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SEC Releases Long-Awaited Guidance on ‘Investment Contract’ Analysis for Digital Assets

April 10, 2019

In recent guidance the US Securities and Exchange Commission provides detailed “investment contract” analysis applicable to digital assets, which will have a significant impact on the design, transfer, sale, and trading of cryptoassets and digital tokens in the United States.

It has been nearly a year since the Staff of the US Securities and Exchange Commission (SEC or Commission) released noteworthy clarification for market participants on the application of federal securities laws to digital assets. On April 3, however, the SEC Staff released a statement and a no-action letter that may have significant impact on the fintech community, particularly with respect to the vexing question of whether and when a digital asset is considered an “investment contract,” and therefore a “security,” such that the issuance, sale, and exchange of such digital assets, including token offerings or initial coin offerings (ICOs), will be subject to the registration requirements under applicable federal securities laws.

First, the SEC’s Strategic Hub for Innovation and Financial Technology (FinHub) published the Framework for ‘Investment Contract’ Analysis of Digital Assets (Framework). The Framework provides additional and more detailed guidance than has otherwise been made public for analyzing whether a digital asset is offered and sold as an investment contract under the so-called Howey test, and it reiterates and enhances the previous guidance given in a June 2018 speech on this topic by SEC Director of Corporation Finance William Hinman. The Framework is not a rule, regulation, or statement of the SEC and therefore is not binding on the SEC. Instead it provides a more robust analytical tool to help market participants assess whether the offer, sale, or resale of a particular digital asset or token may implicate federal securities laws under the Howey test.

At the same time, the SEC Division of Corporation Finance for the first time granted relief for a No-Action Request (the No-Action Letter) to a company seeking to offer and sell digital assets without registration under the federal securities laws. The No-Action Letter involves a blockchain-based digital asset in the form of “tokenized” jet cards, which can be used for prepaid on-demand air charter services, and allow for more efficient settlement and payment of such services for consumers via blockchain technologies. The facts underlying the No-Action Request represent a clear-cut example of a digital asset that does not constitute a security, as the token is consistent with the well-established precedent of the SEC recognizing similar assets as outside the purview of an “investment contract,” such as street car tokens for rides, holiday gift certificates for merchandise, and redeemable trading stamps for goods. Consequently, it is unclear whether the No-Action Letter provides significant new or helpful guidance on tackling the more difficult cases where the facts are less certain and clear.

The Framework

As noted above, the standard of review for analyzing whether a digital asset is an “investment contract” and therefore a security under the federal securities is set forth in the US Supreme Court case SEC vs. Howey. 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. In most cases involving the issuance and sale of digital assets or tokens connected to a blockchain network, or a typical ICO, there is usually no question that there was an “investment of money in a common enterprise.” Accordingly, the most difficult and challenging analysis revolves around the other elements of Howey test, i.e., the expectation of profit from the efforts of others. Accordingly, the Framework focuses primarily on these two elements and provides a nonexhaustive list of factors that are relevant in such inquiry.

Reliance on the Efforts of Others

The Framework focuses on two key issues in analyzing whether purchasers of digital assets or tokens are relying on the efforts of others: (1) Does the purchaser reasonably expect to rely on the efforts of an active participant, and (2) Are those efforts “essential managerial efforts” as opposed to “efforts that are more ministerial in nature”? 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.

The Framework provides a detailed description of various factors that should be examined in the test, including specific examples and cases under the following categories of factors:

  • Whether the Active Participant is responsible for the development, improvement (or enhancement), operation, or promotion of the network.
  • Whether the AP will conduct further developmental efforts of a network that is not fully functional.
  • Whether the AP’s tasks are minimal due to a “decentralized” network.
  • Whether the AP creates or supports a market or the price of the digital asset.
  • Whether the AP has a lead or central role in the direction and governance of the ongoing development of the network or digital asset.
  • Whether purchasers would reasonably expect the AP to undertake efforts to promote its own interests and enhance the value of the network or digital asset.
  • Whether the efforts of the AP, including any successor AP, continue to be important to the value of an investment in the digital asset.
  • Whether the network on which the digital asset is to function operates in such a manner that purchasers would no longer reasonably expect the AP to carry out essential managerial or entrepreneurial efforts.
  • Whether the efforts of the AP are no longer affecting the enterprise’s success.

Reasonable Expectation of Profits

In addition to reliance on the efforts of the AP, the Framework considers the “reasonable expectation of profit” prong of the Howey test and provides a list of factors and specific examples that are relevant in the analysis, including the following:

  • Whether the digital asset gives the holder rights to share in the enterprise's income or profits or to realize gain from capital appreciation of the digital asset.
  • Whether the digital asset is transferable or traded on or through a secondary market or platform now or in the future.
  • Whether purchasers reasonably would expect that the AP's efforts will result in capital appreciation of the digital asset.
  • Whether the digital asset is offered broadly to potential purchasers as compared to being targeted to expected users of the goods or services.
  • The correlation between the purchase/offering price of the digital asset and the market price of the particular goods or services that can be acquired in exchange for the digital asset.
  • The correlation between the quantities the digital asset typically trades in and the amount of the underlying goods or services a typical consumer would purchase for use or consumption.
  • Whether the AP has raised an amount of funds in excess of what may be needed to establish a functional network or digital asset.
  • Whether the AP is able to benefit from its efforts as a result of holding the same class of digital assets as those being distributed to the public.
  • Whether the AP continues to expend funds from proceeds or operations to enhance the functionality or value of the network or digital asset.
  • What methods the AP uses to market the digital assets.

In addition, the Framework provides a list of factors for evaluating whether a digital asset previously sold as a security should be reevaluated under the “reasonable expectation of profits” test.

