On June 14, 2018, William Hinman, Director of the Division of Corporation Finance (“CorpFin”) of the Securities and Exchange Commission (“SEC”), delivered prepared remarks at the Yahoo Finance All Markets Summit: Crypto, addressing the treatment of tokens and token offerings under the Securities Act of 1933, as amended (the “Securities Act”). Titled “Digital Asset Transactions: When Howey Met Gary (Plastic),” the remarks of Director Hinman provide very helpful insights on CorpFin’s thinking about the circumstances in which tokens could be deemed securities and when features of and promises in an offering of tokens could be deemed to create a separate security.1
Director Hinman’s remarks reaffirm the position that offerings of cryptoassets need to be viewed and analyzed within the framework of existing laws and regulations (as opposed to the view that new laws and regulations are needed to address this new asset class). While Director Hinman’s remarks are not an official SEC position, they do reveal the thinking of CorpFin on this subject and provide issuers, investors and their advisors with significant comfort that conclusions in line with the gist of Director Hinman’s remarks should withstand scrutiny by the SEC.
The headlines that swept the cryptoassets community immediately after Director Hinman’s remarks ran along the lines of, “SEC Concludes Ether is not a Security!”2 While these (somewhat inaccurate)3 headlines answered an important question for many in the community, from our perspective other comments may have much more significance for offerings of cryptoassets. Below is a summary of some of the Director’s remarks:
- Utility Tokens Are Possible: Director Hinman unfortunately does not address this important subject in significant depth, but his remarks signal a path forward for issuances of utility tokens. This would require that (a) the token provided is structured for utility purposes only and has no aspects of a security, (b) the network on which the token will be used is up and running, (c) the token is distributed or offered to participants who need the tokens to access the functionality the network, and (d) it is clear that purchasers of the tokens are not making an investment in the enterprise.4
- It’s the Offering, Not Necessarily the Token: Invoking the Howey5 and Gary Plastic6 cases, Director Hinman points to past examples of non-securities that were offered in a way that resulted in the offering of investment contracts, which are securities. These comments re-emphasize the position that adding certain features or promises to a non-security can result in the creation of an investment contract and therefore an offering of securities, even if the tokens themselves are not otherwise securities. Of course, if the tokens are securities to begin with (for instance, if the tokens offers features that make the tokens a security, such as the payment of dividends as cited in the DAO Report7), no Howey and Gary Plastic analysis is necessary to determine that the offer of such tokens is an offer of securities. Director Hinman also reiterated that the analysis of whether something is a security is not static and labelling of the security or token is not dispositive.
- A Token Initially Offered as a Security May Later Become a “Non-Security” Token: While the answer depends on a fact-specific analysis, the answer is “yes.” “In cases where the digital asset represents a set of rights that gives the holder a financial interest in an enterprise, the answer is likely ‘no’.”8 But the answer may be a qualified “yes” in cases “where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created.”9
- There Are Some Threshold Questions Issuers and Advisers Should Take into Consideration in Their Analysis: Stressing that the following list is illustrative, not exhaustive, Director Hinman offers these questions, which should be considered in assessing whether a digital asset offered is an investment contract and therefore a security:
- Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value?
- Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?
- Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?
- Are purchasers “investing,” that is seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?
- Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?
- Do persons or entities other than the promoter exercise governance rights or meaningful influence?10
- The Staff is Open to Dialogue and Will Look to the Economic Substance of the Transaction: Director Hinman states that the SEC staff “stands prepared to provide more formal interpretative or no-action guidance about the proper characterization of a digital asset in a proposed use”11 and offered additional guidance for promoters and their counsels to use in their analysis:
- Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?
- Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading?
- Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent?
- Are the tokens distributed in ways to meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?
- Is the asset marketed and distributed to potential users or the general public?
- Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?
- Is the application fully functioning or in early stages of development?
In summary, the remarks by Director Hinman are extremely helpful for issuers, promoters and advisers who try to structure offerings in a way that complies with the registration requirements of U.S. securities laws and viable from a business perspective. While the remarks do not have the force of law, to date they are the clearest expression of the views of the staff of CorpFin since the DAO Report.
If you have any questions regarding the above, please contact your Seward & Kissel contact attorney or any member of our Blockchain and Cryptocurrency Group listed below.
1 William Hinman, Director, SEC Div. of Corp. Fin., Remarks at the Yahoo Finance All Markets Summit: Crypto (June 14, 2018) (“Hinman Remarks”).
2 See, e.g., Anna Irrera, U.S. SEC Official Says Ether Not a Security, Price Surges, REUTERS (June 14, 2018, 4:24 PM).
3 Director Hinman in his remarks stressed that current offers and sales of Ether are not securities transactions: “And 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 (emphasis added).” Hinman Remarks.
4 “(O)nce the network is up and running, distribute or offer blockchain-based tokens or coins to participants who need the functionality the network and the digital assets offer. This allows the tokens or coins to be structured and offered in a way where it is evident that purchasers are not making an investment in the development of the enterprise.” Hinman Remarks.
5 SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
6 Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 756 F.2d 230 (2d Cir. 1985). Gary Plastic involved the offering of certificates of deposit, which the U.S. Supreme court has held are not securities for purposes of federal securities laws, by a broker that made additional promises, such as making a market in the certificates of deposit for the purpose of achieving trading profits. It was these additional promises that resulted in the creation of an investment contract by the broker.
7 Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Securities Act Release No. 81207 (July 25, 2017) (the “DAO Report”).
8 Hinman Remarks.