As digital assets and cryptocurrencies have become an increasingly important part of the current financial landscape, market participants and their advisors have struggled with to answer the question whether or not the tokens and coins represent “securities” subject to the requirements of the federal securities laws. In a remarkably direct speech on June 14, 2018, SEC Director of Corporate Finance William Hinman provided some helpful guidance on the SEC’s approach to these digital assets. Among other important things in his speech, Hinman shared his view that Bitcoin and Ether are not “securities” under the U.S. securities laws. He also emphasized that all of the circumstances involving a digital asset, including in particular the way in which it was sold, will determine whether or not the asset is a security. The text of Hinman’s speech at the Yahoo Finance All Markets Summit can be found here.
At the outset of his speech, Hinman emphasized that the SEC will apply the facts-and-circumstances test enunciated in SEC v. W.J. Howey Co. to determine whether or not a sale of a digital asset is a sale of securities, with particular emphasis on the economic realities of the transaction. Under Howey’s four-part test, an instrument constitutes an investment contract, and is therefore subject to the federal securities laws, if the transaction involves: (a) an investment of money; (b) is made for a common enterprise; (c) with an expectation of profits; (d) derived from the efforts of others.
In discussing the Howey test in light of digital asset transactions, Hinman drew a distinction between digital assets that represent a set of rights granting a financial interest in a common enterprise and digital assets sold only for purposes of acquiring a good or service from an operational platform. The former are securities, while the latter are not. The label used for the instrument is irrelevant as is its form; “the emphasis should be on economic realities underlying a transaction.”
Hinman also emphasized the principles the federal securities laws. The securities laws’ disclosure regime is, Hinman emphasized, designed to try to eliminate “information asymmetries between investors and promoters. In a particularly interesting aspect of his speech, Hinman stated that a network may become sufficiently decentralized that the information asymmetries “recede” and investors no longer expect a third party to carry out managerial efforts with respect to the network. There may be, he said, sufficient decentralization of networks that regulating the digital assets on these networks may no longer be required.
In line with this analysis, Hinman then made the headline statements that have drawn so much attention to hisspeech. He declared that under this analysis Bitcoin and Ether are sufficiently decentralized that transactions in these assets are not securities transactions. He also noted that “there may be other sufficiently decentralized networks and systems where regulating them as securities may not be required.”
Of particular interest were Hinman’s comment that “whether something is a security is not static and does not strictly inhere in an instrument.” Ether, for example, may have initially been sold as part of a fundraising effort that accompanied the creation of its network, but the current decentralized structure and current offers of Ether are not securities transactions.
Hinman also highlighted the prong of the four-part Howey test focusing on the expectation of profit. What is critical here is the manner in which a digital asset is sold and the expectations of the purchasers in the transaction. Transactions where purchasers expect an investment return through their acquisition of the asset are likelier to be characterized as a security.
In a gesture of reassurance, Hinman emphasized that the SEC is willing to assist and he encouraged market participants to reach out to the SEC. “We are happy to help promoters and their counsel work through these issues. We stand prepared to provide more formal interpretive or no-action guidance about the proper characterization of a digital asset in a proposed use.”
Hinman concluded his remarks with a detailed list of the factors that will affect the SEC’s approach to the characterization of digital asset transactions. One set of questions concern the purposes and motivations of the third party and their expectations of a return. Another set of questions focus on the aspects of the structure of the digital assets relevant to the question of whether transactions in the assets represent securities transactions.
Hinman’s lists of questions are not meant to be exhaustive, but they do provide useful insight into the kinds of factors the SEC will be taking into account in order to determine whether or not specific transactions are subject to the federal securities laws. The challenge for market participants is that even with the benefit of Hinman’s remarks, the facts-and-circumstances test required under Howey still entails uncertainty. Over time, perhaps, greater regulatory clarity will develop as the SEC’s position on specific issues clarifies. In the meantime, Hinman’s comments will provide useful guidance as market participants seek to navigate these issues.