“Can a digital asset that was originally offered in a securities offering ever be later sold in a manner that does not constitute an offering of a security?”
Such was the question posed by William Hinman, Director of the Securities and Exchange Commission’s Division of Corporation Finance, in his speech at the Yahoo Finance All Markets Summit: Crypto event in San Francisco on June 14. Hinman’s answer: a qualified “yes” 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. This may be the most positive guidance yet from the SEC on when a digital asset might be deemed not to be a security under the Howey test. It may help create a pathway for blockchain startups to sell without registration or exemption digital tokens that had previously been sold in securities offerings, and should provide a measure of comfort to past and future issuers of SAFT-based ICOs.
After making his overarching point that a digital asset originally offered in a securities offering could be later sold in a manner that does not constitute an offering of a security when 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, Hinman went on to describe the circumstances under which he believes that could occur. In doing so, Hinman concentrated primarily on the last prong of the Howey test, namely whether an expectation of profit derived through the efforts of others, and suggested that the inquiry should focus on two areas: (i) who are the participants, and (ii) how is the digital asset structured?
Who are the Participants?
When determining whether a digital asset should be deemed to be an investment contract, Hinman stated that one should “consider whether a third party – be it a person, entity or coordinated group of actors – drives the expectation of a return.”
He suggested that this question will always depend on the particular facts and circumstances of a transaction, and offered the following non-exhaustive list of factors:
- Promoter’s efforts play a significant role in the development and maintenance of the digital asset and its potential increase in value.
- Promoter retains a stake or other interest in the digital asset such that he would be motivated to expend efforts to cause an increase in its value, particularly where purchasers are made to reasonably believe such efforts will be undertaken.
- Amount raised in the ICO exceeds amount needed to establish a functional network and use of proceeds includes supporting the token’s value or increasing enterprise’s value
- Promoter continues to expend funds from proceeds or operations to enhance functionality and/or value of system within which the tokens operate.
- No persons or entities other than the promoter exercise governance rights or meaningful influence.
How is the digital asset structured?
Hinman then pointed to the existence of contractual or technical methods to structure digital assets so they function more like consumer items and less like a security, including the following:
- 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?
Director Hinman also pointed out that one of the rationales for the securities laws is to remove the information asymmetry between promoters and investors by mandating adequate disclosure to address that asymmetry. That disclosure regime is needed when a token purchaser relies on a token seller’s efforts to develop a network and generate a potential return on investment for the token purchaser.
Conversely, when the promoter’s efforts are no longer an important factor in determining the enterprise’s success, “material information asymmetries recede” and the protections of the securities laws may no longer be necessary. Moreover, as a practical matter, when a network becomes decentralized, the ability to identify a promoter to make the mandated disclosures “becomes difficult, and less meaningful.”
Implication for SAFTs
The Simple Agreement for Future Tokens or SAFT is modeled after Y Combinator’s Simple Agreement for Future Equity, or SAFE, which has been a popular mechanism for funding startups. With both the SAFE and the SAFT, the investor receives a right to something of value in the future in exchange for the current investment. With a SAFE, the investor gets the right to receive the security issued in the issuer’s next major funding round, typically preferred stock and usually at a discount to the next round’s price. In a SAFT, the investor is given the right to receive tokens, also at a discount, typically once the network is created and the tokens are fully functional.
In a SAFT-based ICO, the SAFT itself is generally acknowledged to be an investment contract and thus a security, and sold to accredited investors under Rule 506(c) of Regulation D. A quick search on EDGAR reveals there have been 37 Form D filings identifying the type of security offered as a SAFT. No court or regulator has interpreted the SAFT framework and whether or not the tokens to be ultimately issued are securities.
Director Hinman’s view that certain tokens initially issued by blockchain startups as securities may have the potential to become part of a decentralized network and no longer bear the attributes of securities may give legitimacy to SAFT-based ICOs. Interestingly, the only place where the word SAFT appears in the speech is in footnote 15 of the written version. In that footnote, Hinman states that although nothing in his remarks should be construed as opining on the legality of a SAFT (because the analysis of a particular SAFT must turn on the economic realities of the particular case), “it is clear from [his speech that he believes] that a token once offered in a security offering can, depending on the circumstances, later be offered in a non-securities transaction.”