Other Relevant Considerations

The Framework also includes a list of other relevant factors derived primarily from federal court cases analyzing the economic reality of the transaction, including the following factors:

  • Whether the distributed ledger network and digital asset are fully developed and operational.
  • Whether 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.
  • Whether the digital asset’s 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.
  • Whether prospects for appreciation in the value of the digital asset are limited.
  • Whether the digital asset can be used immediately to make payments in a wide variety of contexts, or acts as a substitute for real (or fiat) currency.
  • Whether the digital asset can be redeemed within a developed network or platform to acquire or otherwise use those goods or services.
  • Whether any economic benefit that may be derived from appreciation in the value of the digital asset is incidental to the right to use it for its intended functionality.
  • Whether 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, whether transfers of the digital asset may only be made by and among users of the platform.

We note that the above discussion represents only a summary of the Framework and the most relevant factors; readers are encouraged to consult with us to obtain a full understanding of the Framework as it applies a specific digital asset.

No-Action Letter

The relief granted under the No-Action Letter involves a blockchain-based digital asset in the form of “tokenized” jet cards (tokens) issued by TurnKey Jet, Inc. (TKJ), an existing and fully operational company providing interstate air charter services as a licensed US air carrier and air taxi operator. TKJ proposes to launch a Token membership program and develop a token platform to facilitate token sales for air charter services via a private blockchain network. TKJ will manage the program. Consumers will buy tokens, which TKJ will sell only at a price of one US dollar (USD) per token throughout the life of the program, and consumers can redeem the tokens in exchange for air charter services through the platform in a more efficient and user-friendly manner.

The tokens’ design is substantially identical to redeemable points for business jet card programs that are fairly typical in the aviation industry. The tokens will not represent any obligation by TKJ to supply a specified number of flight hours and will not confer any other governance, profit-sharing, or other rights associated with an equity holder. Instead, the tokens will represent an obligation to supply air charter services at a 1 USD:1 USD value. When tokens are purchased and enter into circulation on the platform, TKJ customers may freely trade or exchange the tokens only to other customers and affiliated persons, and TKJ will implement transfer restrictions so that the tokens can be transferred only to designated TKJ wallets on the platform and not outside the platform. Any improvement and construction of the platform will be funded by TKJ through its own capital resources and not from the proceeds of token sales.

Based on the facts presented and following the application of the Howey test, the SEC stated it would not recommend enforcement action against TKJ in reliance on the opinion that the tokens are not securities in the event that TKJ offers and sells the tokens without undertaking registration under the federal securities laws. Specifically, the SEC pointed out the following facts as the most relevant factors for this decision:

  • TKJ will not use any funds from token sales to develop the platform and related network and apps, and each of these will be fully developed and operational at the time any tokens are sold.
  • The tokens will be immediately usable for their intended functionality at the time they are sold.
  • TKJ will restrict transfers of tokens to its wallets only, and not to wallets external to the platform.
  • TKJ will sell tokens at a price of one USD per token throughout the life of the program, and each token will represent an obligation by TKJ to supply air charter services at a value of one USD per token.
  • If TKJ offers to repurchase tokens, it will only do so at a discount to the face value of the tokens (one USD per token) that the holder seeks to resell to TKJ, unless a court orders TKJ to liquidate the tokens.
  • The token is marketed in a manner that emphasizes the functionality of the token, and not the potential for an increase in market value of the token.

Takeaways of Framework and No-Action Letter

It is clear from the Framework and the No-Action Letter that the SEC continues to take a cautious and conservative view on the characterization of digital assets, refusing to break new ground that would allow a more flexible interpretative approach to the Howey test. This position is not surprising given that the SEC has previously stated that most ICOs and token offerings are securities offerings subject to the registration requirements under the federal securities laws.

As the new guidance reinforces and reiterates this position with more clarity and certainty, several important practical consequences will follow on the future of token offerings or ICOs in the United States. First, it will continue to decelerate and diminish incentives for startups and emerging growth companies to use token offerings as a means to raise capital to fund operations. Given that the No-Action Letter prescribes a set of very stringent criteria for designing a nonsecurity token, it will be difficult if not impossible for any early-stage or even late-stage company to rely on token offerings to raise capital efficiently. Second, the trend toward a security token offering or a registered token offering will continue to gain momentum in the United States. We have already seen companies structuring token offerings as private placement under Rule 506(c) of Regulation D of the Securities Act, which will likely continue. We also expect more companies to consider utilizing Regulation A+ to qualify token sales, or even to file a registration statement under the Securities Act in an effort to have tokens that may be distributed broadly to the public. Finally, we are likely to see an acceleration of forum shopping by companies for token offerings, particularly focusing on jurisdictions where the regulatory environment is more favorable. This may pose a risk of continuing the outflow of technology innovation and creativity from the United States to other countries.


If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Laurie Cerveny
Michael Conza
Bryan Keighery
Carl Valenstein
Julio Vega

Torsten Schwarze

Hong Kong
June Chan
Rosita Chu
Eli Gao
Louise Liu
Edwin Luk
Billy Wong

Thomas J. Cartwright
Timothy J. Corbett
Iain Wright

Carter Brod

New York
Thomas P. Giblin, Jr.
John T. Hood
Christopher T. Jensen
Howard A. Kenny
Jeffrey A. Letalien
Christina Melendi
Finnbarr D. Murphy
David W. Pollak
Kimberly M. Reisler

Justin W. Chairman
James W. McKenzie
Joanne R. Soslow

Celia Soehner

Silicon Valley
Albert Lung
E. John Park

Bernard Lui
Joo Khin Ng

Washington, DC
Sean Donahue
Keith E. Gottfried
Linda L. Griggs
Andrew M. Ray
David A. Sirignano
George G. Yearsich