The SEC finally published their long-awaited ‘Framework for Investment Contract Analysis of Digital Assets,’ or colloquially known as the ‘Crypto Token Framework.’ While an important step in detailing the guidelines for issuing digital assets in compliance with federal regulations, the framework is not exhaustive — as cited by the SEC.
“The framework is not intended to be an exhaustive overview of the law, but rather, an analytical tool to help market participants assess whether the federal securities laws apply to the offer, sale, or resale of a particular digital asset,” the public statement on the publication details.
While the reaction to the publication of the SEC’s guidelines has been mixed so far, it will likely take time to play out as pending ICOs, IEOs, and other token models come to the forefront under new regulatory scrutiny.
Understanding the Framework and What Constitutes a Security
The primary focus of the published framework is to provide more definitive information on what digital assets should be considered a regulated security and requires registration with the SEC. The topic has been covered exhaustively in the crypto space, as many ICOs refer to their native tokens as ‘utility tokens,’ which has been disputed by both many industry observers and regulators since the 2017 ICO craze.
The publication by the SEC is not official rules, regulation, or laws, but rather the views of the SEC staff in evaluating various aspects of digital asset projects including issuance, marketing, facilitating exchanges, and more to determine whether a token falls under their jurisdiction. As such, it should be prudently evaluated by any projects planning on offering a token or digital asset in the future.
The bulk of the publication centers on applying the Howey Test to digital assets, which is prescribed by the SEC as the following:
“The U.S. Supreme Court’s Howey case and subsequent case law have found that an ‘investment contract’ exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.”
An ‘investment contract’ is what they consider to be a security within the context of the framework. The SEC applies the Howey Test to digital assets within the confines of three areas:
- The Investment of Money
- Common Enterprise
- Reasonable Expectation of Profits Derived From Others
According to the SEC, digital assets meet the criteria for the first two areas as they involve the sale of a financial asset and most digital asset projects consist of a distinct element of an investment contract — a ‘common enterprise.’ However, it is the third area where the most ambiguity, speculation, and majority of the published framework exist.
According to the framework:
“A purchaser may expect to realize a return through participating in distributions or through other methods of realizing appreciation on the asset, such as selling at a gain in a secondary market. When a promoter, sponsor, or other third party (or affiliated group of third parties) (each, an “Active Participant” or “AP”) provides essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts, then this prong of the test is met.”
Taking that portion of their framework into account, and it is evident that an outsized portion of digital assets likely fall under securities law in the eyes of the SEC. The framework subsequently breaks down the third area into a further three subsections that help articulate whether or not the ‘Reasonable Expectation of Profits Derived From Others’ prong of the Howey Test has been met, including:
- Reliance on the Efforts of Others
- Reasonable Expectations of Profit
- Other Relevant Considerations
Iterating through each of the points made within the three subsections reveals a pretty straightforward perspective that the SEC staff considers the vast majority of ICOs to fall under securities law. Comparing most ICO white papers to the SEC’s published framework would lead to many matches between specific wording on the token issuance, distribution, and centralized development of the project and what the SEC classifies as a security.
However, among the ‘Other Relevant Considerations’ section, the SEC does highlight specific circumstances that would fall outside of their purview of a security. In particular, they reference an example of a token not considered an investment contract:
“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 example continues:
“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.”
While just a specific example, it represents a case that does not align with most ICOs — especially since many of them do not even have working products.
Questions have been raised about ambiguous portions of the framework, notably, regarding the language about custody for broker-dealers and explicit definitions for terms such as ‘active participants’ that might impact projects and the framework’s influence on foreign startups with tokens. On the contrary, other observers view the guidelines as an evident indication that the SEC considers most ICOs securities — a common sentiment among people who are skeptical of the sustainability and structure of ICOs that defined the latter months of 2017.
In other relevant news, the SEC’s framework publication coincided with their first ‘no action’ letter for cryptocurrencies — involving TurnKey Jet, Inc. The letter officially enables the firm to proceed with the sale of the TKJ token to its customers with the sole intention of booking travel on private planes. TurnKey actually contacted the SEC prior to its sale, something that the agency has expressed as a preference of theirs for digital asset issuance.
Overall, the publication of the SEC’s framework for digital assets is an important step for what has been an arduously slow unveiling of regulatory guidelines. Although not definitive regulatory standards or established law on digital assets, the crypto framework by the SEC staff indicates that what happened with ICOs in 2017 will very likely be an anomaly in the market’s long-term outlook as most of them classify as securities.
This is the first part of our analysis of the SEC framework. Click here for Part 2: Comparing the SEC Crypto Framework to Global Positions on ICO’s and Tokens