Review of SEC's Framework - How to apply Howey Test on Digital Assets
SEC's Public Statement released on April 3, 2019
It is a great start! It is a big help for not only the startups in crypto space but also to the existing businesses in this space that can expand their offerings with more clarity.
It does a very good job in dissecting each part of the Howey Test with respect to its application in analyzing digital assets in crypto space. You can go through the original publication here.
Here is the part that is most critical for majority of DLT based startups.
Under the Howey test, 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.
The 1st and 2nd prong, are typically satisfied. The 3rd prong is where most of the analysis is performed. The new guidelines provides clarity by emphasizing that when profits are derived from the efforts of an unaffiliated, dispersed community of network users (commonly known as a "decentralized" network), it is not an "investment contract".
SEC also adds that even when there is a reasonable expectation of profits to be derived from the efforts of others, it may still be not a security. This is the most interesting addition and it says that the Digital Assets with certain types of consumtion characteristics are less likely to be investment contracts. Here is the details,
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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.
- With respect to a digital asset referred to as a virtual currency, it can immediately be used to make payments in a wide variety of contexts, or acts as a substitute for real (or fiat) currency.
- This means that it is possible to pay for goods or services with the digital asset without first having to convert it to another digital asset or real currency.
- If it is characterized as a virtual currency, the digital asset actually operates as a store of value that can be saved, retrieved, and exchanged for something of value at a later time.
- With respect to a digital asset that represents rights to a good or service, it currently can be redeemed within a developed network or platform to acquire or otherwise use those goods or services. Relevant factors may include:
- There is a correlation between the purchase price of the digital asset and a market price of the particular good or service for which it may be redeemed or exchanged.
- The digital asset is available in increments that correlate with a consumptive intent versus an investment or speculative purpose.
- An intent to consume the digital asset may also be more evident if the good or service underlying the digital asset can only be acquired, or more efficiently acquired, through the use of the digital asset on the network.
- Any economic benefit that may be derived from appreciation in the value of the digital asset is incidental to obtaining the right to use it for its intended functionality.
- The digital asset is marketed in a manner that emphasizes the functionality of the digital asset, and not the potential for the increase in market value of the digital asset.
- Potential purchasers have the ability to use the network and use (or have used) the digital asset for its intended functionality.
- Restrictions on the transferability of the digital asset are consistent with the asset's use and not facilitating a speculative market.
- If the AP facilitates the creation of a secondary market, transfers of the digital asset may only be made by and among users of the platform.
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First No Action Letter:
SEC also published its first “no-action letter,” allowing TurnKey Jet LLC to initiate a token sale.
It is a big deal and a cause for celebration to all crypto champions out there.