketplace — the gatekeepers, the lawyers, others like that — to really take a step back and take a true look at what is the underlying substance of a transaction, and that’s really going to be I think what guides someone.  But we are… open in terms of having folks come to us and help work through that analysis.”
  • Rep. Davidson (01:19:00): “What do you make of these folks that are clearly cryptocurrency today, yet if they had raised capital, might be seen as security at the time —  how do you resolve that?”
    Mr. Peikin: “… we’re obviously… encountering [a] kind of new area with new products and changing technology, and some of these issues are being worked out in in the courts… as we speak… We’ve been focused on the tokens and crypto assets that fit the definition of a security, and the CFTC has been focused… on currencies and mediums of exchange, but you know I’m not sure I’m an expert to say… where that exact line is drawn, and I think some of this is going to be worked out… over time.”

And, the coup de grâce:

  • Rep. Davidson (01:20:02): “… Our office is working on an initial coin offering bill that would provide certainty about how a security is…  fundamentally, is the Howey test still relevant, what’s the role of SAFTs, is a white paper paper gonna cut it, or do you to use SEC forms that already exist — how do you advise proceeding forward with your office? …”

There is more discussion on ICOs, throughout — check out the full hearing record to get a complete picture.

We will not attempt to handicap the likelihood of this legislation coming to pass, but the comments do speak revealing to the presence of genuine advocates of ICOs and the new blockchain token asset economy in Congress.  As such, we find the exchange that transpired distinctly encouraging.

(No official transcript of the hearing has been released; however, video of the full session can be accessed here, and KrowneLaw has provided an approximate, marked-up automatic transcript of the entire hearing, below.)

TRANSCRIPT GUIDE  AND ADVISORY:

  • The transcript was produced by a text-to-speech process performed automatically by a third party service outside of our control.
  • KrowneLaw does not vouch for its accuracy; indeed, we guarantee it is inaccurate.
  • As such, each snippet of translated text is linked directly to the point in the video at which it occurs (popup in separate window/tab).   Please use this functionality to confirm exactly what was said in each case.
  • The hearing covers a wide variety of topics; thus, ICO-related terms have been highlighted to assist in quick location of the relevant passages (this highlighting is by no means exhaustive, however).
  • The breaks in the text coincide roughly with changes in topic/changes in Congressperson leading the questioning.  They do not correspond to changes in speaker; thus, each block usually represents multiple speakers, including those on “opposing sides.”  You must listen to each particular segment in the video to determine who is speaking and to get the full context (and therefore, meaning).

Scroll box with transcript follows:

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